Hedge funds: go slowly but surely

Cool heads are required if the right decision is to be made.

Law-making in the European Union poses challenges. One of them is knowing when to pick up the pace and when to slow it down; when to force the issue to a decision and when to take a breather. This week, Elena Salgado, Spain’s finance minister, opted to slow things down, postponing a discussion at the EU’s council of finance ministers on a proposal to regulate hedge funds, the directive on alternative investment fund managers. She said she wanted more time to reach more agreement – particularly given the objections still outstanding from the UK, which is protective of the interests of the City of London.

There are some – notably Nicolas Sarkozy, France’s president – who are impatient to crack down on hedge funds. There are others – particularly in the City of London – who protest bitterly that hedge funds were not the cause of the financial and economic crisis and are being wrongly made scapegoats. But the city financiers cannot expect a sympathetic hearing. Lawmakers – and voters – are not inclined to make finely calibrated distinctions between different types of investor.

Rather, they know that the financial-services industry, in its various guises, did some very stupid things and in some cases some very wicked things. The upshot – after bail-outs for banks – is a mountain of debt for most European countries, which taxpayers will be paying off for years to come. A regulatory backlash is to be expected.

The principle that hedge funds should be regulated has already been decided. Leaders of the G20 countries agreed at their meeting in London in April last year that there should be new arrangements for registration, reporting and oversight of hedge funds. The decision is correct: some hedge funds are so large that they can pose a systemic risk to financial stability.

But the decision in principle was only the easy bit. The more difficult task is how to shape the implementing legislation and how to achieve, across the various jurisdictions around the world, sufficient consistency as to discourage regulatory arbitrage, where hedge funds go shopping for the most benign (ie, passive) regime.

The Basel-based Financial Stability Board has a taskforce assessing the adequacy of regulatory regimes, both national and international, around the world.

The European Commission’s proposal for a law regulating alternative investment fund managers is an attempt at such regulation on behalf of the EU. It has provoked a predictable howl of protest from the London-based hedge-fund groups and dire warnings from the City’s supporters that the hedge-fund industry will leave the EU. Since most of the EU’s financial industry is concentrated in London, other member states have less to lose and are less sympathetic.

Nevertheless, Salgado has acceded to a request from Gordon Brown, the UK prime minister, to defer a Council decision. Brown has bought more time, much to the irritation of France.

But a delay is not a complete reversal of policy: there will still be regulation of hedge funds. What is surely important is that the EU gets its regulatory framework right. The challenge – for Commission staff, as for finance ministers and MEPs – is to get a good handle on the possible risks and the possible effects of the proposed legislation. Bad laws could, in the medium to long term, be very damaging to the EU’s credibility and to its commerce.

The same difficulties apply to proposals that will be forthcoming on regulating over-the-counter derivatives. There are horribly technical issues to be resolved before the EU can have legislation in place. But the principle – that there must be greater transparency – is now a given, even if arguments still rage about the scope of the legislation.

There is a fine judgement to be made. A crisis has created the political impetus for legislation. But cool heads are required. If the lawmakers rush, they risk getting the technical details wrong. If they delay too long over the details, they lose political momentum. Salgado’s decision is right, but hedge funds are not to be let off the hook.

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