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EFRP warns hedge funds could flee EU regulation

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EUROPE - The European Federation for Retirement Provision has warned the European Commission against "rushing into ill-considered regulation" of hedge funds, as it believes "too stringent regulation" would encourage hedge funds to serve their clients from outside the EU".

The Federation has suggested, in its response to an EC consultation on hedge fund regulation, emphasis should be placed on the current system of indirect regulation through financial institutions with systemic relevance, and further argued calls for transparency could be best dealt with by elaborating on the best practices put forward by the hedge fund industry.

The Commission's consultation will result in a public hearing on 26 and 27 February while a parallel consultation is being conducted by the globally coordinator of hedge fund regulation the International Organisation of Securities Commission (IOSCO). Both bodies will feed their suggestions into the G20 summit, which is to be held in London, in early April.

Looking closely at the EC consultation, the EFRP noted the European Commission has identified IORPs (pension funds) as investors of up to 3% of its €2.88trn in total funds held in hedge funds for pension provision. It is the larger pension funds, with more in-house back office support, which tend to have more direct exposure.

Arguing a case in support of hedge funds, the EFRP said they play a crucial role in financial markets by providing liquidity and efficient pricing of financial instruments, and improve the risk-return characteristics of IORPs' investment portfolios by enhancing diversification.

Moreover, the EFRP claimed hedge funds provide attractive absolute returns with low volatility and little correlation with other asset classes as well as appearing to be a good hedge against inflation risk.

While there has been opposition elsewhere in Europe to the concept of short-selling, EFRP acknowledged pension funds gain direct benefit from this activity as they are a prime source of securities lending, though added short-selling did not contribute to the overall fall in equity markets.

The better investment opportunities offered by hedge funds means IORPs can provide pension plan members with higher retirement benefits at lower risk, claimed the body, while misuse of short-selling can be dealt with through the Market Abuse Directive.

Significantly, the EFRP added it is unlikely that the unwinding of some hedge funds has significantly aggravated the fall in overall asset prices, since most hedge fund strategies have low net exposure to financial markets through both long and short positions on the buying and selling of shares.

Officials also stated hedge funds should not be seen as the root of the financial crisis, but rather have also been hit by the effects of the turmoil, such as low liquidity, tough borrowing conditions, and the flight to safety by investors.

EFRP suggested any regulation should be targeted at the banking sector which has, within the last six months, been found to be very sensitive to adverse financial shocks but also plays a crucial role in the proper functioning of global economies.

Referring to Madoff, the EFRP noted some hedge funds exist that might be considered to have poor risk management in place and argued that scandal could probably have been prevented by a clear separation of the manager, custodian and administration functions.

At the same time, however, the institutionally-focused EFRP cautioned against giving retail investors direct access to hedge funds requiring extensive financial knowledge, but should instead investment in funds-of-funds.

Among the other responses submitted to the EC consultation, the CFA Institute, which represents investors, said it sees one regulatory solution might be to have the prime brokers, which provide loan services to hedge funds, share information and reveal leverage ratios.

And the European Banking Federation is also against "product-specific regulation", but has instead come down in favour of a self-regulatory code of conduct.

If you have any comments you would like to add to this or any other story, contact Julie Henderson on + 44 (0)20 7261 4602 or email julie.henderson@ipe.com

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