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| Financial Law Update | Back to article summary. |
| Implications of MiFID for hedge fund managers | ||
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| The Markets in Financial Instruments Directive (MiFID) will have significant implications for all asset managers, including hedge fund managers, located in the EU/EEA, as those who aren't prepared for it by November 2007, 'may have to cease trading'. In this article Joe Beashel partner at Matheson Ormsby Prentice examines the implications of the directive for the hedge fund industry, and warns that 'implementation cannot be put on the long finger'. | ||
The Markets in Financial Instruments Directive (MiFID), due to be effective across the EU/EEA from 1 November 2007, will have significant implications for all asset managers including hedge fund managers located in the EU/EEA. As part of the European Commission’s Financial Services Action Plan, it seeks to allow investors to invest and obtain investment services on a pan-European basis more easily, to foster competition between trading venues in Europe including venues which are not stock exchanges, to improve the effectiveness of the EU passport for investment firms and to ensure standardised levels of protection for investors across Europe.
MiFID is not intended to affect the organisation or distribution rules for hedge funds themselves, which will continue to be regulated individually by member states. What should you do? MiFID is very broad in scope, it includes both a range of principles and many detailed prescriptive requirements. The precise impact of MiFID will vary from firm to firm therefore it will be essential for every firm, if they have not already done so, to carry out an assessment of what the directive will likely mean for their organisations. In particular firms should consider:
The importance of commencing an implementation project has been highlighted by the UK-based Alternative Investment Management Association (AIMA) as recently as June 8th. Matthew Jones, regulatory and legal manager at AIMA, is quoted as saying 'in the worst case scenario, a hedge fund manager that does not have its arrangements in place by then [November 2007] may have to cease trading until they are MiFID compliant'. Which rules apply? Although MiFID seeks to harmonise the rules and approaches to many issues, across Europe some variations are inevitable, particularly at the interface between MiFID and existing rules and regulations. Fund managers will therefore need to look to their principle regulator and its implementation process in order to assess the full implications of MiFID. In the case of hedge fund managers this will most likely be the UK’s Financial Services Authority (FSA). It is estimated that managers authorised in the UK manage 15-20 per cent of global hedge fund assets with much of the balance managed in the US, where estimates are that hedge fund managers located there manage 70 per cent of global hedge fund assets (source: TASS and FSA). Only time will tell whether implementation of MiFID and indeed other recent directives aimed at building European capital markets will influence these market shares. The FSA has taken a very pro-active approach to MiFID, publishing (or planning to publish) general guides, a detailed implementation plan, discussion and consultation papers on matters such as best execution, systems and controls, reforming conduct of business rules and financial promotions. The hedge funds themselves are normally domiciled offshore in jurisdictions such as the Cayman Islands and in respect of UK-based hedge fund managers, the administrations are generally carried out in Ireland. It is not expected that MiFID will affect this structure. MiFID does contain detailed rules on outsourcing but in the typical structure outlined above, the Irish administrator will be a service provider to the Cayman-domiciled fund rather than being a delegate of the UK-based hedge fund manager and as such will not be caught by these requirements. What are some of the key changes? The changes will be internal: that is, organisational changes will be required, and external in that client facing processes such as client categorisation, client agreements, execution and client order handling will need to be adapted. Internal Hedge fund managers will, where 'appropriate and proportionate in view of the nature, scale and complexity of their business', be required to have an independent risk management function and an internal audit function in addition to a compliance function. Even where the absence of a separate risk management function is justifiable, MiFID will require the establishment, implementation and maintenance of adequate risk management policies and procedures to identify and manage risks. These policies and procedures must be'consistently effective'. Meeting these and other organisational requirements will likely add to the compliance costs of many hedge fund managers. External A client classification system which divides clients into 'retail' 'professional' and 'eligible counterparty' will be introduced. Hedge fund managers will need to examine their clients against the MiFID criteria and compare with existing rules. In the UK they compare with the current classifications of'private', 'intermediate' and'market counterparties' though the definitions vary significantly. Although MiFID will not require all clients to be're-papered' all will be required to be informed of their post-MiFID classification. Depending on the current classification criteria, more clients might be classified has'retail' which will have important knock-on implications as many new MiFID obligations will be introduced for retail clients. For example, a detailed best execution policy will be required for retail clients. Best execution in this context requires a firm to deal on terms most favourable to the client, taking into account factors such as cost, speed, likelihood of execution and settlement, size, nature and other factors set out in the directive. Clients will be entitled to a copy of the policy and will have a right to question whether best execution has been achieved in particular cases. In addition, the policy must be reviewed annually. As MiFID permits clients to 'opt down' classification, hedge fund managers may have to be able to deal with clients classified as 'retail', perhaps for the first time. Conclusion Although many aspects of MiFID are still uncertain, the fact is that the broad scope and potentially far reaching and expensive changes which MiFID will necessitate for hedge fund managers mean that implementation cannot be put on the long finger. Hedge fund managers should act now to examine the implications of the directive for their businesses and plan the implementation process. Failure to do so could result in a hasty and expensive last minute implementation or worse, lead to a threat to the business itself. |
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Joe Beashel is a partner in the banking and financial services department at Matheson Ormsby Prentice, and is head of the firm’s regulatory risk management and compliance group. |
