Hedge funds regulatory update

In this edition, we:

• consider the FCA’s recent statements and publications and their relevance to hedge fund managers;
• review developments at a European level which apply to hedge fund managers with European operations or European exposures; and
• provide an overview of regulatory pronouncements in respect of the Covid-19 pandemic and how these might impact hedge fund managers.

FCA updates

Short selling bans

As hedge fund managers will know, many national regulators introduced short selling restrictions as a result of Covid-19. No short selling restrictions were imposed by the Financial Conduct Authority (FCA) of their accord in the UK although the FCA did comply with the decision of the European Securities and Markets Authority (ESMA) to amend the threshold for reporting net short positions from 0.2% of issued share capital to 0.1%.

The FCA has published a webpage noting that, as of 18 May 2020, short selling restrictions have been lifted by regulators in Austria, Belgium, France, Greece, Italy and Spain, which will be welcome news to market participants. We have covered the short-selling bans in more detail in our briefing, “Short-selling bans and calculating short selling positions”.

FCA updates position limits in respect of commodity derivative contracts

On 5 May, the FCA published updated position limits for certain commodity derivative contracts traded on UK trading venues. The reason behind the change appears to be a recognition by the FCA that the 2,500 lot limit could impair markets’ function at a time when market conditions are changing rapidly. Nonetheless, the FCA will announce a revised limit in due course but will give two months’ notice before those limits come into force.

FCA business plan 2020/21

General/Covid-19

The FCA has released its business priorities for this coming year. While Covid-19 has changed the FCA’s approach, most of the regulatory priorities for alternative fund managers which we identified in our briefing in early February remain relevant, as we mentioned in our latest “Private funds regulatory update”.

For the time being, in order to face challenges posed by the Covid-19 pandemic, the FCA will focus on ensuring that, amongst other priorities:

• markets function well; and
• the impact of firm failure is minimised.

The FCA says it is able to change the business plan if amendments are required due to the pandemic. We have considered the FCA’s expectations for asset managers in connection with Covid-19 in an earlier briefing.

Culture, governance and SMCR

For alternative fund managers in 2020, there needs to be a focus on governance. In particular, Senior Managers and Certification Regime (SMCR) implementation for solo-regulated firms, such as hedge fund managers, remains important and it should not be treated as a separate project.

In line with the FCA’s increasing focus on culture in financial services, the business plan notes that the FCA’s aim is to assess and address the drivers of culture, the four major drivers being purpose, leadership, approach to rewarding and managing employees and governance.

Critically, the FCA refers to the fact that it expects regulated firms, such as hedge fund managers, to comply with the requirements of the SMCR and that it wants to foster business cultures where conduct and fair customer outcomes are central.

The FCA has also stated that it is going to prioritise effective governance in the investment management sector and expects firms to implement the SMCR properly in order to achieve this. Clearly, the investment management sector is very broad. Nonetheless, hedge fund managers should be aware of this regulatory focus and consider not only their SMCR implementation but also whether their governance structures are sufficient to meet regulatory requirements.

Exposing alternative funds to retail investors

Fund managers offering products and managing investments with exposure to alternative assets and strategies ought to consider the appropriateness or suitability of those investments for their target investors.

As part of this assessment, alternative fund managers, such as hedge fund managers, should ask questions such as whether the client type and investment need has been properly identified.

The FCA has expressed, in its business plan, a desire to address harm to consumers by ensuring that, amongst other things:

• investment products are appropriate by ensuring that they are designed to meet consumers’ needs, deliver value for money, and are marketed in a fair, clear and not misleading way; and
• firms and individuals operate under high regulatory standards, firms have high standards of governance and firms have a stronger grip over the networks of individuals in their distribution chains.

The FCA will continue to evaluate the effect of the remedies introduced by its Asset Management Market Study. While this is of more relevance to authorised fund managers than hedge fund managers, to the extent that authorised funds have financial exposure to hedge funds, hedge fund managers will need to be aware of these requirements.

LIBOR

The FCA states that it continues to assess managers’ exposure to LIBOR risk. In this area, the FCA’s focus is on asset managers, including hedge fund managers, having the necessary strategies to manage the risks, including conduct risks. The FCA will monitor how firms implement plans to manage such risks. This is all part of the FCA’s push to ensure an orderly transition to LIBOR by firms before the end of 2021 and follows on from the FCA’s Dear CEO letter to asset managers on the topic. We have addressed below the FCA’s attitude to LIBOR transition given the ongoing Covid-19 pandemic.

European developments

ESMA draft guidelines on leverage-related systemic risk

On 27 March, ESMA published a consultation on draft guidelines, which set out a framework for National Competent Authorities (NCAs) to exercise their power under article 25 of Directive 2011/61/EU (the AIFMD) to monitor, assess and then set limits in respect of leverage used by Alternative Investment Funds (AIFs) which may lead to:

• systemic risk to the financial system;
• risks of disorderly markets; or
• risks to the long-term growth of the economy.

The assessment of leverage-related systemic risk held by AIFs

ESMA’s draft guidelines note that NCAs should conduct a risk assessment of leverage-related systemic risk on a quarterly basis using information provided by means of Annex IV reporting. This risk assessment ought to consist of the following steps:

1. Identification of leveraged funds in scope

NCAs ought to identify:

• AIFs deemed to employ leverage on a substantial basis under Commission Delegated Regulation (EU) 231/2013. An AIF is deemed to employ leverage on “a substantial basis” where the exposure of that AIF is three times its net asset value (as calculated under the commitment method);
• AIFs not employing leverage on a substantial basis but with an AUM of more than €500m; and
• other AIFs which employ unusually high leverage and this leverage is deemed to pose risks to financial stability. “Unusually high leverage” is defined by ESMA as leverage which differs significantly from that of other funds of the same type (hedge funds, for example) and the AIF’s historical or average leverage value.

2. Assessment of the systemic risk

NCAs will be required to assess whether the leverage of those AIFs above poses a systemic risk. If so, NCAs will need to determine whether they should set leverage limits for those AIFs. ESMA has set out a number of factors for NCAs to consider under four headings: (a) risk of market impact; (b) risk of fire sale; (c) risk of direct spill over to financial institutions; and (d) risk of interruption in direct credit intermediation.

In particular for hedge funds with holdings in less liquid assets with a smaller underlying market, NCAs, in assessing systemic risk, will consider the market footprint of the relevant AIF (under the “risk of market impact” criterion) and the share of the AIF invested in less liquid assets (under the “risk from fire sales” criterion). This could mean that the leverage of hedge funds with exposures to less liquid assets is more likely to be deemed to be pose a systemic risk by NCAs.

Leverage limits

If an NCA has identified AIFs which are deemed to pose systemic leverage-related risks, ESMA notes that the NCA ought to impose leverage limits on the relevant AIFs.

ESMA has not specified leverage limits, seemingly leaving that to the relevant NCAs. ESMA does, however, state that NCAs may apply leverage limits to a group of AIFs of the same type, which includes hedge funds, and with a similar risk profile provided that the group of funds poses leverage-related systemic risks. As with other types of AIFs, this could mean that hedge funds which do not fall within 1) above may be required to adhere to leverage limits where that hedge fund is deemed to fall into a set of funds which collectively is deemed to pose leverage-related systemic risks.

ESMA also notes that NCAs are able to impose other restrictions on a relevant AIF’s management in the event that imposing leverage limits do not reduce risks “in the same proportion”. Examples given by ESMA are where, despite imposition of leverage limits, hedge funds adjust their strategy to maintain the same level of risk or where the hedge fund manager sells lower risk assets to meet the leverage limits imposed.

In these circumstances, ESMA notes that NCAs could consider restrictions on an AIF’s investment policy, redemption policy or risk policy. In relatively extreme circumstances, this appears to include the relevant NCA having the power to set limits on the proportion of certain assets held by a hedge fund and to reduce the frequency of redemptions offered by a hedge fund. Whilst this appears to be a last resort for NCAs, hedge fund managers should nonetheless be aware of the potentially wide ranging powers afforded to NCAs in the event that the leverage held by funds managed are deemed to pose leverage-related systemic risks.

The consultation closes on 1 September 2020.

MiFID/MiFIR review

The European Commission, earlier this year, launched a review of MiFID II in the form of an open consultation.

Important points for hedge fund managers

• EU consolidated tape – the European Commission notes that an EU-wide consolidated tape has not yet emerged for any financial instruments despite the legal framework in Directive 2014/65/EU (MiFID II Directive) and a consolidated tape already being available for shares and bonds in the United States.
  
  The European Commission requested input on whether pre- and/or post-trade transparency data should be consolidated and what financial instruments should be included, with the examples given being shares, bonds and derivatives. In addition, the European Commission looked for views on how the implementation of the post-trade transparency deferral regime under Regulation 600/2014 (MiFIR) and the MiFID II Directive (together with MiFIR, MiFID II) may be amended in order to accommodate an EU-wide consolidated tape.

• Investor protection – the European Commission requested input on whether:
  • ex-ante cost disclosure requirements should apply in relation to professional clients and eligible counterparties (ECPs) as well as to retail clients. The European Commission notes that many participants in wholesale transactions consider these requirements to be merely an administrative burden;
  • an additional category of regulatory client is necessary in order to encourage certain wealthy investors to participate in EU capital markets; and
  • RTS 28 reports are of sufficiently high quality to provide investors with useful information on the quality of their transactions.

The first two points could potentially impact hedge fund managers’ obligations in respect of individual, high net worth investors who, from a UK regulatory perspective, have traditionally been classified as “professional clients”. However, whilst there is no suggestion that the rules may change in respect of best execution reports in the near future, European hedge fund managers should watch this space given the regulatory burden which best execution reports impose.

• Research unbundling – as mentioned in our recent “Private funds regulatory update”, input has been requested on the effect of the research unbundling rules. The European Commission has suggested a few possibilities, including allowing bundling exclusively for SME research, clarifying what is meant by “research” for MiFID II purposes or amending the rules on issuer-sponsored research.
• Commodity markets – the European Commission notes that it is trying to foster more commodity derivatives trading in euros. As part of this drive, the European Commission appears to suggest that changes need to be made to the position limit regime for illiquid or nascent markets and looked for input on how the regime could be made less restrictive, including by potentially adopting a regime based on a designated list of “critical” contracts as in the United States. ESMA has since published a report on position limits under MiFID II which we consider below. The consultation also requested information on how the MiFID II pre-trade transparency regime has worked for commodity derivatives trading.
• Derivatives trading obligation – whilst not suggesting any specific policy changes, the European Commission asked for stakeholder views on how effective the derivative trading obligation in article 28 MiFID II Directive had been since implementation and whether any tweaks were needed to the scope of this obligation.
• Double Volume Cap – the European Commission acknowledged that the Double Volume Cap has been criticised for being too complex which has, in turn, pushed equities trading towards systemic internalisers and away from trading venues. Views were therefore sought on the Double Volume Cap and its impact on transparency in equities trading.
• Spot foreign exchange – the consultation paper also questions whether NCAs ought to hold additional supervisory powers over spot foreign exchange, which does not currently fall within the scope of MiFID II. Whilst the consultation does not suggest that spot foreign exchange will necessarily fall within the scope of MiFID II in the future, the European Commission does note that it has been asked by stakeholders to analyse whether policy action in this area is needed.

The consultation has now closed. Hedge fund managers with European operations or exposures should nevertheless be conscious of the matters identified above as areas of regulatory focus and should watch this space for any potential changes to the MiFID II regulatory regime.

Delay to initial margin requirements

As noted in our Passle, “Initial margin – delayed”, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) have delayed the implementation of the final two implementation phases of the margin requirements for non-centrally cleared derivatives by one year. As mentioned in that Passle, BCBS/IOSCO perform an advisory role and therefore extension by local regulators will be required to bring these delays into effect. Nonetheless, if these delays are implemented at a European level, this should provide a welcome easing of the margin requirements for hedge fund managers at a time when hedge fund managers’ preparations have been severely impacted by the Covid-19 pandemic.

EMIR Refit and MiFIR

We published a Passle, “ESMA publishes final report on aligning MiFIR and EMIR Refit” in early February, noting that ESMA had published a final report ultimately recommending that the scope of the clearing obligation in Regulation (EU) No 648/2012, as amended (EMIR) and the scope of the derivatives trading obligation in MiFIR be aligned. There has as yet been no further follow-up on this, with the European Commission due to submit a report to the European Parliament and to the Council by 18 December 2020.

EMIR Refit and reporting

As highlighted in our Passle, “EMIR Refit – fund managers to bear reporting responsibility”, the regulatory obligation to report derivative transactions to a trade depositary will shift from AIFs to their managers where the AIF is a counterparty to those derivative transactions from 18 June 2020. Given this looming deadline, hedge fund managers should be acting now to ensure that derivative transactions will be correctly reported from 18 June onwards.

Position limits and position management

ESMA has published a report on the position limit regime under MiFID II which will feed into the European Commission’s consultation on MiFID II (which we have discussed above).

Notably for hedge fund managers, ESMA, in this report:

• agrees with stakeholder input that the calculation of position limits favours the most liquid market with the highest open interest in that commodity derivative. ESMA therefore proposes to delete the “same contract” concept to ensure that there is a more level playing field for trading venues in respect of commodity derivatives;
• notes that, due to the “C(6) carve-out exemption” in the MiFID II Directive, the exact same derivative contract may be subject to MiFID II (and hence the position limit regime) if traded on a regulated market or a multilateral trading facility but may be subject to Regulation (EU) No 1227/2011 (REMIT) if traded on an organised trading facility (OTF) (and hence not subject to the position limit regime). Whilst not suggesting any specific policy changes, ESMA states that it considers that the C(6) carve-out creates a competitive advantage for OTFs trading REMIT products;
• proposes that MiFID II Directive is amended such that securitised derivatives are excluded from the position limit regime; and
• states that it agrees with the view that adopting a position limit regime whereby position limits are maintained only in respect of ‘significant or critical contracts’, in line with the approach in the United States, would be beneficial.

ESMA’s position will feed into the report of the European Commission and therefore this does not appear to mean that there will be significant change to the MiFID II position limit regime in the short term. Nonetheless, ESMA’s position, if implemented, would involve substantial changes to the MiFID II position limit regime so hedge fund managers will need to keep an eye out for future publications by the European Commission on this topic.

Covid-19 developments

FCA’s expectations on the SMCR for FCA solo-regulated firms

The FCA has published guidance for regulated firms such as hedge fund managers in respect of SMCR compliance during the Covid-19 pandemic.

The FCA has acknowledged that firms will need to make appropriate changes but nonetheless stresses that regulated firms should comply in full with the requirements of the SMCR where possible.

Considerations for hedge fund

• Senior management responsibilities – UK regulated firms, such as many hedge fund managers, are not required to have a single senior manager responsible for their Covid-19 response but senior managers should consider the risks arising from the current situation and the current crisis affects existing risks to the firm.
• Statements of responsibilities and significant changes to senior manager responsibilities – the FCA notes that it does not intend to enforce the requirement to submit updated statements of responsibilities if there is a temporary change to responsibilities as a result of Covid-19 and the firm expects to revert to its previous arrangements. The FCA however stresses that regulated firms are required to keep accurate records of any such changes and should notify them of changes made.
• Furlough and reallocating prescribed responsibilities – senior managers who have been furloughed will retain their regulatory approval during their absence and will not need to be re-approved by the FCA when they return. To the extent that a furloughed senior manager held any prescribed responsibilities, these prescribed responsibilities ought to be re-allocated to another senior manager.
• 12-week rule – the FCA has modified the “12-week rule” in respect of senior managers to allow a replacement to stand in for a senior manager for 36 weeks, instead of the traditional 12 weeks, where this is a consequence of a temporary or unforeseen change. Firms will have to notify the FCA in order to make use of this temporary extension of the regime. Notably, where the absent senior manager held prescribed responsibilities, firms are able to allocate these prescribed responsibilities to the replacement where the replacement is an employee of the firm.

LIBOR transition

The FCA, having discussed LIBOR transition plans with the Bank of England and the members of the Working Group on Sterling Risk-Free Reference Rates, has confirmed that the assumption that firms cannot rely on LIBOR being published after the end of 2021 has not changed. This is regardless of the fact that Covid-19 has impacted firms’ LIBOR transition plans.

Nonetheless, the FCA does recognise that the “interim transition milestones” are likely to be affected by Covid-19 and states that it will update the market as soon as possible on transition timelines. Whilst hedge fund managers should clearly still plan for full LIBOR transition by the end of 2021, they should nonetheless be conscious of any publications by the FCA and the Bank of England on this topic.

Share issuances

The FCA has released a statement of policy on companies raising capital in response to the Covid-19 pandemic. The FCA notes that there is a balance to be struck between encouraging firms to use the capital markets whilst maintaining investor protection. This includes:

• encouraging investors to consider, on a temporary basis, supporting issuances by companies of up to 20% of the issued share capital where possible;
• encouraging listed companies issuing new equity to use the simplified prospectus regime for secondary issues; and
• introducing some flexibility on the working capital statement whereby key modelling assumptions on coronavirus underpinning the reasonable worst-case scenario will be permitted to be disclosed in an otherwise clean working capital statement.

Crucially, the FCA also reiterated that Regulation (EU) No 596/2014, otherwise known as the Market Abuse Regulation (MAR), remains in force and companies are still required to fulfil their obligations concerning the identification, handling and disclosure of inside information. All market participants, including hedge fund managers, should take note that, despite the FCA allowing some leniency in other areas of regulation, it will continue to enforce MAR in full.

Covid-19 and AIF reporting

Hedge fund managers should be aware of the following published by the FCA in respect of fund reporting.

• Delaying annual reports – following ESMA’s public statement on the deadlines for the publication of periodic reports by fund managers, the FCA has stated that full-scope UK AIFMs are permitted an additional two months to publish annual reports. In order to make use of these provisions, hedge fund managers which are full-scope UK AIFMs should:
  • promptly inform the depositary and auditors of the relevant funds;
  • provide the FCA with details of the relevant funds and the intended new date of publication; and
  • publish a prominent statement on their website, no later than the original publishing date of the annual report, explaining the reasons behind the hedge fund manager’s decision and giving the revised publication date.
• MiFID 10% depreciation portfolio value reporting – under MiFID II, portfolio managers are typically required to inform investors where the overall value of their portfolio falls by 10% or more in value and for each subsequent 10% fall in value. However, the FCA has noted that it does not intend to take enforcement action where a firm chooses to cease to provide 10% depreciation reports to professional clients.
• Best execution – the FCA has stressed that it expects regulated firms, including hedge fund managers, to meet their applicable best execution obligations. Nonetheless, following on from ESMA’s public statement on best execution reports, the FCA has stated that it has no intention of taking enforcement action where a firm does not publish:
  • a RTS 27 report by 1 April 2020 so long as the report is published no later than 30 June 2020; and
  • Article 65(6) reports provided that such reports are published by 30 June 2020.

Whilst the FCA continues to stress that hedge fund managers are required to comply with their reporting obligations whenever possible, the relief detailed above will be welcome to hedge fund managers who are experiencing operational difficulties as a result of Covid-19.

ESMA’s position on telephone call recordings under MiFID II

ESMA has issued a public statement to clarify its position on the application of the MiFID II requirements on the recording of telephone conversations or electronic communications.

ESMA notes that, as a result of the Covid-19 outbreak, the recording of all relevant conversations may not be possible. If firms are unable to record relevant communications, firms are expected to take alternative steps to mitigate the risks related to the lack of recording. This could include, ESMA notes, the use of written minutes or notes of telephone conversations with clients. However, this is on the condition that:

• prior information is provided by the firm to the client that it is impossible to record the call and that written minutes or notes of the call will be taken; and
• the firm ensures enhanced monitoring and ex-post review of relevant orders and transactions.

ESMA notes that firms are expected to ensure that these measures remain temporary and that recording of telephone conversations is restored as soon as possible. Nonetheless, this should provide some welcome relief for hedge fund managers faced with major difficulties in meeting their recording obligations at this time.

The FCA has adopted a similar approach to the recording of voice communications and firms are expected to notify the FCA where they are unable to record telephone calls. For more information, please see our Passle “Telephone recording and Covid-19: some relief for FCA authorised firms?”.