Managed Funds Association September 2013

EU REGULATION 101 GUIDE TO EUROPEAN OVERSIGHT

OF THE HEDGE FUND INDUSTRY

INTRODUCTION

Hedge funds play a vital role in helping a wide range of

institutions – from pensions to endowments to non-profits

– meet their financial obligations.

In Europe, hedge funds oversee roughly $549 billion in

assets, according to a recent report by Preqin1.

In 2011 a new financial services regulatory structure took

effect, which included the creation of the three new

European Supervisory Authorities.

This guide provides a brief overview of the European

policymaking and new regulatory structure, and provides

information on several issues of specific concern to

hedges funds – and the institutions that invest in them.

1Source: Preqin, February 2013

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ABOUT THE EUROPEAN UNION

The European Union (EU) is an economic and

political union of 27 Member States. The EU was

established in its current form in 1993 by the

Maastricht Treaty. The Treaty of Lisbon, the latest

amendment to the constitutional basis of the EU,

came into force in 2009.

The EU operates through a system of

supranational independent institutions.

These include the European Commission,

the Council of the European Union, the European

Council, the Court of Justice of the European

Union, and the European Central Bank. The

European Parliament is elected every five years.

According to the EU, its policy making is focused

on ensuring the free movement of people, goods,

services and capital.

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IMPORTANT INSTITUTIONS OF THE EU

The European Commission is the executive body of the European Union. The body is

responsible for proposing legislation, implementing decisions, upholding the Union’s

treaties and the general day-to-day running of the Union.

The Council of the European Union (sometimes called the Council or the Council of

Ministers) is the legislative institution that represents the executives of member states

(the other legislative body being the European Parliament).

The European Parliament is the directly elected parliamentary institution of the EU.

Together with the Council of the European Union and the European Commission, it

exercises the legislative function of the EU.

The European Council is comprised the EU heads of state, the President of the

European Commission and the President of the European Council. The European Council

has no formal legislative power. However, under the Treaty of Lisbon, it defines “the

general political directions and priorities" of the Union.

The European Central Bank is the EU institution that administers the monetary policy of

the 17 EU Eurozone member states. The bank was established by the Treaty of

Amsterdam in 1998, and is headquartered in Frankfurt, Germany.

European

Commission

Council of the

European Union

European

Parliament

European

Council

European

Central Bank

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EUROPEAN SYSTEM OF FINANCIAL SUPERVISORS

In 2009, in response to the global financial crisis, the European Commission proposed a new

framework for financial supervision: The European System of Financial Supervisors (ESFS).

The ESFS is an institutional architecture of the EU's framework of financial supervision. It is composed

of three authorities: the European Banking Authority, the European Insurance and Occupational

Pensions Authority and the European Securities and Markets Authority.

ESFS European System of Financial Supervisors

EBA European Banking

Authority

EIOPA European Insurance

and Occupational

Pensions Authority

ESMA European Securities

and Markets

Authority

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In January 2011, the new framework was implemented, with the EBA, EIOPA and ESMA taking on the

responsibilities of previously existing regulatory bodies.

EBA European Banking

Authority

Committee of

European Banking

Supervisors

EIOPA European Insurance

and Occupational

Pensions Authority

Committee of

European Insurance

and Occupational

Pensions

Supervisors

ESMA European Securities

and Markets

Authority

Committee of

European Securities

Regulators

NEW

OLD

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NEW REGULATORY FRAMEWORK

To complement this framework, there is also a European Systemic Risk Board (ESRB). The

ESRB is an independent body within the EU, responsible for the macro-prudential oversight

of the financial system within the Union. Board Members of the ESRB include members of

the European Central Bank, National Bank Governors and Chairs of European Supervisory

Authorities (ESAs).

ESRB European Systemic Risk Board

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EUROPEAN SYSTEMIC RISK BOARD

THE NEW EU REGULATORY FRAMEWORK (IMPLEMENTED JANUARY 2011)

EBA European Banking

Authority

EIOPA European Insurance

and Occupational

Pensions Authority

ESMA European Securities

and Markets

Authority

ESRB European Systemic

Risk Board

Headquartered in Frankfurt, EIOPA regulates certain activities of credit institutions, financial

conglomerates, investment firms, insurance and reinsurance companies, and payment

institutions. It is responsible for supporting the stability of the financial system, transparency of

markets and financial products, as well as the protection of insurance policy holders and pension

members and beneficiaries. EIOPA is part of the European System of Financial Supervisors

(ESFS).

Headquartered in Frankfurt, the ESRB is responsible for the macro-prudential oversight of the

financial system within the EU to help mitigate or prevent systemic risks to financial stability. It is

charged with contributing to the smooth functioning of the EU’s internal market and ensuring a

sustainable contribution of the financial sector to economic growth.

Headquartered in Paris, ESMA is responsible for safeguarding the stability of the European

Union’s financial system by ensuring the integrity, transparency, efficiency and orderly

functioning of securities markets, as well as enhancing investor protection. It coordinates the

work of securities regulators, and across financial sectors by working closely with the other

authorities, in particular the EBA and EIOPA. ESMA is part of the European System of Financial

Supervisors (ESFS).

Headquartered in London, the EBA regulates European banks. The EBA has the power to

overrule national regulators, prevent regulatory arbitrage and promote fair competition

throughout the EU Common Reporting (COREP) is the standardized reporting framework

covering: credit risk, market risk, operational risk, own fund and capital adequacy ratios. EBA is

part of the European System of Financial Supervisors (ESFS).

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EUROPEAN SECURITIES AND MARKETS AUTHORITY (ESMA)

ESMA is the coordinating body for EU Member State financial regulators.

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More About ESMA’s Role

Role and Responsibilities

ESMA is responsible for coordinating actions of securities supervisors or adopting emergency

measures when a crisis situation arises.

ESMA is responsible for helping establishment and implement a single set of financial rules

across Europe. They have two primary goals:

• Ensure consistent treatment of investors across the EU, providing adequate investor protection

through effective regulation and supervision.

• Promote fair and equal competition among financial service providers and ensure effective and

cost-efficient supervision of supervised companies.

According to ESMA, the organization “contributes to the financial stability of the European Union, in

the short, medium and long-term, through its contribution to the work of the European Systemic Risk

Board, which identifies potential risks to the financial system and provides advice to diminish possible

threats to the financial stability of the Union.”

While ESMA is independent, there is full accountability towards the European Parliament, Council of

the EU and European Commission.

Source: www.esma.europa.eu/page/esma-short 10

EU REGULATORY PROCESS

Financial regulation in the EU is governed by the Lamfalussy Framework which established

the legislative approach to securities law.

It was adopted by the EU in the final report of the Committee of Wise Men on the Regulation of

European Securities Markets (an expert committee chaired by Baron Alexandre Lamfalussy).

The Lamfalussy Framework proposed a four-level approach to European securities legislation:

It first applied to the securities sector and was later extended to banking, insurance and

pensions.

The framework has been brought into compliance with the Treaty of Lisbon, which entered into

force in 2009, and the ESA and ESRB Regulations, which entered into force in 2010 and 2011,

respectively.

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Baron Alexandre Lamfalussy

Level 1: Framework Legislation The Commission presents a legislative

proposal to the Parliament and Council

of the EU for recommendations.

Level 2: Implementing Measures ESMA provides advice to the

Commission on implementing

measures. The Commission can take

this advice or implement on its own.

Level 3: Supervisory Convergence Ensures consistent application across

the EU.

Level 4: Enforcement

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Level 1: Framework Legislation

Level 2: Implementing Measures

Level 3: Supervisory Convergence

Level 4: Enforcement

Lamfalussy Framework at Work

EU REGULATIONS OF INTEREST

TO HEDGE FUNDS

There are a number of regulations currently under consideration in the EU that are of specific

interest to hedge funds. These include:

1. Alternative Investment Fund Managers Directive (AIFMD)

2. European Market Infrastructure Regulation (EMIR)

3. Short Selling Regulation

4. Review of Markets in Financial Instruments Directive (MiFID II)

5. Market Abuse Directive (MAD)

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ALTERNATIVE INVESTMENT FUND

MANAGERS DIRECTIVE (AIFMD)

In April 2009, the European Commission proposed a Directive on Alternative Investment Fund

Managers (AIFMs) with the objective of creating a comprehensive regulatory framework for European

Alternative Investment Fund Managers.

The proposed Directive was developed to help create common regulatory standards for all AIFMs that

met specific criteria. The final agreement on the framework Directive (Level I) was achieved in

November 2010 and the text entered into force in July 2011.

The Commission asked the European Securities and Markets Authority (ESMA) to provide technical

advice on the implementing measures of the AIFMD (Level 2).

ESMA and the European Commission have continued to develop implementation measures

throughout 2013.

Member States were to have transposed the Directive and its implementing measures by July 2013,

however, at the time of publication less than half of the 28 EU Member States have done so.

ESMA continues to develop guidelines on the AIFMD in a number of areas.

The final text of the AIFMD (July 2011) is here. More information on AIFMD here.

Sources:

http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2011:174:0001:0073:EN:PDF

http://ec.europa.eu/internal_market/investment/alternative_investments_en.htm 14

EUROPEAN MARKET INFRASTRUCTURE

REGULATION (EMIR)

In September 2010, the European Commission published a proposal for a Regulation on OTC

derivatives, central counterparties (CCPs) and trade repositories, now commonly referred to as the

European Markets Infrastructure Regulation or “EMIR.” EMIR entered into force on August 16, 2012.

ESMA and the European Commission continue to develop technical standards on implementation.

EMIR is currently in its Level 2 implementation phase, with recent consultations coming from ESMA

and the other ESAs.

Notably, EMIR calls for:

• All OTC derivative contracts considered ‘eligible’, entered into between any financial and certain

non-financial counterparties (subject to conditions), will be required to be cleared by a CCP;

• All OTC derivative contracts not considered ‘eligible’ shall be subject to risk mitigation

requirements, including the exchange of collateral or a proportionate holding of capital;

• Counterparties to an OTC derivatives trade (cleared or not) shall report details of that trade to a

trade repository;

• CCPs shall be subject to registration and prudential and conduct of business regulation; and

• Trade repositories shall be subject to conduct of business regulation.

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SHORT SELLING REGULATION

In November 2011, European negotiators reached an agreement on an EU Regulation on Short

Selling and certain aspects of credit default swaps. The regulation, which entered into force on

November 1, 2012, was designed to establish a common regulatory framework and ensure greater

coordination and consistency between Member States. Among other items, the new regulation:

• Requires public disclosure of short positions over a certain threshold

• Requires parties entering into a short sale to have borrowed the instruments, entered into an

agreement to borrow them or made other arrangements to ensure they can be borrowed in time to

cover the deal.

• Requires notification of significant positions in credit default swaps that relate to EU sovereign

debt issuers.

• Provides competent authorities with temporary power to require greater transparency or impose

certain restrictions on short selling and credit default swap transactions.

Both ESMA and the European Commission were to conduct a review of the Short Selling Regulation

by the end of June 2013. ESMA released its findings on June 3, 2013; ultimately, it did not recommend

significant changes to the regulation. As of publication, the European Commission has yet to release

its review of the Short Selling Regulation. More information on EU short selling regulation can be

found here.

Source: http://ec.europa.eu/internal_market/securities/short_selling_en.htm

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MARKETS IN FINANCIAL INSTRUMENTS DIRECTIVE

(MIFID) II

The Markets in Financial Instruments Directive (MiFID) came into force in November 2007. It replaced and expanded

the Investment Services Directive. Its objective was to increase the integration and efficiency of EU financial markets.

MiFID established a common regulatory framework for investment services in financial instruments across the EU and for

the operation of regulated markets by market operators.

The European Commission is currently reviewing the MiFID framework. In October 2011, the European Commission

adopted proposals for (i) a revised Directive and (ii) a new Regulation (MiFIR). Both the European Parliament and Council

of the EU have approved their respective reports on the MiFID proposal and are currently (September 2013) engaged in

trialogue with the European Commission.

Between them, these proposals:

• Extend the existing regulatory framework both in terms of instruments and firms covered, so that, for example, certain

commodity trading firms will fall within scope of the regime;

• Impose regulatory requirements on firms undertaking algorithmic trading (including HFT);

• Impose position limits on the trading of commodity derivatives;

• Impose restrictions on third country firms providing services in the EU;

• Introduce enhanced corporate governance requirements for investment firms; and

• Introduce enhanced pre- and post-trade transparency provisions in respect of both equities and non-equities.

More information about MiFID and MiFIR is available here.

Source: http://ec.europa.eu/internal_market/securities/isd/index_en.htm

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MARKET ABUSE DIRECTIVE (MAD)

In May 2001, the European Commission proposed a directive to address insider dealing and market

manipulation within the EU. The Market Abuse Directive (MAD) aimed to enhance the integrity of

European markets by implementing common standards throughout all Member States.

Currently (September 2013), negotiations among the European Parliament, Council of the EU, and the

European Commission are close to finishing.

More information on MAD available here.

Source: http://ec.europa.eu/internal_market/securities/abuse/index_en.htm

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REFERENCES

European Resources:

European Commission

http://ec.europa.eu/index_en.htm

European Parliament

http://www.europarl.europa.eu/news/en/headlines/

Council of the European Union

http://consilium.europa.eu/homepage?lang=en

European Securities and Market Authority (ESMA)

www.esma.europa.eu/

European Banking Authority (EBA)

http://www.eba.europa.eu/

European Insurance and Occupational Pensions

Authority (EIOPA)

https://eiopa.europa.eu/

European Systemic Risk Board

www.esrb.europa.eu

European Central Bank

http://www.ecb.int

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Information on the global hedge fund industry is available at the Managed Funds Association at

www.managedfunds.org and via Twitter: @MFAUpdates