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prime broking


									                                                                                  Special Report: PRIME BROKING/ADMINISTRATION

THE VOICE OF THE ALTERNATIVE INVESTMENT INDUSTRY                                                            August 2005
                                         CREDIT PROTECTION                                                                  FOREIGN EXCHANGE

 CONTENTS                                Morgan Stanley opens new Euro CDS market SocGen steps into FX
                                         Morgan Stanley has launched a information flow in the high-yield
 1           NEWS
                                         credit default swap (CDS) product capital markets.”              prime brokerage
 2-3         TRENDS IN PRIME             for hedge funds to trade credit risk        In the US, the more liquid lever-
             BROKING                     on European leveraged loan market,       aged loan market allows managers          Société Générale Corporate &
                                         both on individual names and on          to exit more readily, simply by           Investment Banking (SGCIB) has
 5           “HONEY, I SHRUNK            bundled baskets of loans.                selling the loan. In Europe’s less        launched SG Prime for foreign
             THE FUND ADMIN                 Robert Lepone, executive director     liquid loan market, by contrast, gap      exchange hedge funds and already
             INDUSTRY”                   and head of loan trading, at             risk can exist for loan sellers. As       has plans to add options to its
                                         Morgan Stanley, said the invest-         Morgan Stanley’s offering encom-          offering in the Northern summer.
 6-8         UCITS III - HEAVEN          ment bank is already making mar-         passes private as well as public             The investment bank has been
             FOR LAWYERS, HELL           kets on 30 different names, across       leveraged loans, Lepone said it has       developing the service since Feb-
             FOR EUROPE’S FUND           the capital structure.                   opened the universe of available          ruary and it is now open to hedge
                                            “This is a new product for            credits to traditional capital market     funds and commodity trading advi-
             DISTRIBUTORS                Europe,” he said, “and it will enable    investors. These private leveraged        sors (CTAs) using the products and
 Report writer/editor
                                         hedge funds to go long or short          transactions, that is, without public     services it offers.
                                         leveraged loans at the senior            securities, formerly fell below many         SGCIB’s new offering will come in
 Solomon Teague +44 (0)20 7484 9811      secured, second-lien and mezzanine       hedge funds’ radars.                      addition to Fimat, which also offers
 Sub-Editor                              levels of the capital structure”. This      Lepone said the CDS structure          prime brokerage as part of the
 Jay Blanche +44 (0)20 7484 9923         development, he said, “allows            has obviated the problem hedge            broader Société Générale group,
                                         investors to short portions in the       funds occasionally encountered of         under the leadership of Phillipe
 Production Editors
                                         capital structure, where previously      financial sponsors not wanting            Teilhard de Chardin.
 Jay Blanche/Ross Harman                 it was not possible.”                    them in their deals.                         Jay Green, head of e-commerce
 Chief Executive Officer                    Sellers of leveraged CDS protec-         Selling protection via CDS means       and FX prime brokerage at Société
 Tim Weller +44 (0) 20 7484 9700         tion benefit from having to use less     the hedge fund assumes the credit         Générale Corporate & Investment
                                         capital compared to buying loans or      risk from the bank buying the pro-        Banking in New York, said the bank
 Publisher                               using total return swaps, as they        tection from them. Conversely, the        is using Traiana software.
 Jon Greene +44 (0)20 7484 9867          have to commit only a portion of         banks retain their relationship with         He said since SGCIB first launched
 Editorial Director                      the notional as collateral with no       the financial sponsor and continue        the prime broking offering to a wider
                                         residual cost for the balance.           to control the loan right up until a      client base early in the year it has
 Matthew Crabbe +44 (0)20 7484 9700
                                            Lepone said the market for pro-       credit event occurs.                      seen good flow from clients on elec-
 Managing Director                       tection on leveraged loans had not          In addition, there are no loan         tronic communications networks
 Tony Gibson+44 (0)20 7484 9739          taken off previously, partly because     agency transfer fees – charged when       (ECNs), such as Hotspot and eSpeed.
 Marketing Manager                       most institutions have historically      loans are transferred from one bank          As foreign exchange hedge funds
                                         operated their loan and CDS              to another, or to a fund – when a CDS     have, traditionally not needed to
 Vicky Priest +44 (0)20 7484 9973        trading desks separately, “whereas       is used, thereby increasing liquidity.    borrow instruments, and have run
 For further reports such as these and   our approach when we set up the             As Morgan Stanley’s CDS                largely from personal contracts with
 details on how to subscribe to Hedge    loan trading desk has always been        offering is a spread-based product,       brokers and trading houses, they
 Funds Review see page 4 of this PDF.    to have it on the public side            unlike loans that trade on a price-       have arguably not been as quick to
                                         enabling us to better capture the        basis, there is no pre-payment risk.      take on prime brokerage services in
                                                                                                                            the past. However, this has changed
PRIME BROKING                                                                                                               as the large investment banks have
Prime brokers eye up fund of hedge fund business                                                                            entered the market.
                                                                                                                               The French-headquartered bank
                                                                                                                            aims to be competitive and will offer
Prime brokers are increasingly              They need capital for bridge             Société Générale bought Bank of        rates from $5-$15 per million,
looking at funds of hedge funds and      financing and as an investment tool,     America’s structured investments          depending on the size of transaction.
their leveraging needs as a potential    and prime brokers are naturally          business, providing leverage to FoHF         SGCIB’s Jay Green said the bank
growth area, according to Tim            looking at this and considering          clients, in February.                     plans to add further functionality in
Murphy, global hedge fund product        entering the market, he added.              Laurent Seyer, head of marketing       the coming months with the addition
manager at AIBBNY Fund Manage-              This trend has been most promi-       and communications in SG’s equity         of options.
ment in Dublin.                          nent in Europe, Murphy said.             derivatives business, said although
   The flow of institutional money          FoHF custody is not straight for-     there are similarities between its
into alternative assets has increased
the relative significance of FoHFs.
                                         ward, and the execution risk is
                                         high, he noted: while prime brokers
                                                                                  business and that of its sister organi-
                                                                                  sation, prime broker Fimat, there is
                                                                                                                            Citco snapped up
   Three years ago, the business was     are well positioned to enter the         no operational overlap between them       Citco has been bought by an investor
a much smaller component of the          market if they choose to, they need      beyond the exchange of ideas and          group including the Smeets Family
alternatives industry, now it is the     to assess the risks and decide           occasional cross-selling.                 Trust, Citco managers, and related
entry-point of choice for much of the    whether it is worth their while to          Société Générale’s competitors in      parties, from the Sandoz Family
institutional investor community.        enter the market, he added.              the business are primarily the            Foundation (SFF). SSF will retain a
   “They have liquidity needs               UBS has been looking at the possi-    investment banks, and he is not           minority ownership position. Christo-
greater than hedge funds’ because        bility of such business, according to    aware of any moves by the prime           pher Smeets, CEO, and Citco's current
settlement cycles and lock-up            Andrew Dabinett, head of capital         broker community into FoHF                management team will continue oper-
periods,” said Murphy.                   introduction at the bank.                financing, he added.                      ating the business.

Trends in prime brokerage
By Pascal Lambert,                         ment and product development            Naturally, hedge funds expect          must develop and support an effi-
                                           designed specifically for the hedge their prime brokers to be able to          cient network of custodians. The
Bear Stearns                               fund marketplace.                    match over-the-counter positions to       prime broker’s network manage-
                                              We have enhanced our client corresponding cash bond or equity               ment team is constantly assessing
                                           service model                                            positions effec-      the individual custodian’s ability to
The global hedge fund industry’s           by        directly                                       tively     netting    effectively settle and service securi-
dynamic nature is driving the evo-         aligning      our                                        margin require-       ties, as well as adapt to evolving
lution of prime brokerage.                 product capabil-                                         ments for each        regulatory      requirements      and
   As hedge funds extend beyond tra-       ities with the                                           instrument.           increasing trading volumes.
ditional asset classes to structured       needs of our                                                Prime brokers         Both clarity of the settlement
products and non-traditional deriva-       hedge        fund                                        provide cross-        system and the liquidity of these
tive instruments, their financing          clients.                                                 margining solu-       instruments, in turn, drive the
requirements become more complex,             As part of                                            tions for most        leverage appetite from the prime
often requiring tailored solutions.        this alignment,                                          conventional          brokers.
   A hedge fund may launch with a          “Calling     Offi-                                       hedge        fund
single strategy, but quickly find itself   cers”          are                                       strategies.           DIVERSITY OF SERVICE
establishing new funds with different      appointed       to                                          However, as        PROVIDERS
strategies. To be successful, hedge        major       hedge                                        the markets and       As hedge funds increase their
funds must remain nimble.                  fund      clients.                                       trading strate-       assets under management and the
   This demand requires prime bro-         These ‘calling                                           gies become more      number of funds they offer, they
kers to act with a high level of           officers’ deepen                                         sophisticated,        must also extend the “infrastruc-
responsiveness and flexibility.            the level of cus- Pascal Lambert, Bear Stearns           cross-margin          ture” that supports their business.
                                           tomer service                                            capabilities have        More than likely they will be
POTTED HISTORY                             by leveraging their knowledge of been extended across many instru-             establishing multiple prime broker
Previously prime brokerage was             the firm and the industry to ments from traditional equities,                  relationships in order to diversify
seen as a business operated by a           uncover opportunities and develop options, commodities and contracts           their sources of margin and bor-
few US investment banks, more              solutions to meet the client’s for difference (CFDs) to credit default         rowable securities.
recently it has become a “main-            strategic objectives.                swaps, total return swaps and other          These funds may be utilising pro-
stream” product and a key point of                                              derivative securities.                    prietary and/or third-party portfolio
access to the rapidly expanding            BROADER ARRAY, MORE                     More recently, prime brokers           management, risk and trade man-
hedge fund industry.                       COMPLEX STRATEGIES                   have also been challenged to pro-         agement systems. To remain com-
   This vantage point has created a        One of the most significant chal- vide solutions on both structured            petitive, prime brokers must be able
number of challenges and opportu-          lenges presented to prime brokers credit products and on bank debt.            to provide trade, position and port-
nities for prime brokers.                                                                                                 folio data in flexible data formats to
                                                                                                                          their clients and to the third-party
                                            “Hedge funds expect their prime                                               systems used by these clients.

Larger hedge funds require service
models that are tailored to their spe-
                                            brokers to be able to match over-                                             DEVELOPMENT OF
                                                                                                                          DOMESTIC JURISDICTIONS
cific needs and strategies.                  the-counter (OTC) positions to                                               Europe has experienced the devel-
   With a rapidly changing market,
prime brokers must establish struc-            corresponding cash bond or                                                 opment of new domestic jurisdic-
                                                                                                                          tions for hedge funds over the past
tures that enable fast, effective
delivery of first-class service. At         equity positions effectively netting                                          few years. Ireland has developed
                                                                                                                          the most successful model to date.
Bear Stearns, Prime Brokerage Ser-
vices is organised within a separate             margin requirements for                                                     Germany and France are final-
                                                                                                                          ising their rules, while Scandinavia
broker-dealer, Bear, Stearns Securi-
ties Corp. (BSSC).                                  each instrument”                                                      and Luxembourg have a framework
                                                                                                                          in place.
   This structure provides full                                                                                              The challenge for the prime
access to Bear Stearns services, as                                                                                       broker lies primarily in the alloca-
well as the benefit of a discrete          during the past three years has        EMERGING MARKETS                        tion of resources for markets with
client-focused unit.                       been the increasing use of over the    The constant quest to identify prof-    an uncertain potential. Each of these
   This uncommon configuration             counter (OTC) derivatives by hedge     itable opportunities and the develop-   markets has its own specificities, but
provides our hedge fund clients            fund managers.                         ment of more active capital markets     all have one feature in common: the
with one point-of-entry to all Bear           In particular, trading opportuni-   worldwide have turned many hedge        requirement for the fund to appoint
Stearns offerings.                         ties in the credit markets have cre-   fund managers’ attention to             a domestic bank as trustee (in Ire-
   Our suite of products includes          ated an explosion in the volume of     emerging market opportunities.          land)/depositary (in other countries)
dedicated client management, tech-         CDS (credit default swaps) traded         In order to properly support         with full responsibility to the
nology development, risk manage-           by hedge funds.                        these new strategies, a prime broker    investors and regulators.

Trends in prime brokerage
   The trustee/depositary, in turn,       of resources to provide innovative    analysis approach to assessing risk     distinct array of services.
either appoints the prime broker as       solutions to a wide array of chal-    and establishing margin limits. More       One significant service, which
sub-custodian or delegates those                                                                                        evolved a few years ago, is capital
responsibilities.                                                                                                       introduction, where prime brokers
   The establishment of this relation-                                                                                  introduce hedge funds to a wider
ship, from an operational and legal
standpoint, is a significant invest-
                                              “Niche players may initially                                              range of qualified investors than
                                                                                                                        those which would otherwise be
ment. Prime brokers must be pre-
pared to allocate resources to support
                                           capture a share of the market for                                            immediately accessible to a typical
                                                                                                                        hedge fund manager.
these promising new markets.                  specific services, but will be                                               Effective capital introduction
                                                                                                                        services match investors with
It is generally accepted that there are
                                           challenged to build a broad-based                                            hedge funds who meet certain
                                                                                                                        investor-determined criteria.
approximately 10 to 15 global prime          and longstanding relationship                                              In order to participate in the
brokers in operation today.
    This range has remained stable            with hedge funds that grow                                                expanding market of start-up man-
                                                                                                                        agers, some prime brokers have set
over the past three years with the
arrival of new teams offsetting the               rapidly and diversify                                                 up dedicated business consulting
                                                                                                                        teams. These teams provide a wide
consolidation or withdrawal of
other teams. Some of the more                       their strategies”                                                   range of business and infrastruc-
                                                                                                                        ture support including turnkey
recent entrants are attempting to                                                                                       solutions to start-up managers.
make inroads via their expertise in                                                                                        Additionally, these consulting
one or a few of the broad-range                                                                                         capabilities have become a valuable
prime broker services.                    lenges they encounter. While niche    recently, some models using value at    resource for our existing clients
    These particular services may         providers may adequately deliver      risk(VaR) have been employed which      who are facing expansion issues.
include financing arrangements,           specialised capabilities, global      have been used to calculate leverage       Finally, another example of
securities lending services, or spe-      hedge funds depend on global          ratios, which can vary significantly    added value service is offering effec-
cialisation with respect to the pro-      prime brokers.                        from stress testing analyses.           tive cash investment alternatives
cessing of fixed income, derivative                                                Though hedge funds generally         that can enhance returns while
or equity securities.                     REGULATORY ISSUES                     continue to prove quite conservative    enabling the client to maintain their
    Niche players may initially cap-      The UK FSA expressed some con-        in using leverage, the occasionally     liquidity and risk parameters.
ture a share of the market for spe-       cern earlier this year over the       wide range of tolerable leverage           With a large number of clients
cific services, but will be challenged    impact that competition between       ratios proposed by different prime      still not fully invested, these capa-
to build a broad-based and long-          prime brokers could have on           brokers could raise some serious        bilities are particularly attractive
standing relationship with hedge                                                                                        and useful.
funds that grow rapidly and diver-                                                                                         The hedge fund industry is in con-
sify their strategies.
    Over the last several years of
                                             “The UK FSA expressed some                                                 stant transition, and the capacity of

                                           concern earlier this year over the
                                                                                                                        the prime broker to anticipate these
explosive growth in the global hedge                                                                                    challenges and address the changing
fund marketplace, Bear Stearns,
Goldman Sachs and Morgan Stanley           impact that competition between                                              needs of hedge fund clients is key to
                                                                                                                        its long-term success.
together have consistently held over
60% of the market. While new-                 prime brokers could have on                                                  Ongoing dedication and commit-
                                                                                                                        ment of management attention and
comers may come and go, the
leading global players will likely          leverage policies.There is clearly                                          capital and human resources, by
                                                                                                                        the entire firm, to supporting the
continue to hod a dominant share as
the growth and profitability of their         an increasing rift between the                                            demands of the global hedge fund
                                                                                                                        is a prerequisite to building a suc-
franchises enable them to sustain
ongoing investment necessary to
                                                   approaches taken by                                                  cessful prime brokerage service.

continue to provide premier service.
    Barriers to entry in the prime
                                                     prime brokers”                                                     Statistics cited here are taken
                                                                                                                        from HedgeWorld’s 2004 Service
brokerage arena are considerable.                                                                                       Providers’ Directory and Guide.
    Capital investment in technology      leverage policies. There is clearly   concern with hedge fund managers
and global platforms is sizeable.         an increasing rift between the two    on the accuracy and consistency of      AUTHOR:
    The leading global hedge funds        approaches generally adopted by       some of the methodologies.              Pascal Lambert is senior man-
require prime brokers with proven         prime brokers.                           Competition also creates a drive     aging director, head of European
and robust capabilities.                     “Traditional” prime brokers pre-   to establish distinctive value propo-   global clearing services at Bear
    They expect their prime broker        dominately rely on the long-estab-    sitions. Prime brokers create differ-   Stearns International Limited.
to have the expertise and the depth       lished     stress-testing  scenario   entiation by forming a broad and
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An               publication                                                                                           
Diminishing industry, expanding
opportunity: welcome to the world of
the hedge fund administrator
By Dermot Butler,                            When you consider the list of         solidatees because they needed to         only people capable of running a
                                          participants in recent consolida-        have the ability to provide a full        hedge fund and that a plethora of
Custom House                              tions, the rationale behind those        service to their institutional            new hedge funds will not contain
                                          transactions is easy to work out         clients, both in traditional funds        anyone of quality or note.
I participated at a Dublin confer-        from both the consolidators and the      and also in hedge funds, and they            While I accept that several,
ence which discussed the long term        consolidatees point of view – they       needed that ability quickly.              maybe even many, of the new
trends of importance to hedge fund        were taking capital out of their                                                   hedge fund managers may not be
administrators.                           business and getting more ‘clout’ in     IMPACT ON                                 up to Tudor-Jones, Steinhart or
   In particular, the panel was           the marketplace.                         CONSOLIDATEES                             Soros standard, I also believe that
asked whether the industry is                I suppose the first of these ‘con-    First they will see a deal flow of        there will be many who could well
facing capacity problems and also         solidations’ was that of Mees            larger hedge funds, remembering           be up at that level.
asked to comment on the impact of         Pierson into (and then out of) AMRO      that many of the consolidators               Historically, the hedge fund
recent industry consolidation.            and into Fortis. However, that was       mentioned above consider a mutual         market has been characterised by
   It was interesting to note that, in    more a purchase and sale of a bank       fund of $500m to be a small client.       the fact that new managers have
the same panel, we were asked a           that had an administration arm,             Second, I believe the hedge fund       evolved from prop desks in major
somewhat contradictory question -         than the purchase and sale of a          administration departments of             institutions and new trading
“Can so many administrators sur-          hedge fund administrator per se.         these institutional administrators        strategies have been developed by
vive and what were the economics             More recently, we have seen a         (the former consolidatees) will start     each generation.
of business in a crowded market?”         plethora of mergers/takeovers or         to absorb the attitude and culture           There are now numerous strate-
   I found it difficult to understand     consolidations, including, inter alia,   of their parent, which means they         gies, which come under the hedge
how someone could pose two ques-          Bank of New York (BONY) and              will tailor their product to institu-     fund umbrella and which are com-
tions with implied contentions            IMS; State Street and IMA; BYSIS         tions, or at least very large clients.    peting in complexity.
which are so dramatically different.      and Hemisphere; HSBC and the                Indeed, we have already seen evi-         All this leads me to believe that
   How, I wondered, could the             Bank of Bermuda; more recently:          dence of this trend with the recent       we will continue to see start-up
industry be facing capacity issues        Mellon and DPM; and BYSIS                announcement by one of these              hedge funds and, although many of
if there were so many administra-         (again) and RK Consulting (which,        institutions, that, in the future, they   those will fail and several will just
tors that the question cast doubt on      presumably, was intended to              are going to concentrate on the           plod along, many will also perform
their survival.                           increase their hedge fund footprint      institutional hedge fund market.          well and grow in size.
   The most interesting topic was         in the USA); JP Morgan and Tra-             This announcement was some-               This, of course, is very encour-
assessing the impact of industry          naut; and Northern Trust and Bar-        what ironic because the consoli-          aging for the independent adminis-
‘consolidation’, of which there has       ings (although Barings do not have       datee, in this particular case, had,      trator that is capable of handling
been a lot said in the past two or        a very high profile in the hedge         during the past two or three years        smaller funds and startups.
three years.                              fund area, they are, nevertheless,       been very aggressive in acquiring            Furthermore, the reluctance of
   There are basically four groups        involved in a relatively small way).     market share in the hedge fund field      the institutional administrator to
that have and will be effected by                                                  and were taking on all and sundry.        take on, or even continue working
the ‘consolidation’.                      US PREDOMINANCE                             Now it seems likely they will not      with, funds with perhaps less than
   (It is, of course, open to question    What is notable about all of these       look at any fund of less than, say,       $300m, and certainly less than
whether there has been any or             ‘consolidations’ is that the consol-     $100m and possibly $300m.                 $100m, will provide a deal flow for
much ‘consolidation’, as such.            idators are all very large institu-         And this group is not unique,          the specialist independent adminis-
What has actually happened is that        tions with very large traditional,       although perhaps more voluble than        trator, whose business model
the institutions have, for the most       predominantly US, mutual fund            other institutional administrators.       enables them to make a profit on
part, played PacMan and gobbled           administration business.                    It is, I believe, almost inevitable    these ‘smaller’ funds.
up the smaller hedge fund adminis-           These institutions appear to          that the smaller (less than $100m)           Thus, those hedge fund adminis-
trators). But, for the sake of this       have been very concerned that            end of the hedge fund market will         trators that retain their independ-
article, I will use the term ‘consoli-    their ‘bread-and-butter’ clients had     begin to feel vulnerable and per-         ence will, I think, find that their
dation’. Therefore:                       to look elsewhere for the adminis-       haps even find themselves increas-        niche remains and that the poten-
                                          tration of their hedge funds.            ingly unwelcome with their large          tial for growth also remains, not
■ First, there are those independent         The choice of the consolidator        institutional administrator.              despite the consolidation, but
administrators that have been con-        was to either start up their own            This will, I believe, create real      because of the consolidation.
solidated (the ‘consolidatees’) or        hedge fund administration depart-        opportunities for the remaining              Indeed, it is quite feasible that
absorbed, into an institutional           ment, which would take time and          independents who are willing and          we may witness a growth in
administrator;                            be very costly, or go out into the       capable of taking on both “smaller”       smaller specialist hedge fund
■ Second, there are those institu-        market and buy the expertise.            funds and start-ups.                      administrators seeking to serve the
tions that have merged with, or              As we have seen, almost all took         One of the other features of con-      so-called ‘smaller’ hedge funds.
taken over the consolidatees, which       the second choice, with notable          ference presentations and articles
I will refer to as the ‘consolidators’;   exceptions being Goldman Sachs           that have been published in the
■ Third, there are those inde-            and UBS. The reason these institu-       past has been the contention that         AUTHOR:
pendent hedge fund administra-            tions went this route was primarily      the whole market is at risk of some       Dermot Butler is chairman of
tors, like my own company, Custom         because they all had major institu-      form of manager quality famine,           Dublin     fund     administrators
House, that have not yet been con-        tional clients who were, themselves,     as the major managers close to            Custom House. Custom House
solidated (the ‘independants’); and;      getting into the hedge fund market       additional investment.                    recently also commenced opera-
■ Fourth, hedge funds themselves          and they could not service them.            There appears to be a belief that      tions in Chicago through a third
and, of these, the most effected will        It, therefore, seems to me that       the major managers of the past            party joint venture.
be the clients of the consolidatees.      the consolidators acquired the con-      two or three generations are the

UCITS III: a EU fund Nirvana or a
paperwork, retail market Inferno?
                                                                                                                          suffered in the face of passportable
Speakers at a Dublin prime broking and administration                                                                     exotic fund products, such as Luxem-
                                                                                                                          bourg fund of hedge funds (FoHFs).
conference, and beyond, have expressed concern at UCITS III                                                                  “If a consumer buys a Ucits
                                                                                                                          [-compliant fund] and he has a com-
provisions and retail products, as Solomon Teague reports                                                                 plaint, I can only refer him to the
                                                                                                                          consumer bodies [of the jurisdiction
                                                                                                                          in which it gained Ucits registra-
                                                                                                                          tion]. I have absolutely no jurisdic-
                                                                                                                          tion if the fund manager is not under
                                                                                                                          my jurisdiction,” Joe Bannister says.
It was sold to us as financial prod-     derivatives – rather than taking into   retail regulatory fold represents an        “There should be a pan-European
ucts’ realisation of the pan-Euro-       account the ‘underlying’ asset          effective means of reversing this        committee of complaints managers
pean dream – the Ucits directives        beneath the swap.                       trend, he argues.                        for consumers to bring all these
would allow seamless, retail, cross-                                                Mansfeld says hybrid products         issues together and discuss them at
border EU distribution of any            THE WAY FORWARD                         with an exposure to both traditional     a high level,” he adds.
product given Ucits certification in     Wolfgang Mansfeld, president of the     Ucits-compliant and alternative fund        Sven Zeller, partner at Clifford
another member country.                  European Fund and Asset Manage-         elements represent an area of enor-      Chance in Frankfurt, says the
   What Brussels’ visionaries did        ment Association, says such a           mous potential growth.                   German market has been flooded
not account for was different EU         product is unusual, but sees the           Such products give retail investors   with products from Luxembourg, all
jurisdictions holding different          development of structures with both     access to diversification, limited       carrying Ucits III certificates that
views on the retail market and           vanilla and alternative components      downside and absolute return bene-       would not qualify for certification if
Ucits qualification.                                                                                                      produced in Germany.
   Luxembourg has interpreted
Ucits compliance in an arguably           “There should be a pan-European                                                    However, he says Germany’s regu-
                                                                                                                          lator, BaFin, has too many other
more broad sense than other
member states. When Germany
                                              committee of complaints                                                     issues to deal with, such as mixed
                                                                                                                          funds, to concentrate on the issue.
made funds of hedge funds avail-
able to the masses from 1 January
                                          managers for consumers to bring                                                    Disagreements over the interpre-
                                                                                                                          tation of European directives are
2004, it seemed that all countries
were moving towards retail sales.
                                            all these issues together and                                                 inevitable, given their flexibility. “A
                                                                                                                          directive isn’t the same as a regula-
The UK’s Financial Services
Authority (FSA), while barring
                                            discuss them at a high level.”                                                tion, says Robin Gordon-Walker,
                                                                                                                          spokesperson for the UK Financial
onshore, regulated, pure hedge            Joe Bannister, Malta Financial Services Authority                               Services Authority.
funds from UK shores, has allowed                                                                                            “A regulation’s terms are so spe-
quasi-hedge funds, such as Quali-        as precisely the way                              fits, while minimising         cific it can’t be deviated from in any
fied Investor Schemes (QIS), under       the industry should                               risks embedded in              way. A directive is not like that.”
its consultation paper CP185.            be moving.                                        alternative structures,           Zeller cites Ireland and Luxem-
   Neil Simmonds, partner in the           He says such prod-                              such as hedge funds.           bourg as two key “liberal” jurisdic-
financial services practice at lawyers   ucts are “very appro-                             He cites product               tions that issue Ucits III compliance
Simmons and Simmons, says a risk         priate solutions to                               failure risk and man-          stamps in cases where more “conser-
arises when Ucits III-compliant          help retail investors                             ager risk as examples.         vative” jurisdictions – such as Ger-
products are bought and sold in a        to find the way to                                   Retail investors as         many – would not. He says the
European jurisdiction other than the     benefit from the                                  a group have a ten-            amount of German money in Lux-
one in which it received its stamp of    advantages hedge                                  dency to under-diver-          embourg and Irish funds is greater
approval.                                funds can bring.”                                 sify their portfolios,         than in German funds.
   The problem has come up with            He notes there are                              he notes, but such                Simmonds adds the UK to his list of
products receiving Ucits III approval,   “concerns the Ucits Joe Bannister, Malta          products, if regulated         “liberal” jurisdictions, a point on
with a 10% exposure to a hedge fund      product might rep- Financial Services Authority correctly, are inher-            which Gordon-Walker seems to
index, via a total return swap.          resent a decreasing                               ently diversified.             concur.
   One partner at a prominent            share” of the market, with an                                                       He says the Financial Services
London law firm says Ucits compli-       increasing amount of capital CAUSE FOR CONCERN                                   Authority rule CP185 “implemented
ance can be achieved because the         attracted to non-Ucits funds such On the other hand, Joe Bannister,              the directive in a way that does allow
total return swap is the key to Ucits    as hedge funds.                     chairman of the Malta Financial Ser-         a much more open approach, and sim-
qualification – limited to a fund          Bringing an element of exposure vices Authority, is concerned about            plified the rule book a great deal to
having at most 10% exposure to           to alternative assets into Europe’s the loss of control regulators have          encourage collective investment

                          France                          Germany                           Ireland                         Italy*                         Luxembourg
                          (Jérôme Sutour,                 (Sven Zeller, Clifford Chance)    (Deirdre Power, Deloitte        (Jeffrey Greenbaum, Lovells)   (Odile Renner,
                          Simmon & Simmons)                                                 & Touche)                                                      PricewaterhouseCoopers)
Name of fund:             OPCVM à règles                  Funds with additional risks, or   Qualified Investor Schemes      Societa’ Di Gestione Del   There are three possible
                          d’investissement allégées de    fund of hedge funds,              would be the appropriate        Risparmio Speculativa      vehicles: investment fund
                          fonds alternatifs               or Dachhedgefonds                 vehicle for a single manager                               (FCP); investment company
                                                                                            hedge fund or a FoHF                                       with variable capital (SICAV);
                                                                                                                                                       and investment company
                                                                                                                                                       with fixed capital (SICAF)
Investor stipulations:    The minimum investment is       None                             Minimum €250,000 investment The minimum investment          There are no specific
                          €10,000, unless the FoHF is                                      and high net worth individual requirement is €500,000       stipulations regarding an
                          principal guaranteed                                             must have €1.25m, excluding                                 investor in a FoFH. The only
                                                                                           value of home                                               requirements concerning this
                                                                                                                                                       matter are those regarding
                                                                                                                                                       risk warnings in the
Single manager            Subject to min investment       Only allowed on a private        Single manager hedge funds    No solicitation by hedge      Yes, single manager hedge
hedge funds allowed       and whether or not              placement basis; no public       allowed for those qualifying  funds is permitted. Retail    funds can be marketed to
for retail?               French, yes                     marketing                        under above criteria          investors may autonomously retail investors in
                                                                                                                         purchase hedge funds if they Luxembourg. Outside
                                                                                                                         find out about them and       Luxembourg, it depends on
                                                                                                                         meet the minimum capital      the legislation of the
                                                                                                                         requirements                  countries of distribution
FoHF allowed              Subject to min investment       Yes, by every IFA/unregulated    FoHF allowed for those        The rules regarding FoHFs are Yes
for retail?               and whether or not              and regulated distribution       qualifying under above        the same as those regarding
                          French, yes                     system                           criteria                      single manager hedge funds
Hedge fund index-         If structured by French         Yes, but only by banks and other Index-linked products allowed The rules regarding hedge     Yes and, under certain
linked products           company, yes. If not, no        regulated financial institutions for those qualifying under    fund index-linked are the     circumstances, derivatives
allowed for retail?                                                                        above criteria                same as those regarding       on a hedge fund index may
                                                                                                                         single manager hedge          be eligible investments for
                                                                                                                         funds                         Ucits
Minimum investment        For French funds, it depends. €50                                No                            €500,000                      No legal minimum, but may
for retail?               There is no minimum                                                                                                          be mentioned in the
                          requirement on the investor if                                                                                               prospectus
                          the FoHF is capital guaranteed.
                          The minimum is €250,000
                          for contractual funds
Leverage permitted?       N/A                             Yes. No limits set for single    QIS allows unlimited use      No maximum leverage. In       No maximum, but must be
                                                          hedge funds; no for FoHFs on     of leverage                   practice, the Bank of Italy   stated in prospectus and
                                                          the FoHF level                                                 has the discretionary power include a description of the
                                                                                                                         to refuse authorisation of a risks inherent in the
                                                                                                                         hedge fund. Therefore, if     transactions under
                                                                                                                         a fund is considered to       consideration
                                                                                                                         have excessive leverage, it
                                                                                                                         may not be authorised
Derivatives use           N/A                             Yes. No limits set for single    QIS allows unlimited use      The rules regarding           They can invest in exchange
permitted?                                                hedge funds; no for FoHFs on     of derivatives                derivatives are the same as traded derivatives and
                                                          the FoHF level                                                 those regarding leverage. The certain OTC derivatives
                                                                                                                         amount of margin deposits     (index, interest rate, divisas
                                                                                                                         made in connection with       and credit derivatives),
                                                                                                                         derivative financial          subject to some restrictions,
                                                                                                                         instruments may not exceed up to 10% assets
                                                                                                                         50% of the fund’s assets.
                                                                                                                         Funds must maintain a liquid
                                                                                                                         asset reserve amounting to at
                                                                                                                         least the margin deposits
                                                                                                                         made by them
Is shorting allowed?      N/A                             Yes for single hedge funds;      QIS allows unlimited shorting Hedge funds can short stock, Yes, under certain conditions
                                                          no for FoHFs on the FoHF level                                 Ucits funds cannot
* The final Italian rules regarding Ucits III implementation have not yet been published, so these answers generally pertain to hedge funds only.
UCITS III: a fund Nirvana                                                                                                   Fund groups set
                                                                                                                            sail with UCITS
                                                                                                                            III product suites
or a paperwork Inferno?                                                                                                     A number of fund groups, espe-
                                                                                                                            cially in the UK, have been eyeing
                                                                                                                            off the possibility of using UCITS
                                                                                                                            III provisions allowing them to pro-
schemes (CISs) to set up, as long as     Ucits and alternative collective           Typically this occurs when an           duce funds similar to hedge funds.
they are sound entities.”                investments,” Mansfeld says.            investor is given material that has not    JP Morgan Fleming is market
   The UK Financial Services                Broad, inclusive definitions would been looked at by a lawyer, Zeller says.     testing three absolute return man-
Authority’s Gordon-Walker refuses        allow product innovation, Mansfeld         In addition, vendors of retail fund     aged funds for the UK.
to be drawn on the possibility of a      says, and products should then be of hedge fund products are at risk if               The group has confirmed it is
mis-selling crisis in Europe as a        segregated according to risk.           individuals advise clients in groups,      considering benchmarking the
result of diverging interpretations of      With an active retail FoHF market because if an accusation of mis-              products against cash, and it is
the directives across the Continent.     already thriving in Germany, Ireland, selling is made, the investor will           understood the top returning
   However, he does accept such dif-     Italy and Luxembourg, it makes sense have a witness, the advisor will not.         vehicle would aim to provide 5%
ferences of opinion exist, to the        to enlarge and harmonise the market,       Sven Zeller says vendors of these       above base rates.
extent that even the definition of       he adds, and doing this at the mar- products should, therefore, take min-             Both DWS and UBS have
the word directive has been the sub-     keting and distribution level would utes of meetings and not hand out              launched absolute return vehicles
ject of debate. “The term ‘directive’    benefit choice, and                                     any           simplified   adopting cash benchmarks. Capital
sounds stronger in English than in       efficiency as well as                                   prospectus or mar-         protection will be a key goal of the
French. There’s a bit of a debate        its own competitive-                                    keting material that       JPMF funds, and the group is con-
about whether they’re going to           ness.                                                   has not first been sanc-   sidering the use of derivatives
change the whole wording,” he says.         However, he con-                                     tioned by a lawyer.        under Ucits III rules to provide
                                         cedes single hedge                                         Zeller adds this        downside protection.
VIVE LA DIFFERENCE                       funds are not appro-                                    problem is potentially        Under Ucits III law, funds can
The effort to harmonise European         priate for European                                     huge, but in the 15        invest up to 10% of their assets in
financial regulation was always          harmonisation rules,                                    monthsfunds of hedge       derivatives and must hold sufficient
going to encounter problems. Dis-        but FoHFs are.                                          funds have been avail-     non-derivative assets to ensure
parate European regulators with             He says concerns                                     able to retail investors   their asset exposure is covered.
their own cultures and habits are        that all this would                                     in Germany there have         One of JPMF’s funds will invest
bound to interpret legislation differ-   “lead to a monster                                      been few problems,         in equities and bonds, while the
ently, no matter how clearly worded.     directive” – leading                                    because hedge fund         other will be global.
   The Committee of European Secu-       to a larger burden of                                   performance has been          Business consultants Pricewa-
rities Regulators (CESR) is putting      regulation – are not                                    relatively poor, and       terhouseCoopers noted in their
together a consultation document,        necessarily wrong, Sven Zeller, Clifford Chance demand for products                report, The Regulation and Distri-
due out in October, which will           but could be over-                                      correlated with hedge      bution of Hedge Funds in Europe,
address the concerns of jurisdictions    come.                                   funds therefore weak. Zeller hopes         “the implementation of UCITS III
and regulators.                             Clifford Chance’s Sven Zeller says experience in the sector would lead          across the EU offers the possibility
   “There isn’t really a mechanism       mis-selling is also a risk in Germany BaFin to relax its grip on the               of a pan-EU ‘passport’ for hedge
for saying: ‘Product X can’t be mar-     with retail funds of hedge funds, domestic hedge fund industry and                 fund-like products launched by
keted in the UK because we don’t feel    because local licenses necessary for follow the example of its more liberal        hedge fund managers and estab-
the standard of regulation in            intermediaries to sell funds of hedge European Union partners.                     lished institutions alike, provided
country Y is good enough’,” says the     funds are very easy to obtain. Basic                                               that such products satisfy the
Financial Services Authority’s           checks to ensure those with criminal BAFIN: HOISTED BY ITS                         UCITS Directive.”
Gordon-Walker.                           records or a history of fraud are the OWN PETARD?                                     PwC added regulators showing
   “Then we could be taken to infrac-    only real hurdle to authorisation.      However, BaFin could be caught in its      differing interpretations of the
tion proceedings. If we barred the                                               own internal politics – between those in   UCITS III Directives has led to
product from cross-border mar-           GERMAN TRAINING                         Frankfurt, who can be crudely labelled     “confusion and delay” in the
keting… it would almost be the           Zeller notes FoHF products can be ‘liberal/progressive’ and in Berlin, the         industry producing products.
biggest breech of the single market      sold by people without adequate ‘conservatives’. The German regulator                 The CESR has also weighed into
there could be. The whole basis of       training or expertise.                  was focused on protecting the investor,    the debate – on the EU’s behest –
the market is mutual recognition and        The only safeguard in place is that, Clifford Chance’s Zeller says, while       to produce a clarification of which
the ability to trade across borders.”    through the local license, the authori- Luxembourg’s approach is to nurture        ‘eligible assets’ may be held as
   Mansfeld wants to see an exten-       ties have details of any FoHF vendor and protect the market; an approach           assets by UCITS III funds, in a
sion of the single market for retail     in the market, and an investor can sue he feels is being vindicated.               consultation paper produced in the
investors beyond the scope currently     any vendor if he feels he has been sold    Clifford Chance’s Sven Zeller           middle of March.
covered by Ucits and says the idea is    such a product under false pretences.   notes the BaFin’s hedge fund                  “The proposals by CESR on
being discussed at European Com-            Reported cases of mis-selling have department is new to the hedge               UCITS eligible assets suggest that
mission level.                           been most frequent where investment fund market and, as such, says that            regulators are fixated by the legal
   “I believe the right way to go        advisors make unrealistic promises to it is gradually coming over to the           definition of transferable securities
would be one consistent framework        end-investors about the return pro- market approach favoured by its                rather than considering the economic
based on Ucits that would embed          files of hedge fund-related products.   smaller neighbour.                         effect of various instruments.”

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