The new gatekeeper

For quite some time, we have tried to highlight how the EU's new financial supervisors could eventually take on too much power for comfort - not least when viewed from the City of London. The European Securities and Markets Authority, in particular, looks set to become a force to be reckoned with. As we argued in our recent report on the subject, this is a bit peculiar since most of the commentary - such as the de Larosière report or the Turner review - which precipitated the creation of the new supervisors, related to cross-border supervision of large retail banks.

Over the last couple of weeks, negotiations over the AIFM Directive seem to be moving in the direction of giving ESMA powers, possibly exclusive, to supervise hedge funds and other types of funds based outside the EU and decide whether these should be granted EU-wide market access (a so-called passport). In other words, ESMA could become the sole 'gatekeeper' deciding who has the right to enter the EU market. This is no small power.

The UK could possibly accept such far-reaching powers for ESMA in return for keeping the passport provision in the AIFM Directive - a provision which the French don't like at all but that is popular with the industry.

From the City's point of view, the problem with this arrangement is that market access for the many funds which operate in the City but are domiciled elsewhere (i.e. Cayman or the US) could be decided in a forum where the UK has the exact same voting strength as Malta or Slovakia, as most decisions within ESMA will be taken by simple majority voting, meaning one country, one vote. The lack of safeguards in this voting arrangement could lead to this issue being hijacked by narrow commercial or political interests - or protectionist forces.

A blanket solution to market access, with ESMA calling the shots, would therefore be a mistake. As a leader in today's FT argues,

"Restricting this power to ESMA alone sparks concerns about protectionism. Keeping the state-level door open would also ensure that if ESMA proves inefficient, hedge funds can go directly to national bodies."

Quite right. The negotiations are now entering the final stretch - a break-through could even come today. The UK must resist calls to give ESMA exclusive powers over market access.

What are they thinking?

Things aren't looking great for the AIFM Directive. At least not from the point of view of developing countries, SMEs, European taxpayers, pensioners and assorted charities - all of which will be negatively affected if the Directive is passed in its current form. In fact, there has rarely been a law with so many losers and so few winners.

In addition, the City of London is clearly a vital national interest for the UK, and the AIFM Directive would land a blow to the square mile at a very critical time. EU leaders will make a serious political mistake by forcing through something like this only one week after the new British government has taken office. Despite the UK being home to the bulk of the industry in the EU, the Conservative-Liberal government has virtually no room to prepare for the negotiations (or even catch their breath). According to Angela Merkel, EU leaders simply intend to walk all over the Cameron government under majority voting rules. This is a clear break with conventional negotiation practice in the EU, where national interests are usually taken into account. (read our take on it here)

Frankly, what are they thinking? Undercutting a fragile coalition government for which 'Europe' is clearly a make or break issue is probably not the best way to ensure the UK's constructive long-term engagement with Europe. It also happens to be an attack on US interests, as funds and managers based offshore will find it far more difficult to access the EU market under the Directive - in turn increasing the scope for regulatory retaliation.

And from EU leaders' point of view, why put the Lib-Dems - the one remaining voice for EU-enthusiasm in the UK - in such an awkward position? This will seriously undermine the party's ability to defend its line against Tory backbenchers.

And, remember, Europe needs capital - governments and firms alike - in order to bounce back from the downturn (remember the €750 billion package agreed last weekend?). The AIFMD is a blow to an industry which can provide just that. Indeed, it's fully possible to introduce stricter rules for transparency and accountability - which the industry needs - without negatively affecting capital flows and growth (the Swedish EU Presidency came close to producing such a compromise proposal in December).

The story of the AIFM Directive is simultaneously an illustration of how poor the UK government and the City of London are at engaging with Brussels, and how difficult it seems to be for EU leaders to let political and economic reason prevail over ideological bias and short-term thinking.

An often repeated question is: imagine if this was a law threatening French agriculture or the German car industry...? We suspect that the game would have looked very different. For an example, compare the language coming out of the UK over the weekend on the AIFMD to the strong French defence of the agriculture sector in response to recent discussions on possible bilateral trade talks with other regions.

According to the Sunday Telegraph, a UK Government source said that "There is a majority in favour of the directive and we don't want to be in a position where we squander any negotiating capital we have for the future on an issue it doesn't appear we can win." (okay, but why allow it to get to this point in the first place).

In contrast, French Agriculture Minister Bruno Le Maire said today in response to why France is opposed to the EU re-launching trade talks with the Mercosur countries:

France is opposed to resuming negotiations [with Mercosur countries], because they would inevitably end in further concessions to the detriment of French and European farmers. I don’t see why agriculture has always to be the adjustment variable of trade negotiations in Europe.

No compromise there.

It's true, French farmers don't make for as convenient scapegoats for the failures of a certain Single Currency. But still, you would hope that EU leaders could see common sense and have at least delayed this vote to allow the new UK government some time to prepare.

At the end of the day, this would be in Europe's interest - economically as well as politically.

We've been here before

The Spanish EU Presidency yesterday decided to shelve a vote on the proposed AIFM Directive on hedge funds and private equity due to "a last-minute intervention by Gordon Brown", according to the FT. The talks apparently stalled on British concerns over the protectionist elements of the Directive, which could see barriers put up to non-EU funds trading in the EU.

We have estimated that the industry contributed €6.1 billion in tax revenues in the UK alone and €9.2bn overall - an amount that could be under threat if a flawed directive is passed. We have also consistently warned that the protectionist provisions entailed in the proposal would cut off offshore managers and funds from the EU market. This will have at least two negative consequences: less choice and value for money for EU investors (including pension funds and charities) and less capital for European firms struggling to rebalance their books in the wake of the economic downturn. Therefore, the British Government's focus on the protectionist dimension is in principle welcome.

The FT reports that Paris "agreed to defer a vote" in order to avoid appearing to inflict "a defeat on Britain". A vote could have been forced on the UK because this Directive will eventually be decided by qualified majority voting. The question is will anything have changed when ministers next look at the Directive in either May or June.

There are also worrying parallels with what happened with the Temporary Agency Workers Directive in 2007. Then, as today, the FT reported that Brown had "personally intervened to defend Britain’s flexible labour market" and delay agreement on the Directive when it looked as though the UK would be outvoted. However, within a year the UK had been out-foxed and was forced to accept the Directive with only minor concessions. In addition, the UK almost lost its separate opt-out from the EU's 48 hour cap on the working week, entailed in the Working Time Directive, as a horsetrading deal involving the two Directives came dangerously close to backfiring at the hands of the European Parliament.

The Government will no doubt portray yesterday as a victory. And although the postponement of the finance ministers' vote on the proposal leaves UK negotiators, the industry, investors and others with some extra room to find allies and bolster the case for a radically amended Directive, today's developments provide no guarantee that this is going to be straightforward. A vote in the Council is now expected at the finance ministers' meeting on May 18th, meaning that for the time being all eyes will be on the European Parliament (whose economic committee will vote on a draft proposal on April 22nd). The key for MEPs is now to resist protectionist urges.

The postponement of the Council vote also adds another dimension to what already is a very complex amendment process. The British general elections will take place on May 6th, meaning that should the Conservatives win, they will be faced with a major showdown in Brussels after less than two weeks in office.

Whether this is a good or a bad thing for the fate of the AIFM Directive depends on a number of factors, including how much energy and political capital a Conservative government considers it can spend on this (the Tory treasury team is not short of challenges as it is); and how willing European partners are to give concessions to a Conservative government early on, in order to secure its future constructive engagement in EU affairs. This, in turn, depends on what a Conservative government is willing to concede in return, i.e. future concessions on agricultural spending, social legislation and so forth. In Brussels, as ever, nothing is free.

One thing is for certain, this is not a good time for the UK government to let its guard down on the AIFM Directive. Indeed, we've been here before.

Rasmussen v. Lord Myners (and the rest of the City)

In case you missed it, Open Europe last week organised a debate on the EU's proposed new rules for hedge funds, private equity firms, and various other funds currently not regulated by EU law. In good-old Brussels fashion the proposal goes under the acronym AIFMD (Alternative Investment Fund Managers Directive), and has been recieved with some scepticism in the City of London - to put it mildly.

In a Guildhall filled to the brink with angry pin-striped suited City people, the AIFM Directive's key proponent, Poul Nuryp Rasmussen, fearlessly explained why he didn't think the proposal goes far enough. The arguments aside, you have to give Rasmussen credit for his dedication, courage and willingness to walk into what can only be described as a lion's den. And he certainly stood his ground. During the course of the debate, it became evident that Rasmussen knows more about the alternative investment industry than the industry itself perhaps feels comfortable admitting. It would be a mistake to underestimate him, particularly as he still - despite no longer being an MEP - has much input into what kind of amendments the socialists in the EP will put down on the draft Directive.

Rasmussen carries a lot of respect around Europe. During the 90s he took on the unions in Denmark in a bid to get the Danish economy up and running again - a point he was keen to make at the end of the debate. This, he said, highlights that he's a "pragmatic Scandinavian" and a "pro-growth guy" (in addition to being an economist). He's not out to get the City of London. A Scandianvian economist with pragmatist credentials is the nightmare opponent for the alternative investment industry, insofar as he'll draw a lot of sympathy from around Europe (and hedge fund managers aren't exactly the most popular kids on the block). However, notwithstanding his courage and the rest of it, the arguments are against Rasmussen on this issue - as we've outlined here.

The main counter-blast to Rasmussen's arguments did not come from any of the industry representatives, but from City Minister Lord Myners, who used surprisingly strong rethoric - no doubt mindful of his audience. In particular Lord Myners hit out at "the lamentable lack of consultation" which preceded the Directive, and said that the proposal amounted to "protectionism hiding as if it were protection".

One of the most interesting admissions from Rasmussen was that the Directive was designed to keep fund managers from the rest of the world out of the single market, unless they "pay a price". "No one can have my Danish passport", Rasmussen said. As we've argued many times before, this type of protectionist thinking remains one of the EU's greatest flaws. Whether it's raising barriers to global capital flows and investment, or free trade in products and agricultural commodities, this kind of approach leaves everyone worse off.

This flaw is more than enough reason to oppose the draft Directive in its current form.