European hedge funds unprepared for Dodd-Frank
European hedge funds may be unprepared for the implementation of the US Dodd-Frank Act on July 16, warns Gary DeWaal, senior managing director and group general counsel at Newedge.
The US regulation’s extra-territoriality could have a profound impact on European-based hedge funds, DeWaal said.
Although Dodd-Frank comes into force on July 16, there are many questions about its implementation that remain unanswered, according to DeWaal who is based in New York.
In mid-July, 175 Dodd Frank provisions are scheduled to go into effect automatically unless Congress or the regulators – the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) – change the deadline. More provisions are scheduled to go into effect on September 14 while there are around 66 proposed rules, concept releases and interim final rules proposed by the SEC and the CFTC.
Many of these rules and regulations will have extra-territoriality, when a US law applies to companies with even a tangential connection to the US.
There are four areas in particular where DeWaal thinks European hedge fund managers are unaware of the sweep of the US legislation.
“There is a lot of stuff buried in Dodd-Frank and in other rules that have come out as a result of the Act that people need to pay attention to. Collectively these things have a lot of extra-territoriality impact,” warned DeWaal.
“The thing to focus on is over-the-counter [OTC] clearing. A lot is being done bilaterally and will end up being cleared on central clearing counterparties, the clearing houses. They are going to be executed in the first place on some kind of traditional facility. That’s going to be a big change.
“There will also be new rules dealing with pre- and post-trade transparency. There are new rules on position limits and the way you have to aggregate positions limits over different hedge funds that may be under common control. Although not in Dodd-Frank – and it’s obviously something spun out recently – there are lots of new rules also coming out on high frequency trading and algorithmic trading,” DeWaal cautioned.
He said the extra-territoriality impact of OTC rules “is not obvious”. One example is the provision within Dodd-Frank dealing with retail foreign exchange. DeWaal said European hedge funds may believe they are not caught by this provision but the problem is in the way “the definition tracks”.
The general rule under the provision is that a fund needs to determine if it is a US fund. If 10% or more of assets under management are derived from US persons, a fund is caught by the rule.
However, he warned funds needed to look to see if “ultimate investors” were eligible contract participants. This catches anyone who has less than $10 million of investable assets. “So if the ultimate customers are not eligible contract participants, with less than $10 million investable assets, then the fund itself is not considered an eligible contract participant under US law,” explained DeWaal.
Under the US definition an eligible contract participant includes financial institutions, insurance companies, commodity pools and wealthy individuals. Only those designated as an ECP are allowed to engage in complex stock or futures trades such as block trades, exchanging excluded commodities and transacting on a derivatives transaction.
A commodity pool or hedge fund engaging in any foreign exchange transactions with a non-US counterparty may have issues from July 16.
The consequence of this is that only certain types of registered US entities, like future commission merchants (FCMs), may be a counterparty to a fund that is considered a US fund but not eligible to be a contract participant because it is considered to be a retail fund. “That will come as a great surprise to a lot of funds that could have hundreds or even billions of euros under management. Really people will have to look to see if they inadvertently fall into this trap.”