Transatlantic tug-of-war puts European hedge funds in "impossible position"

Some funds will have to comply with Dodd-Frank and Emir simultaneously

Hedge funds are calling for a change to cross-border derivatives rules before European clearing requirements come into force – arguing overseas funds of European managers will be caught in a regulatory tug-of-war. Some of these funds also fall within the scope of the US clearing regime, but are not covered by the transatlantic framework designed to resolve such conflicts, lawyers say.

"The cross-border application of US regulation puts a lot of European hedge funds in the impossible position of having to simultaneously comply with two regimes that are in some respects incompatible," says the head of risk at a hedge fund in London. "The regulators have to do a better job of co-ordinating the implementation of these rules, otherwise, there's going to be a lot of confusion and uncertainty when the clearing mandate becomes effective in Europe."

The issue affects funds that qualify as a US person, by virtue of having a majority US investor base, but which are also authorised as an Alternative Investment Fund Manager (AIFM) under the new European hedge fund directive, which takes effect from July 22. AIFMs are classified as financial counterparties under the European Market Infrastructure Regulation (Emir). That means the funds will have to comply simultaneously with US and European rules on clearing, which are broadly similar, but not identical.

"You won't be able to clear a trade in one place and comply with both regimes at the same time," says Adam Jacobs, head of markets regulation at the Alternative Investment Management Association (Aima).

Regulators have tried to avoid these problems by agreeing a framework of substituted compliance and equivalence rulings, an untested system that is supposed to ensure derivatives users only have to comply with one of two competing regimes, as long as both are similar.

You won't be able to clear a trade in one place and comply with both regimes at the same time

This is of limited help to the affected funds, though – in the US, substituted compliance is available primarily for the foreign branches of US banks, while Europe's equivalence rulings only offer shelter to entities that are established in an approved jurisdiction, or that are trading with a counterparty meeting the same condition.

"Other than with respect to certain situations applicable to foreign branches of US swap dealers, the CFTC guidance essentially says US persons are subject to Dodd-Frank, full stop. Substituted compliance is not generally available to US persons. A hedge fund that is defined as a US person because of its investor base has to comply with the Dodd-Frank transactional rules, irrespective of its domicile or principal place of business. Substituted compliance doesn't apply," says James Schwartz, a lawyer at law firm Morrison Foerster in New York.

The EU will not step aside either, as Emir makes clear in title II, article 13, which states in its second paragraph that equivalence will only apply where at least one of the counterparties is "established" in a jurisdiction with rules that have passed the test. "Certain conditions need to be met for a cross-border transaction to benefit from equivalence – specifically, at least one of the counterparties to the transaction has to be established in a third country with comparable derivatives regulations, and there has to be a determination of equivalence with respect to that third country," says Allan Yip, a London-based partner at law firm Simmons & Simmons.

Esma was not able to provide a response by press time. The CFTC did not return calls asking for comment.

The EU is yet to make any formal equivalence determinations, but it seems safe to assume the US will pass the test when it comes to clearing, at least. At that point, funds would be able to comply with Dodd-Frank, but to satisfy Emir as well, they would have to trade exclusively with US-established dealers and invoke the equivalence ruling.

"If a Cayman fund is defined as a US person and a financial counterparty for Emir, and it's trading with a US dealer, that trade can be cleared in accordance with Dodd-Frank and potentially satisfy Emir under equivalence," says Simmons & Simmons's Yip. "But if that Cayman fund is trading with a European dealer, equivalence cannot currently apply because neither of the counterparties is established in the US, even though the fund is defined as a US person. That's a big gap in the rules. The EU needs to expand the application of equivalence to allow for compliance in that scenario."

Yip says the hedge fund industry needs to be granted relief from the rules until regulators have worked out how to avoid an overlap between the rules. The longer-term solution would be for the CFTC to extend substituted compliance to US persons that are regulated overseas, and for Europe to amend its condition that one of the counterparties to a trade be established in an equivalent jurisdiction, he argues.

Aima is lobbying for exactly that, but there has been no signal yet that regulators are prepared to bend. That leaves a big cloud over many European managers, says Aima's Jacobs: "At the moment, many funds managed in Europe are following the Dodd-Frank rules because they are defined as US persons under the CFTC guidance. The question is what happens when the Emir clearing obligation comes into force?"