Last year Michael Bloomberg, New York mayor, commissioned McKinsey & Co to assess the competitiveness of the city, amid signs the Big Apple and the US in general were losing business to Europe and Asia. The management consultancy concluded that regulation is indeed having a negative impact on the world’s largest economy.
US fund management firms have not escaped the impact, partly because hedge funds were – rightly or wrongly – seen as one of the causes of the financial crisis, and partly because investment firms are being caught by regulation that was not necessarily intended for them.
Dodd-Frank, for instance, is primarily aimed at the banking system, but the shadow banking system is being forced into levels of disclosure that have discomfited some US hedge funds.
George Soros’s Quantum fund, for one, has decided the new regulatory terms are too onerous to continue third-party business.
Other managers are not expected to follow Mr Soros’s lead, preferring to bow to the inevitable. “A lot of hedge funds have pre-emptively registered and appointed chief operating officers, as required under Dodd-Frank rules,” says Dan Bender, a director of Navigant Consulting.
But some of the best names in the US hedge fund industry could have their route to supranormal returns cut off if the disclosure rules are not watered down. Funds such as Citadel, SAC Capital and Paulson & Co, which made big counter-trend bets in the financial crisis, will not find it so easy to repeat the trick.
“Several funds flew under the radar and no-one knew what they were holding,” says Andrew Liegel, of Wolters Kluwer Financial Services. “In the future, they may have to disclose their positions and potentially lose their market edge.”
In tandem with the investment headache is a distribution nightmare as reporting and examination by regulators could lead to the identities of their underlying investors being revealed. “This could make sovereign wealth funds think twice before allocating to US funds,” says Bradley Sabel, a New York-based partner at Shearman & Sterling. Such disclosure would not appeal to members of Middle Eastern royal families, for example.
At the same time, there are worries that regulators are not acting aggressively enough, particularly in terms of addressing systemic risk. The US Financial Stability Oversight Board has as yet failed to provide detail on security transparency.
Wolters Kluwer says there is concern it is moving too slowly. “Municipal bonds are a ticking time bomb, and all money market funds contain these bonds,” says Mr Liegel. A blow up in the $2,700bn municipal bond market could deal the US as damaging a blow as a default on the national debt.
The Volcker Rule is widely viewed as a threat to the competitiveness of the US. The curtailing of proprietary trading could lead to an exodus of some banking business and staff to Europe and Asia. “Outside the US, there is not much movement to replicate the Volcker Rule,” says Mr Sabel. This might mean not only that US banking activities could head overseas, but that foreign banks – particularly cash-rich Middle East entities – may choose Europe over the US to conduct their business.
There is evidence of this happening already. “One of our clients is moving all its prop(rietary trading) desk activities to London,” says Neil Mayall, head of the US financial services practice at Navigant. “This may be a rare case, but it does show the pressure US banks are under.”
Dodd-Frank’s provisions on derivatives are also causing concern. There is fear, bordering on anger, that Gary Gensler, chairman of the Commodity Futures Trading Commission, who is tasked with enforcing 50-odd rules under Dodd-Frank, is determined to create a more severe derivatives regime than will apply in other jurisdictions. Funds that move offshore may well have a freer hand and pay lower margins than under a Gensler-inspired regime.
As if the weight of upcoming regulation were not enough, the US fund industry also has to contend with disadvantageous tax rates in comparison with many of its European rivals. Luxembourg, for instance, taxes funds at 7 per cent on average, against 20-30 per cent in the US.
Unsurprisingly, Vanguard, Fidelity and other large US mutual fund managers continue to expand in Luxembourg. As Mr Liegel says: “From a tax perspective, it doesn’t make sense to be in Connecticut, Chicago or New York. Combine that with the extra transparency demanded by the US authorities and the restrictions on shorts and derivatives in mutual funds compared with Europe, and you have a compelling argument for Canary Wharf, Luxembourg or Dublin.”
Although increased regulation is far from a US phenomenon, as a traditional hotbed for innovation the US is affected disproportionately. The ongoing creation of new hedge funds is particularly at risk, thinks Udo Frank, global chief executive of RCM, a $150bn fund manager. “Not that long ago $50m made a hedge fund viable,” says Mr Frank.” Today that has risen to $150-200m because institutional investors only consider it worth their while to perform costly due diligence on the bigger groups. Also they see more business risk in smaller hedge fund organisations.”
In the final analysis, the biggest threat to the US’s financial dominance is probably not regulation, but politics and geopolitics. As Mr Sabel notes: “The dollar has long been the world’s reserve currency and Treasuries the reserve assets. But people are starting to question this. Even though a deal was struck over the debt ceiling, a lot of damage has been done and outsiders will consider this when deciding whether to set up shop in the US.”
The opportunity in Asia is hastening this shift in sentiment. Mr Frank says: “A financial hub is about people and talent, and regulation is not all that important in that. Companies won’t relocate bits of their business to Asia just to escape regulation. But they will if they see the US as unable to solve its problems and to grow.”