How much leverage will you need to move the world, Archimedes? Can you give us a number?
Archimedes’ famous boast, and that possible follow-up question from some Alexandrian spoil-sport, came to mind when I saw that the Alternative Investment Management Association has expressed its satisfaction with the publication of the final text of a long-labored-over document. AIMA is happy, that is, that the EC has finalized the European Commission’s Alternative Investment Fund Managers’ Directive.
AIMA noted that it doesn’t agree with all of the provisions of this text, “notably on areas like depositaries and delegation,” but in the words of AIMA CEO Andrew Baker, “it is now important to look forward.” So, I wondered: what about leverage? Is there a number?
This spring, the European Union released a draft of its implementing rules. At that time, AIMA was sounding a good deal less than sanguine.
One of the guiding ideas of the AIFMD was that AIFM’s operating out of one of the member states shall report certain data to the home state’s competent authority on a fund by fund basis, for every AIF they market within the EU. Accordingly, if an AIFM manages AIFs that employ “substantial leverage,” than this AIFM must include in its reporting information on the overall level of leverage employed by each fund. The authorities might then require further information as it pertains to systemic risk.
This brings us to the question I would direct at Archimedes, because there has been some back-and-forth during the deliberative process over what “substantial leverage” means, and whether the implementing order ought to give substantiality a specific number.
The AIMA noted in a report it issued in spring 2012 that the European Securities and Markets Authority, in its recommendations, had said it would be inappropriate “to seek to specify a quantitative threshold at which leverage would be considered to be employed on a substantial basis" given the "heterogeneous population of AIF” covered by the directive.
In other words: no single number.
ESMA’s preferred approach to determining substantiality was one that takes into account “offsetting arrangements,” that is, “combinations of trades on financial derivative instruments and/or security positions” aimed at limiting risk. These offsets would enter into the calculation of exposure, and thus in the definition of the extent of leverage, if they were “likely to remain materially effective in terms of stressed market conditions” and if there were a “verifiable reduction of risk at the level of the AIF” as a consequence. AIMA referred to this as the “sophisticated” approach.
Final Answer: 3
But the EU at that stage was using a much simpler approach. Leverage would be deemed substantial when the exposure of an AIF exceeded two times net asset value. So there was a simple number, and it was 2! The definition of “exposure” for this purpose would likewise be a simple one taken over from the UCITS system, and without offsets, the so-called “commitment method.”
In the months since, there has been some change, but not the change away from the commitment method that some desired last spring. Rather, the number has simply increased from 2 to 3: substantial leverage is an exposure of three times NAV, with exposure still defined by the commitment method.
The EC in an explanatory memorandum says that this “provides the best trade-off between adequate reporting on leverage and the administrative burden on the AIFM and the competent authorities.”
Another subject of a good deal of back-and-forth during the Lamfalussy deliberative process has been the relationship between AIFMs and their depositary institutions. This includes the necessary provisions of contracts, the functions of the depositary, and its liabilities in the event of a loss of financial instruments.
By spring 2012, for example, drafters had stipulated that the contracts should stipulate “the geographical region in which the AIF plans to invest” with “country lists and procedures to add and/or withdraw countries from that list,” as such particulars impact the safe-keeping and oversight functions to be performed.
AIMA cautioned that such rules could prove disruptive to the asset management industry in the EU. By adding costs to the rather small number of banks that perform the function, it could exacerbate the too-big-to-fail problem.
But in these respects there has been little give. Article 83 of the final implementing text still contains an elaborate list of “contractual particulars,” including the same geographical stipulations.