GERMANY DEBATES HEDGE FUND REFORM; BACKS

UNCLAS SECTION 01 OF 03 BERLIN 002269

SIPDIS

SIPDIS

DEPARTMENT FOR EB/IFD
TREASURY FOR BRIAN COX

E.O. 12958: N/A
TAGS: EFIN EINV PGOV GM
SUBJECT: GERMANY DEBATES HEDGE FUND REFORM; BACKS
MULTILATERAL MONITORING

REF: 05 BERLIN 02032 (NOTAL)


1. SUMMARY. Hedge funds are politically contentious in
Germany. The two major political parties in Chancellor
Angela Merkel's "Grand Coalition" have staked out opposing
positions on whether Germany should reform its hedge fund
regulations. The three major German financial agencies --
the Bundesbank, the German Financial Services Supervisory
Authority (BaFin),and the Ministry of Finance -- are
advocating separate policy recommendations. This uncertain
policy environment could have an impact on U.S. investors,
who make up approximately 90 percent of Germany's hedge fund
industry. German officials and bankers say the public feels
uneasy about hedge fund strategies. Bundesbank economists
and other German financial experts point to hedge fund risks
that could undermine financial stability. END SUMMARY.

INTRODUCTION TO HEDGE FUNDS IN GERMANY
--------------


2. Hedge funds are defined in Germany as "funds with
additional risk" that allow leverage, the use of derivatives,
and short sales. Germany is a late-comer to the hedge fund
market, having only created a legal basis for hedge funds in

2004. It is also unique among countries in that its
financial regulatory agency (BaFin) monitors hedge funds.
Single hedge funds cannot be publicly traded and may only be
marketed through credit institutions and financial service
providers authorized for investment and contract broking;
they are not permitted to invest in real property and real
property companies; and their investments in enterprises not
part of an exchange or organized market are limited to 30
percent of the value of the fund.


3. Fund of Hedge Funds (FoHFs),which are defined as
investment asset pools that invest at least 51 percent of
their value in individual hedge funds, are additionally
targeted by German regulations. Unlike single hedge funds,
marketing of FoHFs is allowed, but FoHFs must provide
investors with a detailed sales prospectus containing
information on the features of the product as well as the
following warning in bold print: "Warning by the Federal
Minister of Finance: Investors in this investment fund must
be prepared and able to sustain losses of the capital
invested up to a total loss." Short sales, leverage,
cascades, and borrowings are not permitted; a maximum of 20
percent of the value of a FoHF may be invested in a single
target fund; FoHFs may not invest in more than two target
funds of the same issuer or fund manager; and funds must have
no more than 49 percent liquidity. There is also a lengthy
application process for FoHFs that takes between 2-6 months
to complete. In addition to requiring FoHFs to disclose
detailed, audited annual and semi-annual reports, BaFin holds
the right to solicit any information regarding a FoHF's
investments.


4. In June, the German Bundesbank and the European Central
Bank issued warnings on the systemic risks that hedge funds
pose for the international markets. There are approximately
8,600 hedge funds worldwide, worth more than USD 1.4
trillion. The hedge fund industry's lack of transparency and
the high-stakes investment strategies that these hedge funds
pursue are causing many German experts and politicians to
express significant concern regarding the lack of
international standards for regulating hedge funds. Former
Chancellor Gerhard Schroeder proposed at the 2005 G-8 meeting
in the UK a multilateral approach to monitoring hedge funds
to reduce potential risks to financial stability -- a policy
the Finance Ministry continues to pursue (REFTEL). Germany's
Bankers' Association also acknowledges that hedge funds pose
significant risks to the banking sector because it fears
hedge funds would quickly liquidate debt holdings in times of
market stress. Jochen Sanio, President of BaFin, believes
that hedge funds are undoubtedly dangerous to the financial
system, noting at a German conference recently that "the
question is not if, but when the next hedge fund disaster
will take place." As a result, the German Parliament and
federal financial agencies are beginning to consider ways to
mitigate the potential risks that hedge funds pose to the
financial market.

MUCH POLITICAL ADO ABOUT HEDGE FUNDS
--------------


5. Hedge funds have struggled with an image problem in
Germany since the 2005 election campaign. Vice-Chancellor

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and former Social Democratic Party Chairman Franz
Muentefering likened hedge funds in Germany, which are mainly
managed by U.S. investors, to "locusts" that pillage German
medium-sized firms by restructuring, closing certain
operations, and re-selling them. Muentefering's hedge fund
rhetoric captured popular interest in Germany, garnering up
to 75 percent support in public opinion polls. Hedge funds
remain news even after the election, as the general public
continues to view hedge funds with suspicion and distrust.


6. Finance State Secretary Thomas Mirow and other officials
believe hedge funds' negative image in Germany is due to the
foreign ownership of most hedge funds and a lack of financial
literacy among the general public. Embassy contacts in the
finance industry note the German public feels a deep-seated,
culturally ingrained distrust of the finance industry -- and
this distrust is only reinforced by negative press and recent
concern by industry experts about the risks of hedge funds.
According to some experts, this cultural uneasiness about
debt financing and financial leveraging will likely prevent
Germany from embracing the hedge fund industry.


7. Not surprisingly, the finance industry is frustrated by
recent called to curb the activity of hedge funds and
increase federal regulations. Industry experts note that
since enabling legislation in 2004, the growth of the USD 2
billion hedge fund industry in Germany has been
disappointing. According to Bundesbank figures, only 20
domestic single hedge funds and 14 FoHFs have registered with
the German authorities. Industry experts also claim that
Germany's current, comparatively high level of hedge fund
regulation is driving investors away from Germany and toward
its major European competition (e.g. in Luxembourg,
Switzerland, and the UK).

HEDGE FUND REGULATION AT A CROSSROADS
--------------


8. Quite divergent proposals on hedge funds are floating in
the German government. German officials expect that the
future direction of hedge fund regulation in Germany will be
determined by the ability of the political parties in power
to overcome their conflicting positions on the issue.
Currently, there is no indication that this is occurring: The
Social Democratic Party (SPD) continues to fan the flames of
the "locust" debate that Muentefering began during the 2005
election campaign and supports the retention of the current
level of hedge fund regulation; the Christian Democratic
Party (CDU/CSU),which shares majority power with the SPD in
the "Grand Coalition", wishes to foster a Frankfurt-based
hedge fund industry and wants to lighten the regulatory
burden; and the Left Party, which is in the minority, wants
to eliminate hedge funds entirely from Germany.


9. The three legislative initiatives before Parliament
include:

OPTION 1 - BAN HEDGE FUNDS IN GERMANY: In late 2005, with an
eye toward attracting voters skeptical about hedge funds, the
Left Party introduced a proposal in the German Parliament to
ban hedge funds. The Left Party argued that hedge funds have
become too risky and are threatening Germany's financial
stability. Just before the 2006 summer recess, the
Parliament's finance committee passed its recommendation not
to support the Left's proposal. German officials believe the
likelihood of Germany banning hedge funds in the near future
is very low.

OPTION 2 - INCREASE REGISTRATION REQUIREMENT: In an effort
to increase the transparency of hedge fund activity, the
Finance Ministry is currently considering increasing the
number of funds falling under domestic regulation of single
hedge funds. Currently, single hedge funds in Germany are
required to register with BaFin once they invest in at least
5 percent of a company's value. The German government is now
deliberating whether to lower this threshold to 3 percent.
German officials believe the livelihood of Germany enacting
this new rule is very high, as neither industry interest
groups nor political parties have yet to voice opposition to
the proposal.

OPTION 3 - DECREASE REGULATORY BURDEN: Even while supporting
the new registration threshold rule, the Finance Ministry is
also drafting a proposal to revise the current investment
laws governing hedge fund regulation in order to reduce other
regulatory measures and make them more "business-friendly".

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The Finance Ministry avidly seeks to foster growth in
Germany's own hedge fund industry in Frankfurt. Although the
details of the proposal are not yet available, Finance
Ministry officials are confident their proposal will pass the
German Parliament by January 2007 with strong support from
the financial industry.


10. INTERNATIONAL OR EUROPE-WIDE REGULATION: In May, the
Bundesbank unveiled several proposals that called for greater
international and/or Europe-wide regulation of hedge funds.
Edgar Meister, a member of the Bundesbank's executive board,
called for a "code of conduct" modeled on the scheme
developed by IOSCO for oversight of credit rating agencies;
he further proposed that hedge funds voluntarily submit to
credit rating agency assessments. The German Bankers'
Association, BaFin and the Finance Ministry support the
Bundesbank's proposal. In general, while Germany's private
sector and government are in favor of international or
Europe-wide regulation of the hedge fund industry, they doubt
any such plan could be realized in the near future. They
claim that diverging interests at the EU level, as well as at
the international level, will prevent moving soon toward a
multilateral solution to hedge funds. German officials
explain that, as one of the few countries to regulate hedge
funds, Germany naturally seeks an international approach that
would bind financial centers to the same rules for hedge
funds.

REITs: CANARY IN THE COAL MINE?
--------------


11. Although the outcome of the hedge fund regulation debate
remains unclear, Embassy contacts suggest that the outcome of
a parallel debate already in Parliament on the legalization
of REITs (Real Estate Investment Trusts) will be an important
indicator for how the hedge fund debate will turn out. Like
hedge funds, REITs have been labeled "locusts" by the Social
Democrats and their legalization has emerged as a politically
divisive issue. Financial industry groups are interested in
REITs, as Germany's real estate market is valued at an
estimated USD 9.5 trillion. The Finance Ministry's Mirow
believes the REITs draft law proposal could be the bellwether
for revealing the political parties' true positions on
legislation for promoting Germany's financial industry
(SEPTEL).
TIMKEN JR