The Cayman Islands has seen its supremacy as the number one hedge fund jurisdiction rudely shaken. The question is how it will respond to the unprecedented challenges.
Since 1993 when the jurisdiction enacted its mutual funds law, it has reined supreme, capturing an estimated 70% of hedge fund registrations worldwide.
However, the financial crisis and international political attacks have both taken their toll on the island state. First the economic crisis hit Cayman hard. With around 45% of government revenues coming from the financial services industry, a global economic slowdown affecting this sector was a blow to the island’s development.
Coupled with that were unprecedented political attacks on offshore financial centres like Cayman. Regardless of the fact the accusations levelled at Cayman were for the most part inspired by politicians playing to domestic crowds, the island along with other reputable international financial centres has taken a hit.
Cayman’s location to some extent played against it even more. The most sceptical members of the European Union (EU), France and Germany, were demonstrably harder on the Caribbean jurisdictions – particularly Cayman – than on offshore financial centres close to Europe like the Channel Islands.
Although few offshore financial centres were spared, Cayman’s reaction to the attacks was slow and unco-ordinated.
No longer. Cayman Finance, now headed by Anthony Travers, former managing partner of international law firm Maples and Calder, sees his priority at least in the short term to right any wrongs against Cayman.
With over 30 years of experience in all aspects of Cayman Islands law, particularly mutual funds, structured finance and insurance, he is well placed and capable of rebutting any ill advised statements against Cayman from journalists, politicians and governments.
Travers is generally bullish about Cayman’s ability to stay in the number one position.
“I know as a fact throughout the financial crisis the total number of hedge funds [domiciled in Cayman] was almost not affected,” notes Travers.
He thinks other jurisdictions would like to think Cayman is on the decline. “Let’s cut through to the facts. Cayman Islands is still the jurisdiction with by far the greater number of registrations of hedge funds.
“There has been very little change overall. We don’t actually see that fundamentally changing,” declares Travers. He admits no one really knows what the full impact of the financial crisis may be. “We are quietly contemplative.”
Assets under management are still below 2007 levels although Travers among others expects this drop to have little real direct economic impact on Cayman. Fees the Cayman government collects from hedge funds are fixed rather than based on the percentage of AUM.
Travers sees the reorganisation of Cayman Finance into a vehicle to promote and defend Cayman in an active manner as a positive development “because of the overriding success of the Cayman Islands over the past decade there has not been a great need for a PR campaign or public affairs.”
However, when the financial crisis hit, there was a good deal of “negativity”. Travers says most of what was said about Cayman has been not just negative but wrong.
“The Cayman story is very strong. We are a transparent, tax neutral jurisdiction. We were the first domicile to adopt anti-money laundering legislation and we now have full Iosco membership. But this message is not getting across. It’s not a difficult story to tell and we need to ensure the right facts get out there for onshore regulators and politicians to hear,” Travers says.
Cayman Finance is doing this through articles, seminars and events in key partner states. “We have a comprehensive programme of rebuttal, correcting factual errors,” notes Travers.
He believes the real reason behind the negative comments about Cayman and other international financial centres had nothing to do with a lack of transparency or good regulation but were really the need of G20 countries to increase tax revenues and demonstrate to their own populations that they were doing something. “The denigration was never factual,” he says.
“It is, therefore, a constant battle to ensure the true story is told. We should not lose sight of the fact the story we tell is the truth,” he says, noting that countries that spread falsehoods about Cayman “can’t defy gravity forever. There is a policy of diminishing return. The more Cayman accedes to treaties, the greater their difficult in alleging a contrary position.
“It is only a matter to time before one of two things happen: they have to desist in erroneous denigration as no one believes them, or change the rules of the game and in changing the rules of the game, freely admit their true concern is not tax evasion or the lack of regulation but rather that the Cayman Islands poses a tax competition threat,” declares Travers.
There are good reasons, according to Travers, for the Cayman Islands to be regarded as a superior jurisdiction for hedge fund structures. There are deep roots in the island on the legal side as well as a high level of professionalism not seen in other jurisdictions.
The Cayman Islands Monetary Authority (CIMA) is regarded as an effective regulator. Throughout the world, too, there is a high level of understanding of the structures of hedge funds offered from Cayman.
This he believes will continue to attract managers not just from the US but also from emerging countries like Brazil as well as the Far East. “There are structural reasons we remain attractive and have reputational supremacy,” he says, pointing to the “reach of Cayman Islands professionals around the globe” where individual law firms and other providers are present in Hong Kong, Dubai, Singapore and other areas in order to respond to the demand for Cayman fund structures.
“Cayman has the global reach through professional institutions. I think there is an application for Cayman Islands structures, not European control,” says Travers.
Despite the optimism Travers exudes, there are some potential blots on the landscape. Although many outside the island state think the European Union’s alternative investment fund managers (AIFM) directive could throw a spanner in the well-oiled hedge fund machine in Cayman, Travers dismisses the idea. “The effect of [AIFM] is more likely to enhance the position of Cayman as a hedge funds jurisdiction than to detract from it,” he confidently predicts.
While many may consider this to be a rather optimistic view of the EU’s attempt to rein in hedge funds, Travers believes the EU legislation could result in making European managers less competitive and could even push some to move out of the EU.
He is also confident the Cayman government will be able to match any conditions the EU throws up to try to block Cayman funds. Under the latest equivalency criteria looking at non-EU standards on tax, money laundering and regulatory information, Travers says Cayman is already passing the test. As long as the playing field is kept level, he and others are confident Cayman will meet the criteria.
Travers also says the industry is undertaking a “gap analysis” to determine just what might need to be changed in order to comply with the directive.
Although the attacks, jibes and general slanders against Cayman may have subsided, the government is nevertheless facing an even more formidable foe: a whopping great budget deficit.
While the numbers are small compared with other countries, the scale of the problem facing Cayman is immense. Many on the island concede that the biggest threat to the funds industry and financial services in general will come if the government is unable or unwilling to curb a growing imbalance between revenue and expenditure.
The widely reported and wholly inaccurate reports of a bankrupt Cayman have spurred the government into taking unprecedented steps to address the problem.
A highly over-subscribed government bond issue earlier in the year has raised the money needed to continue funding capital projects. While the government is likely to be able to finish 2010 more or less in balance, it needs to address the problem of a growing public sector wage bill and a relatively low tax base.
Paul Byles, managing director of Focus, a corporate services and consulting company, is also economic advisor to the Cayman government.
“The common view is that too many people work for the government,” he concedes.
Slimming down
One way to reduce this he advises is through privatisation of services. The premier, McKeeva Bush, is open to the idea and there are plans being actively examined to address Cayman’s budget problems.
A transition of the civil service to a private sector partnership will, however, present its own political and domestic problems for the government.
While the need to downsize is imperative, “the government understands there are wider considerations” notes Byles.
The government will certainly not be short on help if it does pursue privatisation of some services. Professionals based on the island have had direct experience of privatisation projects or are familiar with such plans and are ready and willing to help.
For the financial services sector, and in particular, the hedge fund community, it is imperative the government tackles the budget imbalance quickly and implements a sustainable programme for the future.
The real centre of action, however, remains hedge funds. Various press reports of a drift away from the Cayman Islands by hedge funds may be exaggerated, but there are some worrying signs. Whether this is due to the natural aftermath of the financial crisis or the trend toward onshore regulation in the EU is an open question. While fund managers globally are inclined to prefer Cayman Island fund structures, the vast majority remain US-based managers.
The trend of European based managers to prefer jurisdictions closer to home, and onshore, may be a result of investor pressure, imagined or real, to choose EU jurisdictions for domiciling funds. There is no sign of a mass exodus from Cayman. Only one significant fund manager, Marshall Wace, re-domiciled its funds from Cayman to Ireland, where it already had several products registered. Interestingly, Cayman counted Marshall Wace’s fund and sub-funds as one while Ireland’s regulator counted the sub-funds, boosting its numbers significantly, once the move was completed.
Looking at the regulation of the funds industry, there is general approval of the way CIMA has been dealing with issues. It is universally applauded for its open-door approach and ability to respond proportionately and appropriately to regulatory challenges. CIMA officials still believe it is important to have a dialogue with the industry and believe the relationship it has with the numerous associations on the island representing various parts of the industry including the local branch of the Alternative Investment Management Association (Aima) has helped it maintain a good level of regulation, remain innovative and quick to respond to industry needs as well as international demands.
Langston Sibblies, general counsel and deputy managing director at CIMA, believes changes on how the regulator can amend and issue guidance notes will strengthen supervision of the industry.
The change was made around a year ago and now allows CIMA to give “clear guidance and exploitation in terms of hedge funds and fund administration” according to Sibblies.
He also believes this gives CIMA a bit more flexibility on how the practical implementation of rules should happen. A good example is the need for a compliance officer at senior level in an organisation. The challenge, says Sibblies, was how to structure the regime for funds that are not physically located in Cayman.
The answer was to allow some functions to be delegated to service providers. The guidance notes issued by CIMA were able to bring clarity to the rules and explain how they would function in practice. These notes were written with input from the industry which was concerned about its ability to comply with the new rules.
Sibblies also believes the ability of CIMA to produce guidance notes and rules further strengthens its independence as an authority. Further guidance notes on areas such as corporate governance are also planned.
“This has given CIMA a tool to give additional guidance and regulation without the need for legislative actions,” notes Sibblies. This is important as it is not always clear to the industry just how regulations should be applied once laws are published.
Mitchell Scott, head of policy and development, believes this makes for a much more efficient industry. “This should help promote best practice,” he says, as well as adding to the transparency of legislation.
One thorny issue CIMA is discussing at present concerns independent directors and in general the corporate governance structures of funds.
Questions around how to impose rules that encourage proper conduct from directors and give CIMA the tools to expand on what its expectations are is exercising the regulator, says Sibblies.
Although CIMA still consults on draft rules and guidance, Sibblies believes this only strengthens industry buy-in for rules and also ensures people know exactly what is expected and what to do to meet new requirements.
Head of the investments and securities division Yolanda McCoy believes CIMA will need to take care in coming up with ideas on how to strengthen overall corporate governance.
To determine the characteristics and skills of a director will be particularly tricky for the regulator. She expects part of the regulation to try to determine competency, fitness and honesty of individuals.
“For regulated funds, once the fund is established, there will probably be an ongoing requirement to monitor directors to ensure they act in a fit and proper manner no matter where they are based,” notes Sibblies.
McCoy points out that CIMA is concerned with funds where the investors are sophisticated individuals and institutions. “We draw a distinction between public and private fund regimes. One prime objective around mutual funds will be disclosure.
“The offering documents mostly contain the information so investors can fully understand the risks being taken. We also intend to adopt a risk-based model like the FSA [UK Financial Services Authority] and other regulators. This more risk-based, pragmatic and practical approach will be aimed at understanding the risks of products and these are the ones CIMA will look at closely,” she says.
Some of the things CIMA will monitor include key areas of risk such as the use of leverage, technological support, a high staff turnover, changing of services providers and directors. These are the “red flags” McCoy says will trigger a review or investigation by CIMA.
“Using this approach will allow CIMA to operate more effectively and understand better the risk inherent in products,” she notes.
Sibblies agrees that it would be “physically impossible to visit all the funds” and believes a risk-based approach is the best solution. He believes what CIMA already does is “pretty consistent” and that a risk-based approach will continue to be the most efficient one for the regulator.
McCoy confirms that one of the aspects of CIMA’s electronic reporting will be a way to understand risks posed by funds. Describing systematic risk, levels of leverage and liquidity, analysing both qualitative and quantitative information, will be helpful not only for CIMA but also in an international context.
“One of the major objectives for CIMA is to develop and ensure sharing of information with on and offshore regulators,” confirms McCoy.
There is already a lot of dialogue with the US Securities and Exchange Commission as well as the UK’s FSA. Keeping Cayman’s rules and supervision in line with international practice remains a priority for CIMA, says McCoy.
“We are under no illusion that e-reporting is the answer to monitoring systemic risk,” notes Sibblies. “But it provides information that didn’t exist before and adds information.”
To ensure timeliness of information CIMA is looking at speeding up the reporting process and considering cutting the time funds have to prepare and submit audits to the regulator. For single funds CIMA is looking at the idea of having regulated funds report within three months of the end of the year, cut from six.
This, however, may be something resisted by auditors who say pushing the deadline would significantly increase costs as more staff would be needed for a relatively short time and then remain idle for the majority of the year.
Also, funds of hedge funds, which need to have the audited statements of the underlying funds before submitting their own statements, would find it difficult to cut the time needed to prepare their reports.
“We are looking at reducing the audit filing to a shorter period in order to get out more timely information,” confirms McCoy.
"But we also need to understand the model and mind of fund managers in various locations,” she adds. CIMA will be looking at the requirements of the US and London in particular before making any changes. The aim, stresses McCoy, is to help the regulator spot any problems more quickly.
Whatever the outcome of this initiative, McCoy admits the long-term aim is more co-ordination and co-operation between regulators as well as to strengthen Cayman’s own regime.
“We are obviously very aware of the trend,” says Sibblies. “There is a need to be more proactive in identifying trends and reacting before, not after, something happens,” he adds.
Looking at the potential response of CIMA to any new regulations coming out of the EU, McCoy says she will “need to understand what equivalency is and how we can ensure Cayman has in place the legislation to allow this.”
However, it is unlikely Cayman will make any precipitous moves. While it is known to be pragmatic in its response to international standards, it is unlikely to rush into any legislation that may harm its competitiveness.
The general consensus seems to be a “wait and see” attitude. Many remain confident little, if anything, would need to change to make Cayman’s existing laws and regulation ‘equivalent’ to the EU’s own rules.