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UNCLAS SECTION 01 OF 04 FRANKFURT 005056 
 
SIPDIS 
 
SENSATIVE 
 
STATE FOR EUR PDAS RIES, EB, EUR/AGS, AND EUR/ERA 
STATE PASS FEDERAL RESERVE BOARD 
STATE PASS NSC 
TREASURY FOR DAS LEE 
TREASURY ALSO FOR ICN COX, HULL 
PARIS ALSO FOR OECD 
TREASURY FOR OCC RUTLEDGE, MCMAHON 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EUN
SUBJECT: The Chancellor and Hedge Funds 
 
 
T-IA-F-05-031 
 
This cable is sensitive but unclassified.  Not/not for 
Internet distribution. 
 
  ¶1.   (SBU)  Summary: Chancellor Schroeder has pledged to 
     raise "standards for hedge funds" at the G-8 Summit.  His 
     position reflects a negative characterization, publicly 
     stated by the Chairman of the SDP and others in the 
     Chancellor's party, of investors fixed on quick financial 
     gain - the proverbial "locusts" - rather than strategic 
     interests of a firm.  Senior government leaders have tried 
     to play down the characterization of hedge funds as 
     "locusts" with some arguing that the remarks were made in 
     the context of the ultimately unsuccessful campaign to keep 
     control of the key state of Nordrhein-Westfalen.  Others 
     have noted the close relations the Chancellor has had with 
     German business leaders.  However, the Chancellor told a 
     party gathering June 13 that he planed to raise hedge funds 
     at the G-8 Summit.  Among German financial experts there is 
     disquiet about the Chancellor's position for several 
     reasons.  First, hedge funds are already supervised in 
     Germany.  Second, investor activism is a corporate 
     governance issue not unique to hedge funds.  There may be 
     hedge fund aspects that need to be explored, but the 
     political debate sparked by some  Social Democratic Party 
     leaders is not conducive to a factual analysis.  This is not 
     the first time the Chancellor has jumped into an economic 
     issue taking views contrary to his Finance Ministry.  Basle 
     II, the EU Takeover Bids Directive, and Stability and Growth 
     Pact bear imprints of the ruling Coalition's political 
     agenda that caused them to miss their respective economic 
     marks.  End Summary. 
 
  Chancellor to Raise Hedge Funds at G-8 Summit 
  --------------------------------------------- 
 
  ¶2.   (SBU)  At a SDP gathering on June 13, Chancellor 
     Schroeder pledged to raise hedge funds at the G-8 Summit. 
     Hedge funds, unregulated in many jurisdictions, principally 
     cater to professional investors by adopting strategies that 
     seek higher yields, which means higher risks.  These funds 
     have grown quickly in recent years.  Eurohedge estimates 
     total assets under management in the European hedge fund 
     industry is $250 billion at the beginning of 2005, up from 
     $170 billion at the beginning of 2004.  In 2004, 250 new 
     funds were set up in Europe.  Hedge Fund Research estimates 
     that for the first time global investments in hedge funds 
     topped $1,000 billion as of the end of the first quarter of 
     ¶2005. 
 
  ¶3.   (SBU)  According to press reports, the Chancellor said, 
     "We want stable markets.  We need effective supervision and 
     clearly improved transparency of the hedge-fund market 
     globally.  For that reason I will speak out in favor of 
     uniform minimum standards for hedge funds at the G-8 
     Summit." 
 
  ¶4.   (SBU)  At a June 27th speech to the United States 
     Chamber of Commerce in Washington the Chancellor said that 
     "In Germany, the activities of some hedge funds, which were 
     focused primarily on the short term, lead quite rightly to a 
     few questions."  For stable markets, he continued, effective 
     international supervision is needed that requires a 
     "considerable improvement in the transparency of the hedge 
     fund market."  Therefore he will propose a "set of 
     international minimum standards for hedge funds" at the G-8 
     Summit. 
 
  German  and London Stock Exchanges as Sources of Concern 
  --------------------------------------------- ----------- 
 
  ¶5.   (SBU)  One reason  for the Chancellor's interest in 
     hedge funds was the political furor stirred by the SPD 
     leadership over the ouster of Werner Siefert, CEO of the 
     German Stock Exchange Company (Deutsche Boerse (DB)).  Some 
     foreign hedge funds insisted that DB use its cash to buy 
     back its own shares, thereby increasing the value of the 
     hedge funds' investments, rather than use the case to 
     purchase the London Stock Exchange (LSE) at a high price. 
     As a senior Finance Ministry official explained, while 
     removals of CEO's is not unusual elsewhere, this was the 
     first such high profile event to occur in Germany.  Another 
     reason the issue may have surfaced was an effort by the SPD 
     leaders to get traditional voters energized in an ultimately 
     failed campaign in May to keep control of Germany's largest 
     state. 
 
  ¶6.   (SBU)  Frankfurt financial experts point out that while 
     UK-based hedge funds were the most vocal in opposition to 
     the Company's bid for LSE, Siefert also had failed to gain 
     the backing of German investors and that this is what tipped 
     the scale for  his removal.  That, however, is a detail lost 
     in the political whirlwind that whipped up at the same time 
     over private equity funds.  SDP Chairman Muentefering, 
     referring to some negative experiences with such funds, 
     likened them to "locusts" striping German companies of 
     profitable assets.  In June Secretary Snow pointed out at 
     his Frankfurt press conference, the analogy is misplaced as 
     equity funds make money only by adding value to a firm, 
     ensuring its profitability and attractiveness to sell to 
     other investors. 
 
  ¶7.   (SBU)  Logic, however, was not part of the politics. 
     And the very different case of DB was sucked in with 
     criticism of private equity funds.  A senior Finance 
     official, noting the role politics were playing, took 
     comfort in his own assessment that there is no time to enact 
     legislation due to the expectations of snap elections, so 
     nothing substantive would happen in Germany. 
 
  Right String , but the Wrong Yo-Yo? 
  ----------------------------------- 
 
 
  ¶8.   (SBU)  Finance Ministry and Bafin and finance experts 
     with whom we spoke were not happy with the political 
     discussion.  In January 2004 Germany had implemented 
     legislation on hedge funds designed to enhance the 
     attractiveness of Frankfurt as a financial center.  The 
     legislation requires such funds to be licensed, audited, and 
     to provide regular reports just like other regulated 
     financial entities.  The regulators believe their approach 
     is solid. 
 
  ¶9.   (SBU)  An expert from the German Investment Funds 
     Associated pointed out that the German hedge funds had been 
     slow to take off, with only 17 such funds operating to date, 
     accounting for 1.7 billion euros (out of a total investment 
     funds industry of 1,200 billion euros).  Despite industry's 
     appreciation for the legislative initiative, the heavy- 
     handed regulatory regime had scared some business away, with 
     German funds setting up more new funds in Luxembourg than in 
     Germany.  In April the Finance Ministry had issued a public 
     discussion paper on the investment fund industry and 
     solicited ideas on how to make hedge fund operations more 
     investor-friendly. 
 
  ¶10.  (SBU)  Among financial experts in Frankfurt, there is a 
     view that hedge funds deserve a closer look, but not for the 
     reasons mentioned by the Chancellor.  In their discussion 
     with U.S. Treasury Secretary Snow June 19, German bankers 
     argued for the need for more transparency of hedge funds and 
     their strategies.  While sophisticated investors can handle 
     the necessary due diligence when investing in a hedge fund, 
     retail investors may not.  In the UK, for example, hedge 
     funds that are unregulated collective investment schemes can 
     only be marketed to a limited class of investors.  In 
     Germany, however, a fund composed of various hedge funds can 
     be advertised to the public while riskier single strategy 
     funds cannot, but both can be sold to retail investors. 
     According to an investment fund expert, German banks sell 
     derivatives based on hedge fund indices to retail clients. 
     This activity explains the bankers' interest in greater 
     transparency for all hedge funds, but it is not the same as 
     the Chancellor's. 
 
  ¶11.  (SBU)  Risk management of hedge funds is being taken up 
     by several entities in the EU.  In its June "Financial 
     Stability Report", the European Central Bank (ECB) pointed 
     to risks of  "crowding of trades" when several hedge funds 
     adopt the same investment strategy in a particular market 
     segment leaving them "vulnerable to adverse market 
     dynamics."  The UK's Financial Service Authority issued two 
     discussion papers in June on the hedge fund risks and risk 
     mitigation techniques and on retail investment products, 
     including hedge funds.  The European Fund and Asset 
     Management Association is scheduled to publish a survey of 
     European regulation of hedge funds, and hope to provide 
     commentary on the regulatory landscape in a second part of 
     their work.  The International Organization of Securities 
     Commissions Standing Committee on Investment Management is 
     also conducting a stocktaking of regulatory regimes 
     including  retail consumers' access to hedge funds. 
 
  ¶12.  (SBU)  While experts think there are issues to discuss, 
     whether new regulation is needed or not is still an open 
     question, and the discussion may have little to do with the 
     corporate governance issues raised by the Chancellor.  The 
     FSA discussion paper flatly rejects taking up that topic 
     declaring that ".shareholder activism is not peculiar to the 
     hedge fund sector but rather generic to the entire 
     institutional asset management industry and so can only be 
     addressed in this broader context."  When Dr. Gerhard 
     Cromme, chairman of the German Corporate Governance 
     Commission, was asked whether hedge funds looking out for 
     short term gains should be put on a "shorter leash," he 
     replied that hedge funds should not be singled out, 
     explaining that they are just another form of investment 
     funds and that the issue is one of whether their corporate 
     governance was transparent. 
 
  Recommendations for Action: "It's Out of Our Hands" 
  --------------------------------------------- ------ 
 
  ¶13.  (SBU)  To prepare the Chancellor for his June 13th 
     speech, a group of experts from the Finance, Economics, and 
     Justice Ministries were tasked with preparing 
     recommendations.  At a loss to suggest new regulations on 
     the German hedge fund industry when they were, in reality, 
     leaning against further rules, the group decided on measures 
     "they could live with," in the words of one of the experts. 
     Among the key recommendations were: (a) to lower the 
     threshold at which a single investor has to notify its 
     shareholdings from 5% of total shares to 3% or 2%; (b) to 
     give a extra dividend to shareholders who vote; (c) to 
     broaden the powers of Bafin to investigate when several 
     shareholders are "acting in concert; and (d) to require 
     reporting of short sales based on borrowed shares.  The 
     first three are corporate governance measures.  The last 
     measure, to gather information when an investor borrows 
     shares and sells them in anticipation of the share price 
     falling, had been considered when adopting regulations in 
     January 2004 but deemed not particularly useful. 
 
  ¶14.  (SBU)  None of these recommendations appeared in the 
     Chancellor's speeches.  Instead, the Chancellor talks about 
     transparency and "international minimum standards for hedge 
     funds."  When we asked a Finance Ministry expert about this 
     specific sounding proposal, he confessed that he had no idea 
     what it meant or where it came from.  After forwarding their 
     recommendations to the Chancellor, the Ministry is no longer 
     in the policy making debate, he said.  "Its is out of our 
     hands." 
 
  ¶15.  (SBU)  The office in the Ministry of Economics and 
     Labor charged with G-8 preparations reports that, so far, 
     none of the documents contains any detailed proposal. 
     Rather, their impression is that the Chancellor wants to 
     sensitize other heads of state/government to the issue, ask 
     for G-8 experts to examine it, and see if there is common 
     ground.  The Chancellor would probably make extensive 
     comments to the German press on the issue due to the 
     "domestic political context" in which the issue is immersed. 
 
  EU Dimension 
  ------------ 
 
  ¶16.  (SBU)  German Finance Ministry experts and the UK's FSA 
     paper point out if any measures are to be taken on hedge 
     funds, they should be at a EU level.  Fortuitously, the 
     European Commission will release a "Green Paper" in July to 
     launch a discussion on whether and, if so, how the 
     Commission should change its mutual fund directive.  That 
     paper will raise the question of whether existing EU law 
     should be expanded to cover hedge funds, flagging the issues 
     of investor protection and potential systemic risks.  The 
     European Commission, however, has no preconceived notions on 
     whether to have regulations on hedge funds, according to a 
     Commission expert. 
 
  ¶17.  (SBU)  The author of the Commission paper commented 
     that, in his view, the Germans are interested in corporate 
     governance issues, a topic that will not be addressed in the 
     "Green Paper."  He admitted that the pressure by the Germans 
     to do something was increasing, but also thought that the 
     political debate was not conducive to considered reflection 
     on the issue.  According to a fund industry expert, the 
     Commission is likely to devote its initial attention to 
     improving implementation of existing law, leaving more 
     ambitious projects, like covering hedge funds, for later. 
 
  Chancellor as CFO 
 
  ----------------- 
 
  ¶18.  (SBU)  This is not the first time the Chancellor has 
     jumped into financial issues, taking a different tack from 
     his finance experts.  On Basle II he sought a weakening of 
     risk weights for lending to SMEs after Bafin had agreed to 
     the draft provisions.  On the EU Takeover Bids Directive he 
     orchestrated blockage of  its passage in the European 
     Parliament after the German Presidency had secured its 
     agreement in the Council.  On the Stability and Growth Pact 
     he publicly rebuked the European Commission for trying to 
     issue Germany a warning that it risked running a deficit 
     over 3% of GDP, a warning the Finance Minister had been 
     willing to accept for leverage to instill budget discipline. 
     In each of these cases the Chancellor pursed his political 
     objective, causing each of these projects to miss some of 
     their respective economic objectives. 
 
 
  ¶19.  (U) This report coordinated with US Embassies Berlin 
     and Paris and USEU. 
 
  ¶20.  (U) POC: James Wallar, Treasury Representative, e-mail 
     wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)- 
     7535-2238 
 
  Bodde