VZCZCXRO4941
RR RUEHAG RUEHDF RUEHIK RUEHLZ
DE RUEHRL #2269/01 2210909
ZNR UUUUU ZZH
R 090909Z AUG 06
FM AMEMBASSY BERLIN
TO RUEHC/SECSTATE WASHDC 4606
RUEATRS/DEPT OF TREASURY WASHDC
RUCPDOC/DEPT OF COMMERCE WASHDC
INFO RUCNMEM/EU MEMBER STATES COLLECTIVE
RUCNFRG/FRG COLLECTIVE

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 
 
BERLIN 00002269  002 OF 003 
 
 
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". 
 
BERLIN 00002269  003 OF 003 
 
 
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