More hedge funds likely will follow the lead of Brevan Howard Asset Management and Tudor Investments and choose not to be regulated by Europe's new MiFID II regime when it comes into force, opting instead to be regulated under the so-called Alternative Investment Fund Managers Directive, legal experts told S&P Global Market Intelligence.

MiFID II, or the second Markets in Financial Instruments Directive, takes effect at the start of 2018, having begun life as a post-crisis review of the first MiFID, which was implemented in 2007. It will impose a raft of new requirements, including requiring 81 pieces of information to be sent to national regulators within minutes of executing each trade (up from 23 under MiFID I), and requiring the separation of research costs from trade commissions.

Article 2(1)(i) of the MiFID II package, however, exempts firms operating under an AIFMD license, which has allowed Brevan Howard and Tudor Capital to escape the regime's new strictures. Brevan Howard, with $15.5 billion in assets under management at the end of 2016, abandoned its MiFID license earlier in 2016, and Tudor Investment's U.K. arm did so in June, the Financial Times reported Aug. 14, suggesting that Finisterre Capital, a London emerging markets-focused hedge fund with $5.6 billion of AUM as of May, had done the same.

An April 2017 survey cited by HedgeWeek magazine found only 36% of firms were confident they were on track to comply with MiFID II by January 2018.

"Many more may well come out of the woodwork," Michelle Kirschner, a partner at London corporate law firm MacFarlanes, said in an interview. Noncompliance fines "have been pretty hefty under MiFID, and the [U.K. Financial Conduct Authority] quite like taking action in this space," she said, leading hedge funds to ask, "Why on earth would we not want to become an AIFMD?"

The latter regime imposes less onerous trade reporting rules than MiFID II and does not force managers to pay for analysts' research, although it also places restrictions on fund managers' pay, requiring part of it to be in shares in their fund and limiting bonus amounts.

Nevertheless, larger hedge funds will be more tempted to follow Jersey-based Brevan Howard and Tudor's move, which will enable them to avoid MiFID II's trade and transaction reporting requirements, she said. Larger U.K.-based hedge funds trading across multiple asset classes include Man Group Plc (with $57.2 billion of AUM as of March), Winton Capital Management Ltd. ($31.7 billion) and Marshall Wace (more than $25 billion).

Brevan Howard and Tudor were "basically trading everything across a huge range of asset classes, and therefore their trade and transaction reporting obligations are huge," said Kirschner.

Alternative choice

Many funds should be considering similar moves, sources within the hedge fund industry told S&P Global Market Intelligence.

"I think it would make sense for other funds to be thinking about this. Switching to AIFM would allow funds to 'side step' the onerous reporting requirements of MiFID II," said Peter Paine, an equity analyst at King's Capital in London.

"It's likely that many will think that MiFID II is onerous, and will do regulatory arbitrage, even moving to a geography with less regulation," including offshore destinations such as Jersey, said Ali Farid Khwaja, a partner at Autonomous Research, a U.K.-based financial services research firm.

AIFMD came into force in 2011 to regulate hedge funds, private equity, and real estate funds after the financial crisis, with then-European Commission President José Barroso saying these firms would "no longer operate in a regulatory void."

U.K. fund managers wishing to change from MiFID to AIFMD would need to make a Variation of Permission application to the FCA, said Kirschner. The regulator is permitted to take up to six months to consider such applications, and with MiFID II coming into effect in January 2018, those wishing to make a new application would need to move quickly and hope for a speedy regulatory reply, she said, or else they will have "kind of missed the boat."

Moving to an AIFMD buys firms several years' delay in designing software to comply with the more exhaustive reporting requirements, though Kirschner added, "Everyone is expecting AIFMD will catch up [with MiFID II's reporting requirements] in four or five years' time."

Should migration to AIFMD licenses become widespread, this might lead the EC to close the reporting gap between the two regimes more quickly. European Securities and Markets Authority Chairman Steven Maijoor expressed concern in a February 2017 letter to the EC that firms would find loopholes to circumvent MiFID II.

Choose your regulation

Hedge funds making the switch would need to be careful to exit lines of business that require a MiFID license, such as investment advice and portfolio management for segregated accounts, said one London financial services lawyer who preferred not to be named.

"An AIFM's permissions are more limited, so if you used to be a MiFID firm it might be tricky to make sure you have cut back your business enough to be sure you aren't still doing MiFID activities," she said.

With a MiFID license, "you don't need to worry if you might be straying into MiFID services," said the lawyer, though not being under MiFID meant "you don't need to worry about all the detailed requirements around research, transparency, execution venue reporting and so on that people are struggling with."

Private equity fund managers are generally AIFMs already, she said, while family offices and other currently unregulated firms about to lose the benefit of exemptions under the first MiFID are likely to become AIFMs as well.