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Cablegate: The Chancellor and Hedge Funds

This record is a partial extract of the original cable. The full text of the original cable is not available.





E.O. 12958: N/A
SUBJECT: The Chancellor and Hedge Funds


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.

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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

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

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

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

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

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

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)-


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