The hedge fund industry has sparked a backlash by lobbying aggressively against proposed European Union rules and now faces possible pay curbs that were not envisaged in the original legislation.

Attacks by London-based hedge funds and British politicians have had an impact in softening European Commission proposals to regulate alternative investment companies. But they have misjudged the tide of public opinion and goaded the EU's Swedish presidency into adding new rules to defer fund managers' bonuses and ban "golden handcuff" payments to retain star performers.

"There is a danger that this lobbying is backfiring against the industry," said Karel Lannoo, chief executive of the Centre for European Policy Studies in Brussels and an expert on financial regulation who supports the aims of the directive.

The draft EU law is part of an international drive to rein in excessive risk-taking by the financial services sector in the light of the global financial crisis.

While hedge funds did not cause the crisis and none has had to be bailed out by taxpayers, many policymakers in Europe and the United States believe their highly leveraged business model poses risks to financial stability and should be regulated.

The collapse of U.S. hedge fund Long Term Capital Management in 1998, which triggered a costly bailout by banks led by the New York Federal Reserve, highlighted the dangers.

There are now fears that bigger volumes of risky trading will shift to hedge funds as banks are more tightly regulated, although the funds' unlimited private liability may make such an investment strategy unattractive.

Interest groups representing hedge funds, private equity and other investment companies have campaigned vociferously against EU efforts to make fund managers register, disclose information about their businesses and fees, and limit their use of debt.

They have especially resisted attempts to bar hedge funds operating out of tax havens such as the Cayman Islands from marketing investment products throughout the 27-nation EU, accusing Brussels of protectionism.

Sweden, which holds the rotating EU presidency, has sought to soften the original proposals to meet British objections. But the Swedes' latest compromise text would impose policies on fund managers' remuneration similar to those agreed by G20 nations for bankers.

EU leaders and the European Parliament have called for all parts of the financial services industry to be brought under regulation to reduce systemic risks to the world economy. France, Germany and Denmark have led pressure for tough rules on hedge funds and private equity.

The Swedish amendments go a long way towards accommodating critics of the bill. The European Commission will no longer be able to set limits on the level of leverage that fund managers employ.

A requirement for an independent valuation of funds' assets has been dropped. And those member states that wish to can permit the marketing of third country funds — including from tax havens — on their territory to professional investors.

Furthermore, the amendments recognise the need for more nuanced treatment of private equity, real estate funds and other investment companies rather than a "one size fits all" approach.

But lawmakers and most governments are unlikely to be moved by threats by hedge fund managers to decamp to Switzerland to escape tougher EU regulation. Some hedgies are already moving from London to Geneva, but industry insiders say the shift is driven by tax increases in London.

The lobbying effort has also generated impact studies dramatising the implementation costs and potential economic fallout from the initial proposals.

A report by consultants Charles River Associates prepared for Britain's Financial Services Authority estimated one-off compliance costs at up to 3.2 billion euros ($4.8 billion) and recurring costs of 311 million euros ($463 million) a year for all market participants.

The European Parliament commissioned its own assessment by outside experts which concluded that the draft law was "poorly constructed, ill-focused and premature". While the legislation might curtail market volatility by limiting the innovative activities of the most dynamic parts of the financial sector, it would be at the cost of lower economic growth, they said.

That political trade-off between risk and return lies at the heart of the European regulatory debate on hedge funds. In the wake of the financial crisis, lawmakers are understandably no longer inclined to leave "consenting adults" free to manage their own investment risks without supervision.

The way the parliamentary debate is headed, lawmakers may end up trying to curb risk-taking through fund managers' pay packets rather than via restrictions on the way they conduct business.

Paul Taylor is a Reuters columnist. The opinions expressed are his own.