Bachelor Thesis: Regulation of Hedge Funds in the EU Web viewThis paper concerns the regulation of...

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Supervisor: Martin Bæk Carstensen

Date of completion: 14.05.2013

STU count: 101.389

International Business and Politics

Bachelor Thesis: Regulation of Hedge Funds in the EU

Bachelor Thesis: Regulation of Hedge Fund in the EU

Abstract

This paper concerns the regulation of hedge funds in the EU after the financial crisis. It

investigates the role played by ideas in policymaking, and develops a method to recognize a

paradigm shift. Taking point of departure in Hall’s (1993) theory including Schmidt (2002)

concept of discourse a policy paradigm shift will be recognized if significant change has

occurred in the hierarchy of goals and ideals; the policy instruments; the policy settings and

the discourse. A thick description and interpretation of 28 primary texts from the European

Commission and the European Parliament is performed, where the weights devoted to ideas

and instruments from the microprudential paradigm and the macroprudential paradigm are

assessed before and after the crisis. The relative weights will be based on a quantitative

analysis counting words from the two paradigms. Due to a lack of significant change in policy

settings it is concluded that no paradigm shift within regulation of hedge funds in the EU can

be recognized yet. However, it remains to be seen if the regulatory framework will be develop

further or stay at this point.

Table of Contents

Introduction.................................................................................................................................2

Theoretical basis.........................................................................................................................4

Method........................................................................................................................................8

Identifying paradigms within financial regulation in the EU................................................10

Microprudentialism...........................................................................................................10

Macroprudentialism...........................................................................................................12

The case: Regulation of HF in the EU......................................................................................15

Key concepts.........................................................................................................................15

Brief historical outline...........................................................................................................15

Literature review...................................................................................................................17

Analysis.....................................................................................................................................18

Situation before the crisis......................................................................................................18

Hierarchy of objectives and ideals.....................................................................................23

Policy instruments.............................................................................................................24

Policy settings....................................................................................................................24

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Discourse...........................................................................................................................25

The situation after the outbreak of the crisis.........................................................................26

Hierarchy of goals and ideal..............................................................................................37

Policy instruments.............................................................................................................38

Policy settings....................................................................................................................38

Discourse...........................................................................................................................39

Comparing the two situations – has a paradigm shift occurred?...........................................40

Conclusion................................................................................................................................43

Bibliography.............................................................................................................................45

Appendix 1) Weights................................................................................................................52

Appendix 2) Concepts...............................................................................................................55

IntroductionIn the aftermath of the financial crisis that broke out in 2007 much attention has been devoted

to financial regulation in the EU. A wide debate has taken place concerning its causes and

consequences and many different views have been presented (fx. Moschella and Tsingou,

2013; Quaglia, 2011, 2012; Pagliari, 2013; Zimmerman, 2010; Heillener and Pagliari 2010;

Overbeek and van Apeldoorn, 2012).

This paper will focus on regulation of hedge funds (HF) in the EU. Regulation of HF in the

EU constitutes an intriguing case because it prior to the crisis was based on self-regulatory

principles whereas after the crisis EU supervisory mechanisms have been laid down. It

therefore appears as an area where significant change has taken place. However, scholars

disagree as to how extensive the changes actually have been. Some scholars, for instance

Ferran (2011) argues that the regulation of HF has become overtly extensive, whereas Quaglia

(2011) and Helleiner and Pagliari (2010) argue that changes have taken place but are cautious

in their conclusions as to the extent of these changes. Yet others, for instance Awrey (2011)

argues that no change has occurred. This paper seeks to contribute to the debate by looking

deeper into the role played by ideas in the regulation of HF after the crisis. More specifically,

the following research question will be answered:

Has a paradigm shift taken place within regulation of hedge funds in the EU?

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To establish a background, the first section will review the traditional theories of ideas in

policy making. Point of departure will be taken in Kuhn’s (1962) theory of paradigm shift in

natural science, which has been applied by Hall’s (1993) to policy paradigms. Recognizing

the limitations of Hall’s theory, the role of ideas will be elaborated by Blyth (2001,2002), the

role of discourse in changing ideas will be enlightened by Schmidt (2002), and Baker (2013)

questions the order of change at the three policy levels. Upon this theoretical background a

paradigm shift will be recognized as a significant change in four factors: The hierarchy of

goals and ideal, the policy instruments, the policy settings and the discourse.

In the second section a method for measuring if significant change has occurred in the four

factors will be outlined. A thick description covering 28 legal texts, discussions and reports

from the European Commission (EC) and the European Parliament (EP) will be performed.

Drawing on Castensen (2011), two paradigms in financial regulation will be outlined and used

as ideal types, providing ideas and words to look for in the thick description. A quantitative

analysis counting selected words in the empirical texts will supplement the thick description

and form the basis for assigning weights to the paradigms. Operationalizing this method

Quaglia’s distinction between the market-making advocacy coalition and the market-shaping

advocacy coalition within the EU will be relied upon. These coalitions respectively support

two paradigms within financial regulation; Microprudentialism, adhering to the efficient

market hypothesis, and macroprudentialism, adhering to the financial instability hypothesis.

Before the analysis a short introduction of the case and its background will be provided. The

fourth section is the main part of the paper and constitutes the analysis. It will be divided into

three subsections. Firstly the situation before the crisis will be analyzed, secondly the

situation after the crisis will be handled, and finally the two situations will be compared and it

will be assessed weather a paradigm shift can be recognized.

The analysis will show that no EU regulation was in place before the outbreak of the crisis,

and that after the crisis a directive (2011/16/EU) and a delegated regulation (No. 231/2013)

regulating Alternative Investment Fund Managers (AIFM) were decided upon. It will be

concluded that significant change has taken place in the hierarchy of goals, the policy

instruments and the discourse. However the policy settings are strictly limiting the newly

developed powers of the supervisory authority and will therefore not be considered to have

changed significantly. In consequence a complete paradigm shift will not be recognized.

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This conclusion goes against the expectations developed in the first section. The short

timespan after the crisis to this evaluation can be the reason that a complete paradigm shift

cannot yet be recognized. The current situation might be a time of experimentation with the

new macroprudential ideas and instruments, which in some years will materialize as a full

blown paradigm shift.

The answer to the research question will be: A paradigm shift has not taken place, yet.

Significant change has occurred at three of the four levels, however it remains to be seen if

the regulatory framework will be develop further or stay at this point. This answer is

necessarily open ended, and further research in the area would be intriguing.

In the coming section the theoretical basis and a definition of paradigm shifts will be

presented.

Theoretical basisWhy is it relevant to look at ideas in policymaking, and especially in the aftermath of a crisis?

One of the first scholars to underline the importance of ideas was Thomas Kuhn (1962). He

studied the progress in scientific knowledge in natural science and challenged the notion that

it progressed linearly. Instead he introduced the concept of paradigms and paradigm shifts.

Practitioners working within a paradigm will perform “normal science”. Normal scientific

research articulates the phenomena and theories that the paradigm already presents. Kuhn

argues that accumulation of anomalies in a paradigm, due to its inability to explain events,

will lead to crisis in the paradigm. This will lead to demise of the old paradigm and a new

paradigm with a new normal science will emerge. This process is termed a paradigm shift.

The new paradigm will be incommensurable with the previous paradigm, meaning that the

new normal science cannot be understood or legitimized within the old paradigm (Kuhn,

1962, p. 26). This is the characteristics of a Kuhnian paradigm shift.

Although developed for natural science Kuhn’s theory was employed by Hall (1993) to

explain change in policy paradigms in Great Britain in 1976-81. Hall defined a policy

paradigm as: “A framework of ideas and standards that specifies not only the goals of policy

and the kind of instruments that can be used to attain them, but also the very nature of the

problems they are meant to be addressing.” (Hall, 1993, p. 279)

Hall developed a model with three levels of policy intervention, where ideas could play a role.

At the highest level the overarching hierarchy of goals was set, at the middle level the

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instruments and techniques for achieving the goals were decided upon, and at the lowest level

the precise setting of these instruments was determined. Based on this understanding three

degrees of change was outlined. Change at the lowest level was termed change of 1st order,

change at the middle and lower level was termed change of 2nd order and simultaneous change

at all three levels was termed change of 3rd order (Hall, 1993). Changes of first and second

order were seen as change within a paradigm, similar to normal science within a paradigm,

whereas change of third order was seen as a change of paradigm, similar to a Kuhnian

paradigm shift. As a consequence Hall’s policy paradigms were incommensurable (Hall,

1993).

Hall argues that the process of change is likely to start by experimentation with new policies

and policy failures. The existing paradigm will be weakened by the accumulation of

anomalies within it. By anomalies is meant the paradigms inability to explain developments

and outcomes. This will lead politicians to try to stretch the paradigm so that it includes these

anomalies, however this is likely to gradually undermine the coherence and precision of the

existing paradigm. Experimentation and failures will in this way undermine the authority of

the existing paradigm, and spark a contest between competing paradigms, offering

explanations and solutions for the anomalies. This contest will only end when supporters of

the new paradigm secure positions of authority and institutionalize it (Hall, 1993).

Hall’s theory has contributed tremendously to the discussion of the role of ideas in

policymaking, however, it has been subject to much critique (Schmidt, 2002; Baker, 2013;

Blyth, 2002; Goul Andersen and Albrekt Larsen, 2009).

Mark Blyth (2001,2002) has directed a critique towards historical institutionalists, among

them Hall, and their use of ideas in explaining institutional change. He pinpoints the lack of

theorizing about the relationship between ideas, interests and institutions, and criticize that

ideas are seen as auxiliary hypothesis that can explain anomalies rather than causal factors in

their own right. To accommodate this shortcoming he developed a dynamic theory about

institutional change, where ideas and interests were essential and embedded elements (Blyth,

2002).

According to Blyth economic ideas are vital in times of crisis when existing institutions fail

and Knightian uncertainty1 prevails. He outlines five hypotheses about the roles and

1 Occurs in highly unique situations, where no probabilities can be assigned to the possible outcomes, and the agents are unsure of what their interests are (Blyth,2002, p.9).

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importance of ideas. Firstly they provide actors with a scientific and normative interpretative

framework of the existing institutions. In this way they allow actors to interpret and diagnose

a crisis as a crisis and reduce uncertainty by providing solutions, in form of new institutions.

Secondly they shape the interests of the actors, and can serve as a factor in coalition-building

and promote collective action. Thirdly ideas can be used as weapons to delegitimize existing

institutions. Fourthly ideas provide actors with blueprints for new institutions and fifthly, once

the new institutions are in place with the new ideas embedded, they serve to coordinate

expectations and thereby provide institutional stability. As a consequence ideas can have

different effects at different points in time, which makes the framework dynamic and able to

explain both stability and change (Blyth, 2002).

The main conclusion by Blyth is that ideas themselves can cause a crisis in an existing

paradigm and thereby a paradigm shift and institutional change (Blyth,2002). This claim was

empirically underlined by Goul Andersen and Albrekt Larsen (2009).

The section above makes it clear that ideas are important as they play vital roles in

policymaking and can cause institutional change. However, it is still unclear how ideas

change. Schmidt (2002) offers an explanation.

Schmidt’s definition of discourse entails that discourse encompasses both a set of policy ideas

and an interactive process. Discourse as a set of ideas has both a normative and a cognitive

function. The normative function is concerned with demonstrating the appropriateness of a

policy program, by relating it to existing norms and values in the public, thereby legitimizing

it. The cognitive function is concerned with elaborating the necessity and logic of the policy

program, thereby justifying it (Schmidt, 2002).

Change in ideas can occur because a policy discourse can be distinct from the ideas and

values of the polity, thereby having the ability to affect not only reflect underlying ideas and

values. Schmidt’s framework indicates that a vital factor for the success of a new policy

program is a good normative function in the discourse, providing the policy program with

legitimacy. While the normative function has to reflect existing values and ideas it is however

simultaneously able to change those values and ideas, by reinterpreting them or change their

prioritization. In so doing the discourse can have transformative powers (Schmidt, 2002).

Traditional literature, as for instance Hall, tends to focus only on the cognitive aspect of ideas

and discourses. The notion of normatively legitimizing a new policy program in ideas and

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values present in the prevailing paradigm draws on Lakato’s concept of overlapping

paradigms and lead Schmidt to argue, that it is always possible to understand past ideas and

values, even if they are not shared in the present. This understanding breaks with Hall’s

conception of incommensurability between policy paradigms. Schmidt in this way challenges

Hall’s model by defining that a change of 3rd order or what she terms a revolutionary change

(as opposed to change of 1st and 2nd order which she terms evolutionary change) is not the

same as a Kuhnian paradigm shift (Schmidt, 2002).

Schmidt however agrees with Hall that change takes place when the existing policy program

is experiencing a crisis, be it due to its inability to solve problems created by external events

or a decreasing ability of the discourse to legitimize the policy program (Schmidt, 2002).

Another more resent critique of Hall was presented by Baker in his 2013 article analyzing the

development in the attitude towards macroprudentialism in the Basel committee after the

financial crisis. His analysis concludes that an ideational shift has occurred leading

macroprudential policies to the center of the new policy agenda. This observation challenges

Hall’s conception of a paradigm shift, as that would demand change on all three levels of

policymaking simultaneously. In the case of macroprudentialism in Basel the instruments and

setting have not yet changed. Therefore the ideational shift is not a paradigm shift, although it

is a change of 3rd order. This challenges Hall’s equivalence between paradigm shifts and

change of 3rd order, and the sequencing of events foreseen by Hall is also reversed.

This theoretical outline has made it clear that a paradigm shift is not easily defined and

therefore not easily recognized. The apparent vagueness of Hall’s term change of 3 rd order

makes it unsuitable as a means to recognize a paradigm shift. Recognizing a paradigm shift

only in the narrow sense of a Kuhnian paradigm shift would be inappropriate, as investigating

regulation of HF in the EU is a non-natural scientific research. Complete incommensurability

between the two financial regulation paradigms within the EU would be unlikely (Schmidt,

2002).

Schmidt’s notion of revolutionary change therefore seems to be the most suitable method to

recognize a non-Kuhnian paradigm shift within a non-natural scientific research area. It

describes a significant change at all three levels of policymaking and in the discourse,

however is not demanding a complete break with all existing values and ideas. In this way it

allows the changes to be normatively legitimized in existing values, however demands a

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change in the policy core, the hierarchy of values, instruments, setting and cognitive discourse

(Schmidt, 2002).

In conclusion, a paradigm shift will be recognized as a significant change in:

The hierarchy of objectives and ideals.

The policy instruments.

The policy settings.

The discourse.

This conception entails that a paradigm shift is only recognized when significant change

towards the new paradigm has occurred within all four factors. Incommensurability between

the prevailing paradigm and the new paradigm is however not demanded.

In the next section the method employed to analyze if these four factors have changed

significantly after the crisis will be outlined.

MethodThe analysis is a thick description, however, it has been supplemented by a quantitative

analysis in order form a basis for assigning weights to the paradigms. Thick description is best

known from the works of the anthropologist Cliffort Geertz. It is detailed and includes the

context of the action; where and when it took place, who performed it and what the intention

behind it was (Geertz, 1973). As a result the distinction between description and interpretation

becomes blurred. A description cannot be objective, as it will always rely on inferences by the

observer, however a thick description tries to be as little interpretive as possible by not relying

on theoretically informed concepts (Geertz, 1973). Ideally a thick description forms the basis

for what Dezin terms a thick interpretation (Denzin, 1989). This is what this paper sets out to

do. In both sections of the analysis firstly a thick description will be performed and secondly a

thick interpretation will be carried out, as to interpret whether a paradigm shift has occurred.

Due to the amount of empirical material and the space constraints to this paper a few

interpretative remarks will be connected to each of the descriptive paragraphs, so that the final

(therefore less) thick interpretation can draw on these and avoid repetition.

The thick description was used to perform a process tracing through primary sources

published on the homepages of the EC, http://ec.europa.eu, and of the EP,

http://www.europarl.europa.eu. Both institutions publish all their working papers, expert group

papers, summaries of discussions and open hearings, summaries of feedback sessions,

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http://www.europarl.europa.eu/

http://ec.europa.eu/


legislative proposals, final legislative texts and impact assessments. Furthermore all reports

initiated by the institutions but performed by consultancy groups are published on the pages

and have also been integrated in the analysis. In total 28 primary sources from the EU have

been read through and form the empirical basis for the analysis. In addition the homepage of

the Hedge Fund Stability Board, www.hfsb.org , and their standards have been included as

primary sources. Secondary sources have been used primarily as means of triangulation and

contextualization. Quaglia (2011,2012,2013), Pagliari and Helleiner (2010), Pagliari (2013),

Baker (2013) and Awrey (2011) have been especially helpful in this regard.

Inspired by Carstensen’s (2011), the next section will describe and briefly compare the two

main paradigms within financial regulation, and indicate their positions with regards to the

four factors outlined above. These two paradigms will thereafter be used as ideal types,

providing words, ideas, goals and instruments to look for within the empirical texts. This

method will allow for an open mind for new constellations of ideas instead of a schematic

attempt to fit the observed policy process into the ideal types. In order to judge how important

an idea from a paradigm is, the structure and respective weights of the ideas will be

investigated through the thick description.

The significance of an idea will be determined by examining to what extend other ideas are

structured upon this idea and how it is related to the policy outcomes. A change in

instruments and setting will be regarded as significant if it has impacted upon the policy

output, in a way that furthered the institutionalization of the paradigm it is related to. Output

is here to be understood as changes in the regulatory framework (Hackman, 2011).

Assigning weights to ideas is a complicated issue. All weights in this paper will be relative

rather than absolute, as the aim is to assess whether the ideas from the macroprudential

paradigm have gained more weight than before relative to the ideas from the microprudential

paradigm, and if they have come to prevail. To obtain a hint of the weights, the number of

times five selected words from each paradigm are mentioned in the texts have been counted.

The words represent ideals, goals and instruments from each paradigm. The number of times

the word occurred in each of the texts referenced in the analysis was recorded. Ratios before

and after the crisis were calculated and used to assess which paradigm prevailed and how the

relative weights of the ideals, goal and instruments had changed (Appendix 1). This method is

imperfect, as the words chosen might not fully reflect the ideas, and as they can be mentioned

also by their opponents. Nevertheless, it provides a hint of the relative weight devoted to the

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http://www.hfsb.org/


paradigms in the debate and discourse, and it forms the basis for the illustrations on p. 26 and

p. 40.

Thick description and quantitative measurement supplement each other well in this analysis,

as the quantitative measurement forms the basis for assigning weights to the ideas, whereas

the thick description investigated the structure and interconnectedness between the different

ideas, goals and instruments.

With this method in place to recognize a paradigm shift it is possible to move on. The next

section will identify the paradigms within financial regulation in the EU.

Identifying paradigms within financial regulation in the EUThe concept of advocacy coalitions within the EU offers helpful insight when identifying

paradigms. Quaglia (2011,2012) defines an advocacy coalition as a group of public and

private actors at different levels, who share a normative and causal belief and engage in a

nontrivial degree of coordinated activity over time.

Within financial regulation in the EU Quaglia identified two advocacy coalitions; the market-

making coalition and the the market-shaping coalition (Quaglia,2012). The market-making

coalition is led by UK, Ireland and the Nordic countries. It emphasizes competition and

market efficiency as primary policy goals and prefers light-touch regulation and private sector

governance. Important non-statist actors in this coalition are industry organizations. The

market-shaping coalition is led by France, Italy, the Mediterranean countries and often

Germany. It emphasizes financial stability, consumer protection as well as a veiled form of

protectionism as primary policy goals and prefers prescriptive, rule-based regulation and a

strong steering role devoted to public authorities. Important non-statist actors in this coalition

are consumer organizations and socialist parties form the EP (Quaglia, 2011, 2012, 2013;

Pagliari 2013).

Identifying the competing paradigms more broadly, the market-making coalition adheres to

the efficient market hypothesis and what in this paper will be termed the microprudential

paradigm, whereas the market-shaping coalition adheres to the financial instability hypothesis

and what will be termed the macroprudential paradigm. These two paradigms will function as

ideal types and are described and contrasted below.

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MicroprudentialismMicroprudentialism has its roots in liberalism and it focuses on the actions of the individuals

rather than the aggregate outcomes. It rests on a true belief in the efficient market hypothesis.

The efficient market hypothesis in turn evolves around the Capital Asset Pricing Model

(CAPM). This model is developed from Markowitz portfolio theory, stating that rational

investors will always seek to gain the highest level of return given their level of risk. Adding

the concept of a risk free asset allows for a positive linear relationship between expected

return and volatility, meaning a positive relationship between price and risk. This relationship

constitutes the Capital Market Line (CML). Volatility levels above the market portfolio can

be obtained through the use of leverage. The CML however is only useful for evaluating

portfolios as it considers the total volatility (Reilly and Brown, 2010).

To price individual asset it is important to understand the concept of diversification. Some

assets move with the market, whereas others moves counter to the market. By combining

different kinds of assets from different sectors it is possible to diversify away all unique risk

related to the individual assets. The relevant mesure of risk for a single asset therefore is its

covariation with the marketportfolio, the systematic risk, which is denoted by β. By using β as

the relevant measure of risk it is possible to price each individual assets according to its

riskiness. The result is the Securities Market Line, which is the essence of the CAPM (Reilly

and Brown, 2010).

According to the efficient market hypothesis, all securities will be placed on the SML, as it

states that financial markets are extremely efficient in reflecting all information through

emediate changes in prices. In an efficient market it is therfore impossible for investors to

earn exess returns (Reilly and Brown, 2010).

This very brief outline of CAPM provides some insights that ease understanding of the

policies promoted by actors who believe in it. It is first of all clear that risk is understood as

something that can be measured and reduced by diversification. Secondly a strong belief in

the market mechanism through instant arbitrage is evident, and therefore gaining high returns

is only possible by taking on more risk, for instance by leveraging the portfolio. Thirdly

unimpeded information is a vital factor and an assumption for the accurate functioning of the

model. A fifth insight, which is not directly dirivable from CAPM, but from the strong belive

in an efficent market, is that any impediments will make the pricing mechanism imprecise

(Reilly and Brown, 2010).

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The overall ideational goal in the microprudential paradigm is to allow the market

mechanisms to function unimpeded. This will ensure optimal pricing of assets reflecting their

riskiness (Reilly and Brown, 2010).

To reach this ideal microprudentialists attemp to enhance transparancy and limit regulations

to the market. They are only concerned with microprudential risk, ie the entities individual

risk, and they trust that the models of private investors, banks and fund managers are able to

measure this risk in a more precise way than any public authority (Baker,2013).

With regards to HF advocates of the efficient market hypothesis believe that they increase the

resalience of the financial system as they offer new methods to manage and reduce risk. In

addition HF trading activities are understood to improve the price-setting mechanisms and

increase capital liquidity (Baker, 2013;Quaglia, 2011).

MacroprudentialismMacroprudentialists cover a diverse array of actors. They share disbelieve in the efficient

market hypothesis and instead adhere to Minsky’s financial instability hypothesis, and

therefore see instability as endogenous to the system (Carstensen, 2010).

The macroprudentialists support the Keynesian idea that what matter are the collective

systemic outcomes. They are skeptical towards the risk minimizing function of

diversification, as even individually diversified institutions can pose a systemic risk. This

argument rest on understanding of three concepts central to macroprudentialism: pro-

cyclicality, herding and externalities (Baker, 2013).

Pro-cyclical tendencies in financial markets refer to the phenomenon that in a downturn when

asset prices fall, risk appears to rise. This causes actors to sell their assets, which further

depresses the prices. In addition acceptable debt levels are reduced leading to a contraction of

credit, further decreasing prices. In a boom the opposite happens (Baker, 2013).

Herding occurs because many investors invest in the same diversified portfolio of assets and

use similar models to measure their exposure to risk. As a result, when asset prices fall and

risk appears to rise, many institutions hit their maximum risk exposure limits on the same

assets at the same time, leading to a massive simultaneous selling of these assets and steep

drops in prices (Baker, 2013).

The concept of externalities is relevant for HF. According to Haldane shadow banking and

securization provided linkages between markets and market participants, which increased the

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complexity of the financial eco-system, and thereby make the externalities provoked by a

seemingly small failure unforeseeable and incalculable. Due to the low modularization in the

financial eco-system a small change can result in major dislocations and chain reactions

(Baker, 2013).

This very different view on the financial market leads supporters of the macroprudential

paradigm to propose different policies than microprudentialists.

To counter pro-cyclicality macroprudentialists propose a policy framework that demands

institutions to build up buffers in periods of upswing. This would dampen the price inflating

spiral and at the same time provide the institutions with a cushion in a downswing period

(Baker, 2013).

Herding could be limited by moving the risk measuring mechanisms from the individual

institutions and investors to public authorities, who as opposed to individual actors, would be

able to gauge the overall systemic exposures (Baker, 2013).

The extent of externalities can be reduced by including all financial institutions under

regulation and by increasing modularity in the financial market. Supporters of the

macroprudential paradigm argue that it would be rational to tax or even prohibit certain

financial activities, as the economic value they generate is not perceived as exceeding the

social costs they produce (Baker, 2013).

The adherence to different ideational paradigms has repercussions in all areas of the policies

proposed by the two coalitions. Due to the focus of this paper it is important to include that

the market-making coalition supports the shareholder corporate governance model, whereas

the market-shaping coalition supports the stakeholder corporate governance model. This has

an impact on their view on the right of employers and employees, not least in connection with

company takeovers (Pagliari, 2013; Horn,2012).

The paradigms of the two coalitions are summed up in the following table:

Market-making coalition Market-shaping coalition

Paradigm Microprudentialism Macroprudentialism

Hypothesis Efficient market hypothesis Financial instability hypothesis

Ideational roots Liberalism Keynesianism

Core ideas Capital markets are Capital markets are

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efficient

Risk can be measured an

diversified away

Market discipline

inherently unstable

Risk is systemic and

incalculable

Ideal Unimpeded efficient markets Stable markets

Hierarchy of goals Getting the prices rights

Efficient allocation of

capital

Competitive financial

institutions

Protecting investors

Stable employment

opportunities

Instruments

proposed

Enhance transparency and

disclosure

Risk management placed

with the individual private

entities (Micro-prudential

oversight)

Allow innovation

Limit regulations –

principle-based approach

Induce build-up of capital

buffers

Limit leverage

Public authorities oversee

systemic risk exposure

(Macro-prudential

oversight)

Increase modularity

Extend regulation– rule-

based approach

Policy settings At a minimum level At a level guiding investors and

institutions to reduce risk

View on HF Increase stability

Improve risk management

Optimize the pricing

mechanism

Increase liquidity

Improves the functioning of

the shareholder corporate

governance model

Increase instability

Increase complexities,

linkages and the extend

of externalities

Increase pro-cyclicality

Increase herding

Their short-termism

conflicts with employees’

rights and interests

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The case: Regulation of HF in the EUIn the previous sections a method to recognize a paradigm shift has been developed and the

two competing paradigms within financial regulation in the EU have been identified. Before

moving on to the analysis, this section will present the case. Key concepts will be defined, a

brief historical overview and a literature review will be provided.

Key conceptsThis paper is concerned with regulation in the EU. By this is meant legislation decided upon

by the Council and the Parliament, and not legislation in the single member states decided

upon by the national governments.

The pivotal concept in this paper is the concept of a hedge fund. The EU did not have a

definition of HF until 2008. When it then adopted a definition, it chose a principle-based one,

due to the diversity of investment strategies employed by funds understood as HF. The EC

defined HF as collective investment vehicles which generally could be distinguished from

other types of investment fund by the following characteristics:

Focus on delivery of absolute returns even in the context of declining markets through

the use of hedging and flexible investment strategies.

These investment strategies typically translate into a relatively high and systematic use

of leverage – through borrowing, short-selling and derivatives positions.

Traditionally, the hedge fund investor base has been confined to institutional or other

sophisticated investors which have led regulators to exempt HF from many investment

protection and disclosure requirements. However, the extent to which HF are exempt

from regulatory requirements differs across countries. (CP, 2008, p.3)

This will be the definition employed in this paper.

In the policy debate and the regulatory texts two distinctions are made; between retail

investors and professional/institutional investors; and between Undertakings for Collective

Investment in Transferable Securities (UICTS) and Alternative Investment Funds (AIF).

Definitions of these concepts can be found in Appendix 2.

Whit these concepts clarified it is possible to move on to a brief history of HF.

Brief historical outlineThe first hedge fund was established in 1949 by Alfred Winslow Jones. The term “hedge

fund” was however not coined until 1966 when an article in Fortune praised Jones’

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investment strategies. The industry has grown remarkably in the latest years and an estimate

from Hedge Fund Research shows that AuM by HF increased from US$ 39 billion in 1990 to

US$ 487 billion in 2000 (Agarwal and Naik, 2000).

Three major incidences have impacted upon the industry. Firstly, the East Asian financial

crisis in 1997-98 raised the awareness of regulators to the destabilizing effects of HF. It was

however not clear if HF had played a causal role, and no regulation was decided. In the

second incident there was no doubt that HF were the central cause. In 1998 the world’s largest

hedge fund Long-Term Capital Management (LTCM) managing US$ 125 million in total

assets nearly collapsed. This illustrated the systemic risk that a large leveraged HF could pose

to the financial system, through the losses incurred by its prime brokers. As a result G7

decided that regulation was necessary. However finally, on the recommendations from the

Financial Stability Forum, only indirect regulatory measures were implemented through

regulations on banks and prime brokers on their provision of leverage to HF (Pagliari, 2013).

Thirdly the failure of Deutsche Börse and London Stock Exchange to merge in 2005, after a

hostile bid from Children’s Investment Fund, highlighted the damaging impact HF could have

on corporate governance in continental Europe (Pagliari, 2013; Quaglia, 2011).

Timeline for major incidences and regulatory developments influencing HF in the EU

Year Incident/regulatory development

1949 First hedge fund established

1997-98 East Asian Financial Crisis

1998 Long-Term Capital Management nearly

bankrupt

2005 Merger between London Stock Exchange and

Deutsche Börse fails

2006 Basel II implemented in EU through redraft of

Banking Directive, Directive 2006/48/EC, and

the Capital Adequacy Directive, Directive

2006/49/EC tighter indirect regulation of

HF

2007 HFSB established voluntary industry

standards

2009 EU decides not to extend UCITS regulation to

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HF, leaving them unregulated at EU level

2011 AIFM2 Directive approved

2012 AIFM Regulation on Level 2 measures

approved

Literature reviewIn the literature a positive view on HF is present in many publications made by financial

institutions, for instance ECB and FED. An example from ECB is Grabaravicius and Dierick

(2005), and from FED Timorthy Geithner (2004). In these papers it is argued that hedge fund

contribute to the functioning of the market mechanism and reduce herding behavior, and

thereby increase the financial stability. The critical view on HF have been presented by

amongst others Boyson, Stahel and Stulz (2010) and by the Chicago School through Chan,

Getmansky, Haas and Lo (January 2007). These papers highlight the systemic risk posed by

HF and their herding behavior, thereby arguing that they reduce the financial stability. Notice

that the second paper was published before the crisis. Zimmermann (2010) has argued that HF

represent a threat to the continental European variety of capitalism.

Within the EU regulation of HF have been treated in depth by Quaglia (2011), Helleiner and

Pagliari (2010), Awrey (2011), Ferran (2011) and Pagliari (2013). Heilleiner and Pagliari

(2010) and Pagliari (2013) argued that the area of HF is an area where change has occurred in

the regulation after the crisis. Pagliari (2013) explains this by reference to the importance of

public salience. However both papers made it clear that the Franco-German coalition

demanded even more change, and that UK was in opposition. Ferran (2011) argued that the

change was significant and out of proportions, as HF did not play a causal role in the financial

crisis. On the other hand Awrey (2011) argued that the AIFM Directive will have no effect, as

national regulation was already in place. In between Quaglia (2011) as mentioned used the

advocacy coalition approach and looked more into the ideas behind the regulation. She

identified that the market-making coalition gained strength after the crisis, however argued

that no fully-fledged paradigm shift occurred (p.678). This statement was however not further

elaborated, which is what this paper seeks to do.

2 Alternative Investment Fund Managers

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Provided with a definition of HF, an understanding of their history and the literature

concerning them moving on to the analysis of the development in regulation of HF in the EU

is appropriate.

AnalysisThe analysis will be divided into three sections. Firstly the situation before the crisis will be

analyzed, secondly the situation after the crisis will be handled and finally in the third section

the two situations will be compared and it will be assessed weather a paradigm shift can be

recognized. The analysis will be a thick description of EU regulation of HF paying particular

attention to the four factors outlined as central to the recognition of a paradigm shift. It will be

analyzed and assessed whether most weight has been assigned to ideas and words from the

microprudential or the macroprudential paradigm in each of the periods. The quantitative

measurements will contribute to this assessment.

Situation before the crisisUntil 2011 only UCITS was regulated at EU level. A patchwork of national regulations in the

member states regulated the operations of AIF within their respective jurisdictions (Directive

2011/16/EU).

This situation gave rise to concern in the EC, who in a Green Paper on the enhancement of the

functioning of the EU framework for investment funds in July 2005 expressed worry that the

patchwork of national regulations might inhibit the industry and the functioning of the

internal market (SEC(2005)947).

The EC stated that the investment fund industry had strategic importance, as it contributed to

adequate provisioning for retirement, allocated savings to productive investments and helped

the development of sound corporate governance (SEC(2005)947, p. 2-3). The green paper

was mainly meant to evaluate the performance of the UCITS Directive, however the EC

realized that AIF were increasingly competing with the UCITS funds, which changed the risk

structure in the industry (SEC(2005)947, p. 3). In order to clarify the issue it was decided to

arrange an open hearing in October 2005. The Green Paper was permeated by a strong belief

in the efficient market hypothesis.

At the open hearing on investment funds held in October 2005 ideas and instruments from

both paradigms were represented. The European Fund and Asset Management Association

(EFAMA) expressed the view that a coherent cross-sectoral approach to asset management

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was needed, but that regulation should be as light as possible (OH, 2005, p.3). In opposition a

consumer panel stated that the financial innovations had made financial products harder to

evaluate, and more disclosure and transparency were demanded. They strongly disagreed with

the view that self-regulation was the best approach (OH, 2005, p.5).

With specific regard to HF the market making coalition stood strong, and regulators were

urged to avoid creating new barriers to flexibility and innovation (OH, 2005, p.6). The

Spanish financial regulatory agency however called for EU investigation and dialogue on the

risks associated with HF. The hearing was concluded by Mr. Gerd Häusler, counselor and

director of the capital market department in the IMF. He underlined that the asset

management industry was of vital importance to the European economy, especially because of

the pension reforms. He concluded that no call for intervention was appropriate, and stated

that investors should not be put in a nursing home environment (OH, 2005, p.8-9). This

statement clearly reflects a strong belief in the efficient market and market discipline.

The EC in December 2005 decided to appoint an Expert Group (EG) to report on ways to

improve the efficiency of the EU investment funds market. The group was made up of experts

with direct commercial experience within the area, and should be appointed on the basis of

recommendation from trade associations (C(2005) 4653, p. 4). This way to design an EG

illustrated the strong position of the market-making coalition, and was strongly criticized in

the feedback session in 2006 by the socialist party in the EP (FS, 2006, p. 19).

The EG released its report in July 2006, a report that resembled propaganda from the market-

making coalition. It argued that the industry was thriving under the established light-touch

regulation and no regulatory measures were necessary. It urged the EC not to implement

regulation on investment strategies and products, and said that such attempts would drive the

industry abroad (EG, 2006, p.5). The EG outlined 11 non-legislative recommendations within

two areas:

- Freeing up access to investors in other Member States by removing unproductive,

inefficient and unjustified legal or regulatory impediments.

- Removing and not creating barriers to the free provision of services between Member

States, which impedes access to the best service providers for support services such as

fund administration, custody and prime brokerage (EG, 2006, p.6).

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The EG also took advantage of the opportunity to correct, what it saw as common

misconceptions about HF. It argued that HF were not more prone to fraud than other types of

funds; that HF were no longer preserved to super-rich investors; and that HF were no threat to

financial stability nor contributed to asset bobbles (EG, 2006, p.12). It argued that HF

improved the functioning of the financial markets and had a stabilizing effect, due to their

strategy of spreading risk across many investors. HF enhanced risk-adjusted portfolio

performance, and was an attractive addition to an investor’s portfolio and offered long term

investment solutions that reduced the impact of market cycles and correct timing (EG, 2006,

p.10-11). HF constituted increasingly important providers of liquidity, due to their

innovativeness in financial products, and played a key role in allocation of risk between

market actors, by acting as counterparties in many different markets. According to the EG

corporate governance was not threatened by HF, in contrast they enhanced the functioning of

the shareholder corporate governance model (EG, 2006, p.11).

Most of the respondents to the EG report were industry stakeholders, (FS, 2006, p.4)

nevertheless, some ideas from the macroprudential paradigm were recognizable in the debate.

Trade unions, consumer protection associations and one party in the EP requested an analysis

of the economic impact of HF investments for the target firm and its employees, as the short-

term-strategies of HF might conflict with the long-term interests of employees (FS, 2006,

p.19). The trade unions and a group from the EP argued that the EG did not tackle the

influence of HF on financial stability thoroughly (FS, 2006, p.19-20).

Ideas and instrument from the microprudential paradigm were also represented and the risk of

overregulation was continuously highlighted by industry representatives. A majority of the

respondents agreed with the EG that no regulation on HF was necessary. This agreement was

based on the argument that institutional investors did not need protection (FS, 2006, p.21). A

majority endorsed the idea of a harmonized PPR (PPR) for HF for distribution among

institutional investors only (FS, 2006, p.22).

The EC in November 2006 published a White Paper on enhancing the single market

framework for investment funds (COM(2006) 686 final). The EC proposed amendments to

the UCITS directive, but took the decision not to extend the UCITS framework to AIF

(COM(2006) 686 final, p.4). The EC also initiated further investigation into the possibilities

of establishing a PPR (COM(2006) 686 final, p.5), and to assess whether a single market

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framework should be created to allow the cross-border sale of some AIF to retail investors

(COM(2006) 686 final, p. 12). The White Paper stroked a balance between ideas from both

paradigms.

With regard to the PPR the EC proposed to use the MiFID suitability and appropriateness test

to determine whether an investor should be allowed to buy a product or not. In this way

inflexible product regulations would be avoided, and much responsibility would be placed

with the investment firm, judging on a client-to-client basis. The EC would work closely with

national regulators to remove the existing restrictions impeding cross-border distribution of

AIF to institutional investors. The rationale behind this decision was, that there were no

investor protection reasons for national regulators to interfere in financial transactions

involving professional investors (COM(2006) 686 final, p. 13). These statements reflect the

microprudential paradigm, moving judgment powers and responsibility form public national

authorities to the individual private investment firm. It also shows how the market-shaping

coalition was sidelined by constant repetition of the fact that professional investors needed no

protection.

The outcome of the two years of discussion was threefold. Firstly a directive clarifying

definitions for eligible assets for UCITS was adopted in March 2007, Directive/2007/16/EC.

Secondly a Call for Evidence Regarding a PPR in the EU was released by the EC in April

2007, and thirdly in April 2008 an open hearing on AIF was held.

The directive of March 2007 clarified that UCITS could only invest indirectly in HF through

the use of derivatives and indices of HF. However it was also laid down that UCITS were

allowed to make use of investment strategies that resembled the strategies of hedge fund

(Directive/2007/16/EC, article 9,11,12).

Broadening of the UCITS techniques and eligible assets is a weakening of an important

consumer protecting directive, representing a defeat to the macroprudential paradigm.

However, that HF and other AIF with high risk exposure did not obtain UCITS status

illustrated that the market-shaping coalition in areas of retail investor protection still had

power and could not be easily overridden (FS, 2006, p. 20).

At the Call for Evidence Regarding a PPR in April 2007 and the following consultation in

September, all respondents agreed that the current framework imposed unnecessary costs on

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firms and limited investors’ choices, and therefore there was support for an EU wide

arrangement (PP Responses, 2007, p.6). Several respondents proposed action on national

level, where member states should align voluntary definitions and regulatory frameworks

based on best practices and support mutual recognition. Only if this approach failed a

directive should be issued, and any EU framework should be light-touch (PP Responses,

2007, p. 10-11).

In this discussion ideas from both paradigms were present, but the ones from the

microprudential paradigm clearly outnumbered and overrode the ones from the

macroprudential paradigm. The market-making coalition supported an EU framework,

because a more homogenous market would reduce legal costs and allow realization of

economies of scale. It underlined that investors would also benefit as they would be presented

with a wider selection of securities and therefore be better able to diversify their portfolios

and reduce their risk exposure (PP Responses, 2007, p.5-6). Although this might be an

attempt to get the market-shaping coalition on board, it misses the point, as

macroprudentialists do not see diversification as risk reducing.

The Basel Committee in 2004 agreed on new capital requirements to banks, the Basel II

accord, which was meant to increase stability in the financial system by insuring international

convergence of capital measurement and capital standards (BIS, 2005). To live up to these

new standards the EC in 2006 recasted the EU Banking Directive, Directive 2006/48/EC, and

the Capital Adequacy Directive, Directive 2006/49/EC.

The redrafts had two consequences; Firstly the capital requirements was reduced marginally

(Markt/2003/02/F, 2004, p. 9), secondly performance of stricter risk management procedures

was imposed on banks for instance higher use of collaterals was implemented, however on a

risk-sensitive basis (Markt/2003/02/F, 2004, p.59). The overall objective was to obtain a

better and more efficient allocation of credit, thereby increasing stability in the financial

system (Markt/2003/02/F, 2004, p. 16). This limited banks’ ability to lend to leveraged

institutions, such as HF, and was an indirect regulation of their leverage. The risk sensitive

capital requirements lead macroprudentialists to warn against the risk of increasing pro-

cyclicality. The EC however argued that sufficient steps to reduce pro-cyclicality had been

taken by encouraging stress-tests and flattening the risk curve (Markt/2003/02/F, 2004, p. 15).

Page 22 of 56


Although these changes to the regulation of banks indirectly regulated HF the approach was

still microprudential as it was up to the individual bank to measure its risk exposure. Capital

requirements and an attempt to increase stability at first sight seem to be in the interest of the

market-shaping coalition. However the degrading of pro-cyclicality and a marginal reduction

of the overall capital requirements were more in line with the preferences of the market-

making coalition.

An influential group of 14 hedge fund managers from the UK in the summer of 2007 decided

to establish a set of voluntary best practice industry standards. This initiative in 2008

developed into the Hedge Fund Standards Board (HFSB) (HFSB, 2013). The

recommendations were however not released until October 2008, and will be outlined in the

next section. A self-regulatory initiative was a strong hint that the microprudential paradigm

were prevailing.

The above thick description with short interpretations can be summarized and structured using

the four factors outlined in the methodology section. This allows interpretation of which

paradigm prevailed before the crisis.

Hierarchy of objectives and idealsThe focus of the discussions before the crisis was on enhancing the functioning of the internal

market. An example of this focus is the initial concern expressed by the EC in the Green

Paper from 2005 (SEC(2005)947). The criteria for selecting the EG members and the

instruments to implement the Basel II accord also reflexed the microprudential paradigm, as it

relies on the abilities of the individuals from the industry to judge their own practices.

Remarkably the concluding speaker in the first open hearing came from IMF, and

organization recognized for its liberal ideals (O’Brien and Williamson, 2010, chap. 8). On the

basis of the thick description the following hierarchy of goals can be outlined:

Ensuring an integrated and competitive market for both UCITS and AIF in the EU

o Thereby ensuring economies of scale and legal cost reductions competitive

European funds

o and ensuring a wider selection of securities available to investors so that their

possibilities for diversification increase reduce risk and increase returns (EC

PP Responses, 2007, p.5-6).

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Protecting retail investors (but retail investors only) from excessive risk exposure

(Directive/2007/16/EC)

Reduce systemic risk (Markt/2003/02/F, 2004, p. 15)

The ideal was an unimpeded financial market with perfect information covering the entire

EU. In several reports the EU market for AIF was compared with its US counterpart, which

was seen as closer to the ideal (CRA, 2006; SEC(2006) 1451).

Policy instrumentsTo reach the first goal two instruments was repeatedly emphasized, at times even by

supporters of the market-shaping coalition:

Transparency

Light-touch governance / self-regulation

Enhanced transparency was argued to ease evaluation of the products for investors and

therefore the pricing mechanism would function in a more optimal way. A light-touch

governance structure encompassing self-regulation through industry codes was by industry

representatives highlighted as the preferable, heavy and strict regulation would inhibit

innovation and impose unnecessary costs on the fund managers, thereby reducing the

competitiveness of the European market for UICTS and AIF (OH, 2005, p.2).

To reach the second goal, retail investor protection, it was decided to keep on excluding retail

investors from funds with high risk exposure, by changing the division between UCITS and

AIF only slightly (Directive 2009/65/EC). This approach represents a slight weakening of the

macroprudential paradigm.

The third goal, reduce systemic risk, was to be reached through indirect regulation, by

imposing limits to bank’s exposure to leveraged funds. Measuring of risk exposure was

however placed with the individual financial institutions (Markt/2003/02/F, 2004, p. 59). This

is an odd combination of a goal from the macroprudential paradigm, attempted solved with a

microprudential instrument.

Policy settings More transparency was demanded, and the definition of professional investors contained in

MiFID was deemed most suitable to distinguishing between retail and professional investors

(COM(2006) 686 final, p.13). Through the indirect regulation the minimal capital

requirements imposed on banks in the EU were estimated to be reduced by 5,3 % on average

(Markt/2003/02/F, 2004, p. 9). The risk measuring mechanism that banks were encouraged to

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implement was risk-sensitive (Markt/2003/02/F, 2004, p. 15). This approach to set capital-

requirements was pro-cyclical (Baker, 2013), therefore contradicting the macroprudential

paradigm.

DiscourseThe cognitive function of the discourse justified the attention devoted to AIF through their

growing importance in the European economy and their ability to help alleviate the challenges

posed by the retirement reforms (OH, 2005, p.8-9). Furthermore the competitiveness

argument, that funds could move offshore to escape too rigid regulation, justifies the caution

against overregulation (EG, 2006, p.5). Normatively the policy goals and instruments can be

understood as rooted in the third of the aims of the EU outlined in article 3 of the TEU:

“3.The Union shall establish an internal market. It shall work for the sustainable

development of Europe based on balanced economic growth and price stability, a highly

competitive social market economy, aiming at full employment and social progress…” (TEU,

1992) with priority devoted to the underlined ideals.

In conclusion the idea of an efficient market has permeated the discussions and regulatory

proposals. This is also supported by the quantitative data in App. 1. Many of the ideas in the

debate are structured upon this idea, for instance the need for integration, competition and

self-regulation. Most of the instruments proposed are microprudential, especially transparency

is mentioned often (App. 1). These instruments are even applied to reach goals associated

with the macroprudential paradigm. The ideas, their related goals and instruments are

illustrated in the following diagram, where their relative weights have been assigned on the

basis of the quantitative analysis in App. 1 and the thick description and interpretation from

above:

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Coding: Green = Macroprudential, Blue = Microprudential, Dark = Idea, Light = Goal, Size = Weight,

Triangle = Instrument.

The situation after the outbreak of the crisis

In October 2007 the Hedge Fund Working Group (HFWG) issued five recommendations for

industry best practices. The five areas covered were; disclosure to investors and

counterparties; valuation; prudential and risk issues; fund governance; and activism (HFWG,

2007, p. I). This self-regulatory initiative shows continued support to the instruments of the

microprudential paradigm, and was understood as an attempt to avoid stricter regulation

imposed by public authorities (Quaglia,2011).

The EP reacted to the crisis by two self-initiated reports with recommendations to the EC on

transparency of institutional investors, the Lehne Report published in July 2008

(2007/2239(INI)), and HF and private equity, the Rasmussen Report in September 2008

(2007/2238(INI)). In these reports higher weight was laid on ensuring financial stability,

however transparency was continuously highlighted as the appropriate instrument

(2007/2239(INI), p.10-13; 2007/2238(INI), 10-12). Nevertheless the idea of public regulation

and oversight had taken a stronger hold, especially in the Rasmussen report, and the self-

Page 26 of 56

Efficient market

Competitiveness

Diversif-ication

Protection of investors

Unstable market

Transparency

Supervision through Indirect

regulation

Self-regulati

on

Protection of

employees


regulatory approach was criticized as insufficient in both reports (2007/2238(INI), 8-9;

2007/2239(INI), p.12). The reports also illustrated the disagreement within the Parliament on

this issue, and that ideas from the microprudential paradigm still stood strong

(2007/2238(INI), p. 14). New subjects were introduced in the debate, specifically the target

firm and its employees were presented as losers under the current regulation (2007/2238(INI),

p. 8+10; 2007/2239(INI), p.6).

In December 2008 The EC sat up a public consultation on HF. In the introduction, the EC

stated that the crisis had underlined the vulnerabilities within the financial system, and shown

that risk was easily transmitted between markets and actors. As a response to the crisis the

G20 had at the summit in Washington in November 2008 agreed the objective: “Ensure that

all financial products and participants are regulated or subjects to oversight, appropriate for

their circumstances” (CP, 2008, p. 2). This agreement was a great victory for the

macroprudential paradigm however, how influential this victory will be depends on the

instruments used to implement it (Baker, 2013).

As a result of the G20 agreement the EU was conducting a review of the supervisory and

regulatory framework in the Union. In accordance with the advice from G20 this review had

the existing self-regulatory actions as point of departure (CP, 2008, p. 2 footnote 1), a fact that

strongly limits the glory of the macroprudential victory.

HF were affected by the financial crisis. This became evident as they experienced sudden

substantial deterioration in performance; significant losses for investors; difficulties to obtain

leverage, and confrontation with large-scale withdrawals from investors leading to

compulsory sale of assets. This led to failures for some funds and justified the attention from

the EC (CP, 2008, p.3).

The EC outlined five subjects on which it requested all stakeholders to contribute to the

analysis: Scoping the issue, systemic risks, market efficiency and integrity, management of

micro-prudential risks, transparency towards investors, and investor protection.

Concerning systemic risk it was noted that despite HF high levels of leverage, they had earlier

not been seen as systemic threats. The crisis had made the EC aware that prime brokers were

subject to high counterparty risk from HF and could be damaged severely by a fund failure,

and that HF did also pose a more direct systemic risk through their volume and frequency of

Page 27 of 56


trading which had a pro-cyclical effect. This contributed to the volatility in asset prices and

herding. The EC concluded that existing transparency rules and indirect regulation had not

been sufficient (CP, 2008, p.5).

This admission from the EC was a damaging hit to the microprudential paradigm, as the EC

before the crisis was strong in its support to this paradigm (Quaglia, 2013). This vacuum gave

the macroprudential and other ideas the opportunity to present themselves as appropriate

alternatives. Regarding market efficiency the EC realized the positive contributions of HF on

pricing mechanisms, nevertheless it raised the issue of short-selling as disruptive or used in a

dishonest fashion (CP, 2008, p.6). The EC reflected that no EU regulation existed regarding

micro-prudential risk management, as HF were primarily distributed among institutional

investors. However due to the systemic importance of HF the EC questioned the

appropriateness of internal valuation and risk management (CP, 2008, p.8). The last subject,

investor protection, discussed the relevance of HF for retail investors (CP, 2008, p. 9).

This consultation paper shows a shift in the attention of the EC towards the systemic risk

posed by HF. Although it seems sparked by the agreement in G20, it is important to take the

influence of the EU market-shaping coalition, represented by Angela Merkel and Nicholas

Sarkozy, exerted prior to and at the G7 and G20 summits into consideration. The awareness

and urgency of regulation of HF became particularly vital for German politicians from year

2005, due to the failure of Deutsche Börse and London Stock Exchange to merge (Pagliari,

2013, p.240-242).

Responses to the consultation paper should contribute to the discussion at a High Level

Conference on Private Equity and HF in February 2009, where a report from the High Level

EG chaired by Jacques de Larosiere served as basis for a new regulatory proposal (CP, 2008,

p.10).

The de Larosiere report (February 2009) was very comprehensive. The group was established

by the EC in October 2008 with the objective to give advice on the future of European

financial regulation and supervision (de Larosiere, 2009, p.3). As illustrated below, this report

was a complete contradiction to the EG report released in 2006.

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On the opening pages it stated the earnestness of the situation and argued that financial

regulation and supervision had been too weak or provided the wrong incentives, and that

repair was urgently needed (de Larosiere, 2009, p.3).

The first chapter contained an analysis of the causes of the crisis, indicating ample credit,

innovative and complex products, insufficient risk management, lack of transparency and

supervisory focus on micro-prudential rather than macro-systemic risks as the most prominent

causes (de Larosiere, 2009, p.7-9). It emphasized the negative dynamics of the crisis, where

HF played an amplifying role (de Larosiere, 2009, p.11-12). This represents a clear

reshuffling of ideas, bringing systemic risk to the forefront and at the same time criticizing the

efficient market hypothesis.

In the second chapter rhe group outlined many weaknesses in the established framework. Two

overall weaknesses were highlighted, the unsystematic and incoherent implementation of

directives (de Larosiere, 2009, p.27), and the insufficient oversight with self-regulation (de

Larosiere, 2009, p.15). The report was critical towards the Basel II framework, accusing it of

being very procyclical (de Larosiere, 2009, p.15-17). Specific to HF the group recommended

that appropriate regulation was extended to all firms or entities conducting financial activities,

even if they had no direct links with the public at large (de Larosiere, 2009, p.23). The group

saw a need for higher transparency and proposed the establishment of a formal authority to

register HF, to assess their strategies, their methods and their leverage (de Larosiere, 2009,

p.24-25). In addition the group expressed the urgency of rectifying the incentives given to

managers in form of remuneration, so that excessive risk taking and short-termism would not

be rewarded (de Larosiere, 2009, p.30-31).

The group recommended a new overarching supervisory framework, which should be

implemented by means of regulations, in order to avoid incoherent implementation (de

Larosiere, 2009, p.29). To perform the supervision the group proposed establishing a

European System of Financial Supervisors (ESFS), which would cooperate with the national

supervisory authorities (de Larosiere, 2009, p.46-48 + 57), and a European Systemic Risk

Council (ESRC) to decide on macroprudential policy (de Larosiere, 2009, p. 44-46 + 57).

This report marks a clear break with the prior self-regulation/indirect regulatory approach to

HF by proposing directives and even direct regulations. Regarding instrument it was

proposed, in line with the macroprudential paradigm, to move risk management to a

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supervisory authority (de Larosiere, 2009, p. 44-48 + 57) and cover all financial institutions

by the regulation (de Larosiere, 2009, p.23). Transparency was still advocated as an important

instrument (de Larosiere, 2009, fx. p.24 + 59). The de Larosiere report marks a significant

change in the overall approach to financial regulation in the EU, not just with regards to HF

(Hudson and Quaglia, 2009, p. 944). The increasing weight assigned to the macroprudential

paradigm in the report is also outstanding in the quantitative analysis, which shows that the

word supervision has been mentioned 550 times in the de Larosiere report (App. 1).

Taking point of departure in the de Larosiere report, the regulatory approach to HF and

private equity funds after the crisis was discussed at an open hearing held by the EC in

February 2009. At this open hearing representatives from both the market-making and the

market-shaping coalition expressed their views.

Industry representatives, amongst them the chairman of the HFSB urged the regulators to

show humility, due to the many regulatory failures that had already been made in the wake of

the crisis. They reminded the EC that HF had acted responsibly in the crisis and no HF had

been bailed out. The industry expressed willingness to take collective responsibility and

improve industry standards ensuring transparency, good governance and independent

administration and valuation, in cooperation with regulators (OH, 2009, p.10). They regarded

this option as more appropriate and effective than pure regulation, and underlined that HF

were already indirectly regulated (OH, 2009, p.11).

In contrast, the representative from the German finance ministry supported the proposal of the

EC to establish an EU-wide registration of HF managers, in order to increase transparency

and regulatory oversight (OH, 2009, p.13). Many participants expressed the view that self-

regulatory industry codes and standards were a useful complement to regulation, however

underlined the problem of enforcing the codes (OH, 2009, p.17 +19).

The concluding panel was opened by the chairman of CERS, who suggested that fund

managers should be licensed and monitored with respect to risk management, compliance

function, robust valuation techniques, asset segregation, independent audit, adequate capital

resources, and management of conflicts of interest (OH, 2009, p.17-18).

The panel however was concluded by the managing director of Proprietary Alpha Strategies,

who stated that the level of information that his company provided to investors seemed to be

appropriate for them to perform due diligence, which made further regulation unnecessary. He

Page 30 of 56


concluded that HF were part of the financial eco-system and their contribution to the market

functioning should be valued, not inhibited by unnecessary and costly disclosure requirements

(OH, 2009, p.20-21).

The open hearing showed that the market-making coalition had not changes its point of view

in the wake of the crisis and stood strong on their ideal of an efficient market, although most

other participants had become more open to public regulation. The prevalence of ideas and

instruments from the macroprudential paradigm in the de Larosiere report was watered down

during this open hearing.

Despite the opposition from the industry expressed at the open hearing, the EC in April 2009

published a proposal for a directive on AIFM (COM(2009) 207 final). In the introduction the

EC argued that HF had contributed to inflation of asset prices and growth in the structured

credit market; they had had procyclical impacts on declining market; and impaired market

liquidity. The EC stated that these risks had been underestimated and current rules were

insufficient and did not adequately reflect the cross-border nature of the risks (COM(2009)

207 final, p.3). The EC highlighted that it was working closely with its international partners

to ensure convergence (COM(2009) 207 final, p.4).

The proposed directive had two aims, presented in the following order:

To establish a secure and harmonized EU framework for monitoring and supervising

the risks that AIFM pose to their investors, counterparties, other financial market

participants and to financial stability.

To permit, subject to compliance with strict requirements, AIFM to provide services

and market their funds across the internal market (COM(2009) 207 final, p.5).

This hierarchy of the two central goals represents a change in the hierarchy of goals. Although

the efficient market hypothesis is still present in the second goal, it has been down prioritized

whereas the goal of stability has risen to prominence.

The EC choose a directive as the legal form due to the trade-off between harmonization and

flexibility (COM(2009) 207 final, p.7-8). This decision strikes a balance between the

industry’s wish to retain a self-regulatory approach and the recommendations made by the de

Larosiere report.

The member states were asked to designate a competent authority to carry out the duties

provided in the proposed directive. The competent authorities were obliged to work together

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and share information, and on a quarterly basis to provide the Economic and Financial

Committee with all aggregated information on AIFM under their responsibility (COM(2009)

207 final, p.48). This should ensure timely sharing and macroprudential oversight, a strong

sign of the enhanced importance of the macroprudential paradigm.

All AIFM were required to obtain authorization to operate in the EU through their domestic

authority. To obtain authorization AIFM should be required to provide information on their

planned activity, identity and characteristics of the AIF they manage, the governance of the

AIFM, arrangements for the valuation and safe-keeping of its assets and its systems of

regulatory reporting (COM(2009) 207 final, p.8). In addition the AIFM should be required to

hold own funds of at least €125.000, and if the assets under management (AuM) exceeded

€250.000 additionally 0,02 % of the funds above €250.000 (COM(2009) 207 final, p.28).

To ensure investors ability to perform due diligence the AIFM should provide investors with

information on investment policy, including descriptions of the type of assets and the use of

leverage, redemption policy in normal and exceptional circumstances, valuation, custody,

administration and risk management procedures, and fees, charges and expenses associated

with the investment. The AIFM should also make available an annual report for each financial

year for each of the AIF it manages (COM(2009) 207 final, p.8-9).

Guaranteeing effective macro-prudential oversight the AIFM should be required to report to

the competent authority on a regular basis on the principal markets and instruments in which

it traded, its principal exposures, performance data and concentrations of risk (COM(2009)

207 final, p.9). The AIFM was required to implement risk management systems and review

them at least annually (COM(2009) 207 final, p. 26).

Although these requirements clearly reflexed the idea and goal of encouraging financial

stability, the instrument to achieve them was microprudential at the core, as the risk

assessment would be carried out by the AIFM themselves and then reported to the supervisory

authority, through increased disclosure (COM(2009) 207 final, p.26).

The proposed directive also entitled the EC to set leverage limits where it assessed that

leveraged funds posed a threat to the financial integrity and stability. Additionally it laid the

way for national authorities to demand full disclosure of aggregate leverage and the sources of

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leverage of funds systematically employing leverage, and required those national authorities

to share the additional information (COM(2009) 207 final, p.9 + 15). An AIFM would be

considered to employ leverage on a systematic basis if the combined leverage exceeded the

value of the equity capital of the AIF in two out of the past four quarters (COM(2009) 207

final, p.35). These parts of the directive are more full blown macroprudential.

New disclosure requirements towards target firms were proposed, these would enter into force

if an AIF acquired more than 30 % of the voting rights of the target firm. The funds should

disclose information on future plans, strategies to overcome conflicts of interest and the

policy of external and internal communication, to other shareholders and the employees of the

target firm (COM(2009) 207 final, p.36-37). This requirement would however not apply if the

target firm was a SME (COM(2009) 207 final, p.9). This showed a new prioritization of goals

and actors. Protection of employees is in line with the macroprudential paradigm.

The directive entitled all authorized AIFM to market their funds to professional investors in

all member states, and once authorized they should only be subject to notification procedures.

This established a PPR for AIF within the EU. The national authorities were in this way

prohibited from imposing additional requirements on foreign AIFM (COM(2009) 207 final,

p.10).

The directive did not provide rights in relation to marketing of funds to retail investors. It did

nevertheless not prohibit member states from allowing AIFM to market AIF’s to retail

investors within their territory, subject to additional investor protecting requirements

(COM(2009) 207 final, p.10).

The proposed directive also permitted AIFM to market AIF located in third countries to

investors in the EU. This provision was subject to strict controls. Furthermore the proposed

directive would, with a delay of 3 years, allow AIFM established in a third country to market

their AIF’s in the EU, if the regulatory framework and supervisory arrangements in the third

country could be assessed as equivalent to the EU framework (COM(2009) 207 final, p.10).

The measures taken to integrate the European AIF industry is essentially a market efficiency

enhancing goal, however imposing strict restrictions and demands for equivalence upon third

country AIFM, it can also be seen as a mild form of protectionism (Quaglia, 2011, p.675),

thereby adhering to the macroprudential paradigm.

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The EP reviewed the proposal and released a report in June 2010, indicating where it meant

that amendments were needed (A7-0171/2010). The report expressed strong support for EU

level action in the AIF areas, but highlighted the importance of striking the right balance

between on the one hand the vitality and creativity of the industry and on the other hand the

need for effective regulation and supervision (A7-0171/2010, p. 69).

On the issue of company takeover, the EP proposed to decide which AIFM had to apply to the

specific rules on the basis of the standard criteria used under company law, rather than by a 30

% of shares rules (A7-0171/2010, p.72). It added ten subjects that had to be included in the

AIF annual reports in which the AIFM had a controlling stake (A7-0171/2010, p.45-46).

Furthermore the EP envisaged a dominant role to ESMA3, for instance as a mediator between

national competent authorities (A7-0171/2010, p.58), and as the body holding a central public

register of identifying the competent supervisory authority for each AIFM (A7-0171/2010,

p.23). Additionally ESMA should define and regularly review guidelines on exercise of

authorization power and reporting obligations (A7-0171/2010, p.47-48). The EP proposed a

ceiling of €10million to the initial capital requirements for AIFM (A7-0171/2010, p.29).

Four goals were continuously mentioned in the proposed amendments; the provision of a

level playing field (A7-0171/2010, p.13,14,69,80,81), reduce compliance costs (A7-

0171/2010, p. 29,69), increase supervision (A7-0171/2010, p.

7,23,36,40,47,52,57,58,72,84,103,129) and increase transparency (A7-0171/2010,

p.13,16,37,69,70,71,74,81). This is an untraditional combination of ideas and instruments

from both paradigms.

Finally in June 2011 the Directive 2011/61/EU of the EP and of the Council on AIFM was

adopted. This directive had five objectives, presented in the following order:

Increase the transparency of AIFM towards investors, supervisors and the employees

of the companies in which they invest.

Equip national supervisors, the ESMA and ESRB with the information and tools

necessary to monitor and respond to risks to the stability of the financial system that

could be caused or amplified by AIFM activity.

Introduce a common and robust approach to the protection of investors in these funds.

3 European Securities and Markets Authority

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Strengthen and deepen the single market, thereby creating the conditions for increased

investor choice and competition in the EU, subject always to high and consistent

regulatory standards.

Increase the accountability of AIFM holding controlling stakes in companies towards

employees and the public at large (Memo/10/572).

The directive had been amended so that the EP could accept it, however not all the

shortcomings it had pointed out above were accommodated (2011/61/EU vs A7-0171/2010).

The amendments reflexed an unexpected mix of instruments from the different paradigms.

This inconsistence reduce the degree of change, and can be understood as a result of the need

for compromises in the EU policymaking process, where many different actors and

representatives from both coalitions have to reach agreement on a common directive

(Quaglia,2013, p. 26-27; Schmidt, 2002, p. 246-250).

The overall hierarchy of goals in the directive is more important than the ideas behind the

single amendments, as it reflects which paradigm has managed to prevail. Here it is worth

noticing that the first goal has been changed from

“To establish a secure and harmonized EU framework for monitoring and supervising the

risks that AIFM pose to their investors, counterparties, other financial market participants

and to financial stability”

in the first proposal to

“Increase the transparency of AIFM towards investors, supervisors and the employees of the

companies in which they invest”

in the final directive. This change illustrates a weakening of the macroprudential ideas behind

the first proposal, and is evidence that the market-making coalition has been able to water

down the originally primarily macroprudential proposal to a directive having increased

transparency as its primary goal. The goal however still has macroprudential straits as it

includes transparency towards both supervisors and employees. These finding are supported

by Pagliari (2013, p.256-257). The two subsequent goals in the final directive are drawn from

the macroprudential paradigm, whereas the fourth resembles the second goal from the first

proposal and clearly steams from the efficient market hypothesis. Finally the fifth goal in the

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directive integrates the macroprudential concern for employees, which was completely absent

in the first proposal.

Although the market-making coalition has been able to water down the directive and force the

market-shaping coalition into compromises, macroprudential ideas carry the prominent

weight. When the question comes to instruments the picture gets blurred, with prominent

roles devoted to both transparency and to new supervisory institutions. These findings are

supported by the quantitative analysis.

In December 2012 the EC issued an impact assessment of the proposal, on the basis of which

it adopted a delegated regulation on the level two measures for the AIFM directive, also in

December 2012 (No 231/2013). This delegated regulation regarded exemptions, general

operating conditions, depositaries, leverage, transparency and supervision (No 231/2013, p.1).

In the delegated regulation the EC intended to create a single rule book for all AIFM in the

EU. By making use of a regulation the risk of divergent implementation had been minimized

(No 231/2013, p.1).

The first issue addressed by the regulation was a procedure for calculating AuM. It was

decided that the AIFM had to calculate total AuM by determining the value of all assets it

manages, without deducting liabilities, and valuing financial derivative instruments at the

value of an equivalent position in the underlying assets (No 231/2013, p. 19-20).

The next issue handled was calculation of leverage. An AIF would be considered to be

employing leverage on a substantial basis if its exposure, calculated using the commitment

method, exceeded three times its NAV (C(2012) 8370 final ,p.10). This represents a less strict

definition of substantial leverage than the one proposed in the AIFM directive.

Thirdly the regulation defined appropriate additional own funds and professional indemnity

insurance (PII). It was laid down that an AIFM’s additional own funds should be seen as

appropriate if they amounted to at least 0,01 % of the value of the portfolios of the AIF

managed, and a PII should be considered appropriate if it covered 0,9% of AuM for claims in

aggregate per year and 0,7% of AuM per individual claim (C(2012) 8370 final, p.6). This also

represents less strict limits than the ones proposed in the AIFM directive.

Rules and procedures concerning the risk management system that should be established and

applied by AIFM were laid down. The regulation required a permanent risk management

function within the AIFM to be established and entrusted it with specific tasks, including:

Page 36 of 56


implementation of the risk management policy, risk monitoring, measuring the risk level and

ensuring that it complied with the AIF’s risk profile. The regulation also laid down conditions

for functional and hierarchical separation of the risk management function from operational

units (C(2012) 8370 final, p.7).

AIFM were required to conduct stress tests at least annually (C(2012) 8370 final, p.7).

In relation to transparency towards investors and supervisory authorities minimum standards

and requirements were laid down. Following the responses to ESMAs consultation paper it

was demanded to provide the information on an annual rather than quarterly basis (C(2012)

8370 final, p.9).

This extensive regulation provided the settings for the instruments decided upon in the AIFM

directive. The regulation was comprehensive, but generally the instruments were sat at low

levels, for instance own funds of 0,01 % of the portfolio managed, annual stress tests and

mandatory disclosure to employees in the target firm only when acquiring 50% of the shares.

At first sight it seems like a great victory for the macroprudential paradigm that a direct

regulation was adopted, however reviewing the consultations hosted by ESMA (SWD(2012)

386 final, p.104, fx p. 109, 115, 117, 123, 131, 147) it becomes clear that the market-making

coalition has been able to lobby successfully and keep the setting of the instruments at a low

level.

The regulation of December 19th 2012 is the latest piece of legislation concerning HF at EU

level (EC Homepage).

As in the previous section the main points form the thick description will form the basis for an

interpretation structured by the four factors for recognizing a paradigm shift.

Hierarchy of goals and idealLike before the crisis, after the crisis representatives from both coalitions were present in the

discussions. It is clear from both the quantitative analysis and the thick description that ideas

from the macroprudential paradigm had gained strength (de Larosiere, 2009; App. 1).

However in the area of hedge fund regulation the market-making coalition was able to water

down the macroprudential ideas in the regulatory proposals and influence the setting of the

instruments (Pagliari, 2013). In the final AIFM directive from 2011 the hierarchy of goals was

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Increase the transparency of AIFM towards investors, supervisors and the employees

of the companies in which they invest.

Equip national supervisors, the ESMA and ESRB with the information and tools

necessary to monitor and respond to risks to the stability of the financial system that

could be caused or amplified by AIFM activity.

Introduce a common and robust approach to the protection of investors in these funds.

Strengthen and deepen the single market, thereby creating the conditions for increased

investor choice and competition in the EU, subject always to high and consistent

regulatory standards.

Increase the accountability of AIFM holding controlling stakes in companies towards

employees and the public at large (Memo/10/572).

The overall ideal behind these goals was a secure and stable financial system (Memo/10/572).

Policy instrumentsAlthough the hierarchy of goals and the ideal are rooted in the macroprudential paradigm, the

instruments implemented to reach the goals have their origin within both of the paradigms.

Overall direct regulation through the AIFM Directive and the supplementing Delegated

Regulation (No 231/2013) are macroprudential instruments to reach the first two and the last

goal. However the instruments encompassed in the Delegated Regulation are to a large extent

microprudential. Demands for transparency are omnipresent in the texts (App. 1), and is at

times even presented as a goal in itself (2011/61/EU).

With regard to risk management a supervisory authority and central registry has been

established, a clear victory to the macroprudentialists. However, the risk measurement is still

carried out by the AIFM themselves and the models takes point of departure in the former

self-regulation. Protecting retail investors is still pursued by excluding them form investing in

AIF. The third goal, strengthening and deepening the single market, is accommodated by

introducing the EU passport for AIFM once they have been registered in one member state.

This is a clear victory to the market-making coalition.

Overall a pragmatic mix of instrument has been implemented.

Policy settingsThe settings of the instruments were decided upon in the Delegated Regulation (No 231/2013)

from 2012. It covers many articles in the AIFM Directive, however, the final minimum

standard settings are low in most areas, lower than proposed in the directive. For instance

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annual stress testing and minimum own funds of 0,01% of AuM. One prominent exception is

the requirements for transparency which are set at a high level towards both investors,

supervisors and, to a lesser extent, employees in the target firms.

Discourse Cognitively the policy is justified by referring to the growing importance of HF in the EU,

and their pro-cyclical effect, herding behavior and contribution to high systemic risk (CP,

2008, p.5). Normatively the policy goals and instruments can still be understood as rooted in

the third of the aims of the EU outlined in article 3 of the TEU: “3.The Union shall establish

an internal market. It shall work for the sustainable development of Europe based on

balanced economic growth and price stability, a highly competitive social market economy,

aiming at full employment and social progress…” (TEU, 1992). The third aim has however

been reinterpreted and the priority of the ideals has been changed. More weight has been

devoted to balanced economic growth, and social market economy, and the meaning of

highly competitive markets has changed from meaning unimpeded operations for the market

forces (EG, 2006, p.5) to meaning stable markets also in periods of crisis (SEC(2009) 576,

p.41).

Based on Appendix 1 and the thick description the ideas, their related goals and instruments

have been illustrated in the following way:

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Coding: Green = Macroprudential, Blue = Microprudential, Dark = Idea, Light = Goal, Size = Weight,

Triangle = Instrument.

Comparing the two situations – has a paradigm shift occurred?

When comparing the illustration above with the illustration of the situation before the crisis

on p.26, several differences become apparent.

First of all the green macroprudential area is now dominating and the idea of an instable

financial market has gained prominence over the efficient market idea. It is also evident that

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Efficient market

Diversifi-cation

Competi-tiveness

Protection of investors

Instable market hypothesis

Micro-prudential oversight

Transparency

Indirect regula-

tion

EU-Passport

Supervisory authority

Protection of employees

Reduce systemic risk


more goals and instruments are structured upon the idea of an instable financial market.

Another observation is that the number of instruments has increased, both new

microprudential and new macroprudential instruments have ascended. This is in itself a sign

of a weakening of the efficient market ideas. In the quantitative analysis the word supervision

has been mentioned 1048 times in the texts after the crisis, indicating a prominent weight to

the macroprudential instrument of supervisory authority.

Most importantly however, the two paradigms have become enmeshed with one another. In

the first illustration the two ideational cores were unrelated. In the last illustration the

macroprudential paradigm draws on instruments from the microprudential paradigm to reach

its goals and for instance the EU passport, a microprudential instrument, relies on the

macroprudential supervisory authority.

Change is obviously evident, but has a paradigm shift occurred?

To determine that the method developed in the second section will be applied. That method

states that a paradigm shift only can be recognized when significant change has happened in

all of the four factors; Hierarchy of objectives and ideals, policy instruments, policy settings

and discourse.

Change in the hierarchy of goals and ideal has certainly happened, reduction of systemic risk

has risen to prominence together with investor protection, however, unimpeded functioning of

the market has not been completely discharged but moved to a third place in the ranking of

goals (Memo/10/572, App.1).

With regards to policy instruments change is recognizable as the self-regulatory approach has

been substituted by direct regulation and a supervisory authority has been established. This at

first sight remarkable change which also is supported by the quantitative analysis however has

to be treated with caution, as the new instruments are combined with instruments from the

microprudential paradigm, and are in some instances used to reach microprudential goals.

Regarding policy settings, the level of transparency demanded is still high. Furthermore

although direct regulation have been decided upon and supervisory authorities have been

established, their powers are constrained by the minimum/maximum settings decided upon in

the Delegated Regulation (No 231/2013) from 2012.

Are these significant changes? In terms of this paper the change in instruments is significant

as the legislative framework has been changed in a way that enables regulators to perform

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more supervisory oversight in line with the macroprudential paradigm. However the change

in policy settings limits this ability by constraining the room for maneuver of the newly

established macroprudential instruments while at the same time allowing continuity of

microprudential instruments. In effect the change in policy settings therefore cannot be

rendered significant, as it is not impacting the policy output in line with the new paradigm,

much the contrary actually.

Concerning discourse a clear shift has taken place in the cognitive function. From justifying

the light-touch governance before the crisis by reference to the benefits HF provided to the

economy, it changed to justify the direct regulation by referring to the pro-cyclical and

herding behavior of HF. Normatively the policy has remained rooted in the third of the aims

of the EU outlined in article 3 of the TEU, however this aim has been reinterpreted and the

priority of ideals has changed.

In sum, based on the method developed in the second section, it can be concluded that a

complete paradigm shift cannot be recognized. Although change has occurred in the four

factors it has not been significant at in the policy settings, which in effect has offset the new

macroprudential instruments. The cognitive discourse has clearly changed, however are still

rooted in the same normative ideals, which have been reinterpreted. This would not be a

problem for recognizing this as a paradigm shift however, as this paper does not demand

incommensurability.

The research question: Has a paradigm shift taken place within regulation of hedge funds in

the EU? Can therefore be answered with a no.

This conclusion goes against the expectations developed in the theory section, namely that a

paradigm shift could be expected to occur after a crisis. The limitations to this paper do not

allow investigation of the reasons for this unexpected result, however it is suggested that the

need for compromises in the EU policymaking and the strong representation of industry in all

consultations have made it difficult for a full blown paradigm shift to materialize (Quaglia,

2013, 2011).

A word of caution is necessary at this point. The scholars cited in the theory section all agree,

that a paradigm shift takes time and is preceded by a period of experimentation with new

instruments. It is now 5 years since the crisis started, and that might not be enough time for a

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full paradigm shift to materialize The incoherent use and implementation of instruments from

both paradigms can be a part of an experimentation phase, reflecting the path-dependence and

stretching of the microprudential paradigm in combination with the beginning

institutionalization of ideas from the macroprudential paradigm. If however the change will

not go further in the coming years this situation corresponds to Schmidt’s evolutionary

change, which build on Lakatos’ concept of overlapping paradigms, which will not

necessarily lead to a paradigm shift (Schmidt, 2002).

A more nuanced answer to the research question would therefore be: No paradigm shift has

taken place, yet. Significant change has occurred at three of the four levels, however it

remains to be seen if the regulatory framework will be develop further or stay at this point.

ConclusionThis paper started out by reviewing the traditional theories of ideas in policy making. Taking

point of departure in Kuhn’s (1962) theory of paradigm shift in natural science, the paper

moved on to Hall’s (1993) application of the theory to policy paradigms. Recognizing the

limitations of Hall’s theory, the role of ideas was elaborated by Blyth (2001,2002), the role of

discourse in changing ideas enlightened by Schmidt (2002) and the order of change at the

three policy levels was questioned by Baker (2013). With this theoretical background it was

decided to recognize a paradigm shift as a significant change in four factors: The hierarchy of

goals and ideal, the policy instruments, the policy settings and the discourse.

Incommensurability between the policy paradigms was not demanded. In addition the

expectation was formed that a paradigm shift could be expected to occur in the aftermath of

the financial crisis.

As next step the method for measuring if significant change had occurred in the four factors

was outlined. The method employed was thick description, which was carried out in a way

inspired by Carstensen (2011). 29 texts, encompassing legislative acts, reports and discussions

mainly published by the EC and the EP have formed the empirical material upon which the

thick description has been based. In addition a quantitative analysis counting selected words

from the two paradigms in the texts has been performed to provide a basis for assigning

relative weights to the paradigms before and after the crisis. To operationalize this method in

the context of the EU, Quaglia’s distinction between the market-making advocacy coalition

and the market-shaping advocacy coalition within the EU were introduced. These coalitions

respectively support the two primary paradigms within financial regulation;

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Microprudentialism and macroprudentialism. These paradigms were described and used as

ideal types, providing ideas and words to look for in the thick description and the quantitative

analysis.

The analysis showed that no EU regulation was in place before the outbreak of the crisis; a

self-regulation and indirect regulation approach was institutionalized. After the crisis however

the market-shaping coalition had gained strength and a directive, the AIFM directive, and a

delegated regulation were decided upon to directly regulate the operations of HF and other

AIF. The rhetoric had changed and HF were continuously highlighted as constituting systemic

risk as they enhanced pro-cyclicality and herding. Representatives from the market-making

coalition, however kept advocating for a light-touch governance approach.

The analysis concluded that significant change has taken place in the hierarchy of goals, the

policy instruments and the discourse. However the policy settings are limiting the newly

developed powers of the supervisory authority and are therefore not influencing the legislative

output line with the macroprudential paradigm. In consequence a complete paradigm shift

cannot be recognized.

This conclusion goes against the expectations developed in the first section, and further

research looking into the reasons for the lack of a paradigm shift would be interesting but falls

outside the scope of this paper. The short timespan after the crisis to this evaluation can

however be the reason why a complete paradigm shift has not occurred yet. The current

situation might be a time of experimentation with the new macroprudential ideas and

instruments, which in some years will materialize as a full blown paradigm shift. The answer

to the research question is therefore: A paradigm shift has not taken place, yet. Significant

change has occurred at three of the four levels, however it remains to be seen if the regulatory

framework will be develop further or stay at this point.

This uncertainty in the answer is of course a limitation to the argument. However, the main

point, that the change till date has not been as remarkable as it at first sight seems, is still

valid. Furthermore the method developed to measure a paradigm shift is still reusable on other

cases.

This paper has contributed to the debate about ideas in financial policy-making at the EU

level. It underlines that a crisis is not always leading to a paradigm shift, even when an

ideational shift might take place following the accumulation of anomalies within the old

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paradigm. The consensus oriented policy-making in the multilayered EU system with many

actors necessitates compromises which makes realization of a full blown paradigm shift

difficult. Further research testing this conclusion in other financial regulatory areas in the EU

would be intriguing.

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Appendix 1) WeightsMicroprudential

Efficiency

Competitive

Diversification

Transparency

Self-regulation

Before crisisGreen Paper 5 10 1 7 0Open hearing 8 8 1 11 1Expert Group 5 7 5 15 0Feedback statement 11 1 0 3 0White paper 0 9 3 2 0PP responses 2 3 0 1 1Total 31 38 10 39 2Micro total before 120

After crisisLehne Report 1 1 2 34 1Rasmussen Report 2 8 1 17 0Consultation Paper 3 0 0 6 0de Larosiere 10 24 0 20 3Open hearing 5 0 3 22 8Proposal AIFMD 4 0 0 11 0Parliament report 1 6 0 12 0Final AIFMD 2 7 0 8 0Impact Assessment 42 3 2 17 0Delegated Regulation 1 1 5 9 0Total 71 50 13 156 12Micro total after 302

MacroprudentialStability Systemic risk Investor protection Supervision Employees

Before crisisGreen Paper 0 1 22 5 0Open hearing 1 0 7 3 1Expert Group 7 0 15 10 0Feedback statement 2 0 8 8 5White paper 0 0 5 4 0PP responses 0 0 8 3 0Total 10 1 65 33 6Macro total before 115

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After crisis Stability Systemic risk Investor protection Supervision EmployeesLehne Report 3 0 0 5 4Rasmussen Report 10 0 1 14 14Consultation Paper 4 1 1 3 0de Larosiere 60 11 0 550 0Open hearing 5 10 3 11 1Proposal AIFMD 17 6 4 47 14Parliament report 26 21 3 79 35Final AIFMD 12 30 15 123 51Impact Assessment 10 71 93 136 3Delegated Regulation 4 13 8 80 2Total 151 163 128 1048 124Macro total after 1614

Ratios Before AfterEfficiency/stability 3,10 0,47Competitiveness/systemic risk 38,00 0,31Diversification/investor protection 0,15 0,10Transparency/supervision 1,18 0,15Self-regulation/employees 0,33 0,10Total micro/ total macro 1,04 0,19

%-change Macro 13,03%-change Micro 1,52

As outlined in the methodology section the method to obtain these numbers is imperfect.

Nevertheless it gives a hint of how important the respective ideas, goals and instruments from

the two paradigms were in the discussions and texts, and provides a basis for assigning their

weights. It can however not be underlined strongly enough that these numbers and weights

have to be taken with a grain of salt!

Due to the unequal number of texts surveyed in the two periods the total number of

occurrences for each word in each period is not directly comparable. It is the relative weight

between the ideas, goals and instruments from each paradigm that is of interest to this paper,

therefore the respective ratios before and after the crisis has been calculated.

The selection of words is based on the description of the two paradigms provided at p. 10-14.

To represent the ideal from the microprudential paradigm the word efficiency has been

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chosen, whereas the word stability represents the macroprudential ideal of a stable financial

market. The ratio between these two words has helped in assigning weights in the illustrations

on p.26 and p.40 in two ways. Firstly, before the crisis the ratio was 3,1, indicating that the

idea of an efficient market prevailed strongly in the discourse. Therefore the efficient market

circle in the illustration of p.26 is much bigger than the unstable market one. However, after

the crisis the ratio was 0,47, indicating that the macroprudential ideal of a stable market now

prevailed the discourse. As a result the instable market hypothesis circle in the illustration on

p.40 is bigger than the efficient market circle. In comparison to the situation before the crisis

the efficient market circle is smaller, however, this is only due to space constraints, as it has

actually also grown (however much less than stability). It is therefore very important to

highlight that it is the relative weights assigned to the different ideas in each illustration that

are of relevance, not the absolute weights.

The same procedure has been followed for the two ratios of goals competitiveness/stability

and diversification/investor protection and the ratio of instruments transparency/supervision.

The last ratio is odd, as it compares a microprudential instrument with a macroprudential goal,

however they are both representative word from their paradigms.

The total micro/ total macro ratio helps evaluate the overall picture and corresponds to the

shift in the dominance of colors in the two illustrations, from dominantly blue

(microprudential) before the crisis to dominantly green (macroprudential) after the crisis.

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Appendix 2) Concepts

Professional/institutional investors are defined in the Markets in Financial Instruments

Directive (MiFID) as “a client who possesses the experience, knowledge and expertise to

make their own investment decisions and is able to properly assess the risks incurred.”

Examples are credit institutions, investment firms and pension funds.

Retail investors are in MIFID defined as neither a professional investors nor an eligible

counterparty (FSC, 2007, p.4-5).

UICTS are investment funds regulated under Directive 85/116/ECC, and are subject to strict

limitations as to which asset classes they are allowed to invest in, level of leverage and risk-

diversification requirements. A fund classified as an UCITS is allowed to be distributed

among retail investors in all member states.

AIF are all investment funds that are not UICTS. HF fall in this category (Directive

85/116/ECC).

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