The new prudential regime for MiFID investment firms

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The FCA recently published a discussion paper (DP20/02) setting out the technical details on the EU’s Investment Firm Directive (IFD) and the Investment Firm Regulation (IFR). As the UK has already left the EU and with the transition period ending on the 31 Dec 2020, the UK will not be implementing IFD/IFR. However, this discussion paper asks authorised firms to respond to questions regarding the EU legislation in preparation to the FCA’s own rule changes which the Chancellor mentioned in the March budget earlier this year. The FCA states that by introducing UK specific rules it intends to achieve the same overall outcome as the IFD/IFR regime although it would no longer be bound by future EU standards.

Key features of the new regime

  • The initial capital required for authorisation increases for most firms. The new levels are EUR 75k, EUR 150k and EUR 750k which depend on the investment activities carried out by the firm.
  • The definitions of Common Equity Tier 1 capital (CET1), Additional 1 capital (AT1) and Tier 2 capital (T2) are taken from the Capital Requirements Regulation (CRR). However, a number of deductions now apply in full and certain concessions will apply. Also, AT1 instruments can specify the trigger event in their terms.
  • Permanent minimum requirement (PMR) is now equal to initial capital required for authorisation.
  • A fixed overhead requirement (FOR) is required by all investment firms.
  • Some investment firms will need to calculate a new activity based, or K factor, capital requirement (KFR).
  • The minimum capital requirement will be the higher of the PMR, FOR and KFR (where applicable).
  • Consolidation groups will be broadened to include unregulated parent firms, with a group capital test available for simple structures.
  • All investment firms will be required to monitor and control their concentration risk.
  • All investment firms now have a basic liquidity requirement based on holding liquid assets equivalent to at least 1/3 of their FOR.
  • Additional capital may be required to be held by investment firms after supervisory review.
  • Regulatory reporting requirements are very similar to the present ones on a quarterly or annual basis.
  • Investment firms of a certain size are required to have a clearly documented remuneration policy, including gender pay gap disclosures.
  • Investment firms will generally have to publish information on risk management, governance, own funds, remuneration and investment policy and later, environmental, social and governance risks (ESG).

In an effort to streamline and simplify the prudential regime for investment firms in the UK, the FCA is considering adopting a similar investment firm category to the IFR’s small and non-interconnected investment firm (SNI) and do away with the existing prudential categories such as ‘full scope IFPRU and BIPRU’.

Generally, the IFD/IFR will apply to all EU investment firms currently authorised and supervised under MiFID. However, the IFR will require a few investment firms to apply for authorisation under the Capital Requirements Directive (CRD) and remain subject to the provisions of the CRD and the Capital Requirements Regulations (CRR).

Investment firms that meet all of the criteria set out in Article 12 of the IFR are considered to be SNIs. This means they will benefit from additional proportionality and so less onerous prudential requirements. This includes their reporting, disclosure and remuneration requirements.

Summary of investment firm types

Types of firm

Authorisation

Prudential requirements

Systematically important firms

Credit institution – CRD

CRR and CRD

Certain large firms that deal on own account and/or underwrite on a commitment basis

Investment firm – MiFID

CRR and parts of CRD

SNIs

Investment firm – MiFID

Reduced IFR and IFD

All other investment firms

Investment firm – MiFID

Full IFR and IFD

 

Minimum Own Funds & K-Factors

The IFR all but replaces the initial capital requirements (ICR) on firms by introducing a new categorisation matrix which allocates firms on a streamlined activity basis and utilises a formulated and risk-centric approach to computation of the minimum on-going provisions.

With few exceptions, firms holding client money or placing trades on behalf of clients, even on a ‘straight through’ basis, are likely to find themselves obliged to hold the full EUR 750k of good quality capital. This is a major change from the matched principle exemption currently available and firms will need to plan carefully to avoid breaching the transitional relief arrangements.

Once the ICR is established, firms should note that their ongoing requirement is formed by the higher of said ICR, an unmodified fixed overhead requirement (although we should expect future enhanced guidance on the FOR calculation from the European authorities in time), and the newly introduced K Factors.

Many of the metrics used in the calculations are already represented in MI packs for the majority of boards in the City, but the guidance provided by the FCA is detailed in nature and firms will need to ensure they have timely access to client money balances, order flow, AUM and other datapoints as relevant to their business.

K-factor requirements

K-Factors will be relevant for all firms which are not deemed to be SNI’s and represent a large diversion from methods previously used in this area. Prescriptive and risk based, the approach is designed to allow firms to select those relevant to their own business model and are grouped into three categories to assess potential harm to clients (RtC), the firm itself (RtF), and the wider market including counterparties (RtM).

Consolidation and the Group Capital Test

The overall approach to consolidation within the draft IFR text is coherent with that to be found in the existing CRR with one major and notable exception, the introduction of the concept of an ‘Investment Firm Group’. This moves the regulatory obligations to the parent company in any group containing a regulated business, a change in approach which is likely to affect many investment firms. ‘Control’, including shareholding and common management, is the key determinant in identifying a Group.

The parent entity in an Investment Firm Group would under the draft text be responsible for applying the IFR across the group, maintaining own funds as deemed relevant at the group level. This is likely to mean the total of all permanent minimum requirements, consolidated fixed overheads and a consolidated K-Factor matrix. Netting for intra-group items would likely be permitted, but many transactions are likely to require regulator approval beforehand.

As an alternative approach to full prudential consolidation, the FCA intend to make use of a ‘Group Capital Test’ designed to work alongside the solo ICARA process, ensuring that any potential for financial strain on the entity due to its membership of the group is taken into account. Leveraged parent entities will find their group own funds compromised, especially where debt has been used to finance investment in subsidiary investment firms. This method will likely require prior approval from the regulator, demonstrating a sufficiently simple group structure and an absence of significant risks to clients or markets will be key to this.

Concentration risk

The IFR introduces a similar regime to that in the CRR that limits the size of exposure permitted to a counterparty. It also sets out associated large exposure capital requirements that only apply to certain investment firms that deal on own account. It applies this to all investment firms that deal in their own name, even if for clients. It is likely the FCA will require investment firms (including SNIs) to monitor and control various sources of concentration risk. It therefore seems reasonable that a policy for monitoring and controlling concentration risk will be required.

Liquidity

The IFR introduces for the first time the minimum quantitative liquidity requirements to all investment firms (including SNIs) which aim to help ensure investment firms have some resilience to sudden liquidity shocks by continuing to fund their overheads for a period of time without having to rely on continued income. The FCA agree with the IFR that a 1/3 of FOR is a baseline requirement.

Under IFR an investment firm can only include specific assets as part of its liquidity requirement with various minimum ‘haircuts’ applied to reduce the value that may be counted.

Cash, short-term deposits and financial instruments belonging to clients, even when held in the investment firm’s name do not count towards the liquidity requirement.

Risk management, governance and review process

The financial resources requirement in the IFD/IFR is determined through a rules-based requirement (pillar 1) and a risk-based requirement (pillar 2).

The current capital adequacy process is set to be superseded by the ICARA document focussing on identification and mitigation of vulnerabilities within the firm’s business model. The FCA will expect all firms including SNIs to document the ICARA process which for the first time makes a wind down plan compulsory.

As with the more formulaic K-Factor process, the IFD groups risks into those affecting clients, the market and the firm and expects senior management to assess potential impacts on own funds, including through the economic cycle. There is indication that the supervisory review process is likely to take special note of the security of information systems and the geographic nature of exposures.

However, in contrast to the K-Factor approach, and the current ICAAP process, the ICARA moves away from utilising a specified list of risk categories which in the past could lead to risks being unhelpfully classified, instead driving out estimates of potential harm and assessing the control systems and financial resources available.

An enhanced focus on liquidity for all firms including SNIs also sees management required to compute mandated and additional liquidity levels, with a minimum level set as a proportion of fixed overheads adjusted for guarantees written or received. The FCA expect firms to then assess the appropriateness of this level and increase if the business model requires.

The FCA is considering a legal minimum requirement (P2R) to replace the Individual Capital Guidance (ICG) with an additional buffer where appropriate (P2G).

While the IFD does not require a consolidated ICARA process in every instance the FCA is considering the requirement for an investment firm group to operate a consolidated ICARA process demonstrating how the investment firm is meeting its COND 2.4 obligations.

The FCA is considering adopting an approach for Supervisory Review and Evaluation Process (SREP) that is broadly similar to the existing approach for IFPRU and BIPRU firms but reflecting the new focus of IFD/IFR on the potential for wider harm and be done at a consolidated level if appropriate. Voluntary requirement (VREQ) and FCA’s own initiative (OIREQ) will still be part of the SREP process.

For SNI firms the FCA do not envision regular, cycle-driven supervisory reviews. However, they will be expected to consider the risks they may pose to others and which they might be exposed themselves.

Regulatory reporting requirements

In IFR SNI firms must meet annual regulatory reporting requirements, all other firms must report quarterly. The FCA does not expect the reporting forms will be as complex or detailed as the current common reporting (COREP) forms in CRR.

Remuneration

The IFD sets out a remuneration regime that aims to ensure all investment firms (except SNIs) have remuneration policies that are consistent with and promote effective risk management. These should be ‘proportionate to the size, internal organisation and nature, as well as to the scope and complexity, of the activities of the investment firm’. If the FCA were to adopt a similar approach it would delete the IFPRU and BIPRU Remuneration Codes entirely and create a new remuneration code based on the IFD remuneration provisions.

As remuneration policies need to be drafted and adopted before the beginning of each performance year, firms would need to perform the new calculation before the end of the preceding performance year.

Environmental, social and governance (ESG) issues

The FCA states that it would want to ensure that all firms integrate consideration of ESG-related risks and opportunities into the business, investment and risk decisions they make, particularly over the long term where appropriate.

Public disclosure

The IFR introduces a public disclosure regime that the FCA believes better reflects the business model and potential risk of harm by investment firms than the CRR regime. It applies a proportionate approach by only setting minimum requirements for SNIs requiring disclosure only where they have issued AT1 instruments and this disclosure can help investment decisions. The regime introduces new disclosure requirements around remuneration and ESG in line with new requirements and expectations for investment firms in these areas.

We, at Objectivus, intend to publish further information regarding the IFD/IFR as well as the FCA’s responses to the DP20/02. In the meantime, if you have any questions or thoughts (including help in responding to this discussion paper) please contact us in the normal way.