The prudential rules relevant to investment firms will soon be changing following the introduction of the Investment Firms Regulation ((EU) 2019/2033) ('IFR') and Investment Firms Directive ((EU) 2019/2034 ) ('IFD') by the European Commission. The new regime will likely amount to a significant shift in the current rules and the strong potential for increased regulatory capital requirements for most investment firms subject to transitional phasing in.
The new regime forms part of a body of work on the Capital Markets Union (one of the Junker Commission’s top political priorities) by the European Commission to boost growth in Europe. It follows a review of the legislation that applies to investment firms, particularly around capital, liquidity and other risk management requirements, in order to ensure proportionate rules and better supervision for those firms, whilst ensuring a level-playing field between large and systemic financial institutions.
Timing
The proposal for the new rules was agreed by the European Parliament and Member States on 26 February 2019 and in 18 April 2019 the European Parliament endorsed that proposal. The rules were published in the Official Journal of the European Union on 5 December 2019 and entered into force on 25 December.
The IFR becomes directly applicable from 26 June 2021 and Member States have until that date to adopt and publish the measures necessary to transpose the IFD.
The New Rules
Firm Categorisation
The new rules apply to investment firms (as defined under MiFID II) but not credit institutions (with whom investment firms currently share their prudential regime), insurers or non-MiFID financial services firms; save that the IFD (at articles 60 and 61) makes certain amendments to the prudential rules for UCITS ManCos and AIFMs as discussed further below.
How each firm is affected will depend on which of four classes of firm it falls into as based on the size and complexity of the firm’s business (and that of its wider group) and a further new concept, the applicable K-factors.
'Class 3' firms (or 'small and non-interconnected' firms (see Article 12 IFR)) are those which do not undertake any higher risk activities and whose activities fall within the following thresholds (note, each threshold is one of the new K-factors and certain thresholds apply on a sole basis while others apply on a consolidated basis):
| (a) Assets Under Management (measured in accordance with Article 17 IFR) |
< EUR 1.2bn |
| (b) Client Orders Handled (measured in accordance with Article 20 IFR) |
< either
EUR 100m per day for cash trades, or
EUR 1bn per day for derivatives |
| (c) Assets Safeguarded and Administered (in accordance with Article 19 IFR) |
Zero |
| (d) Client Money Held (in accordance with Article 18 IFR) |
Zero |
| (e) Daily Trading Flow (in accordance with Article 33 IFR) |
Zero |
| (f) Net Position Risk or Clearing Margin Given (in accordance with Articles 22 and 23) |
Zero |
| (g) Net Position Risk or Clearing Margin Given (in accordance with Articles 22 and 23) |
Zero |
| (h) Trading Counterparty Default (in accordance with Article 26) |
Zero |
| (i) On- and Off-Balance Sheet Total |
< EUR 100m |
| (j) Total Annual Gross Revenue from Investment Services and Activities (calculated as an average on the basis of the annual figures from the two-years immediately preceding the given financial year) |
< EUR 30m
|
Class 3 firms are considered not to conduct investment services which carry a high risk for clients, markets or themselves and will therefore be subject to a much lighter version of the IFR prudential rules. Although their specific prudential requirements will not relate to the K-factors, they will still need to calculate their K-factor scope for categorisation purposes. Instead, Class 3 firms should have own funds equal to the higher of their permanent minimum capital requirement or a quarter of their fixed overheads measured on the basis of their activity in the preceding year.
'Class 2' firms are non-systemic investment firms who exceed one or more of the Class 3 thresholds described above. They will need to comply with the full IFR and IFD regimes, including in respect of own funds, concentration risk, liquidity, reporting and public disclosure requirements.
It is possible that a Class 2 firm can become a Class 3 firm where it falls within all of the above thresholds for an uninterrupted period of six months and the firm notifies its regulator without delay. Conversely, a Class 3 firm will be re-categorised as Class 2 if it no longer satisfies the above thresholds – either immediately or after three months depending on the relevant threshold.
Large investment firms are split into two categories, 'Class 1' and 'Class 1 minus' firms. Both categories of firm will deal on their own account and underwrite or place financial instruments on a firm commitment basis. They will also satisfy certain threshold criteria, which generally amounts to total consolidated assets of EUR 30bn for Class 1 firms and certain lower asset thresholds for Class 1 minus firms.
Class 1 firms will be reclassified as credit institutions under the amendments made to the CRR by Article 62(3) IFR and, along with Class 1 minus firms (who, unlike Class 1 firms, will not need to seek authorisation as credit institutions), will be subject to the existing prudential and remuneration requirements under CRR and CRD IV (and CRR2 / CRD V in future).
The IFR / IFD Prudential Regimes
Class 2 investment firms subject to the IFR / IFD will need to comply with new requirements in relation to own funds, concentration risk, liquidity, reporting and public disclosure.
Own funds
To account for the higher risks of investment firms which are not small and non‐interconnected (i.e. Class 2 firms), the minimum own funds requirement for such firms should be the higher of their permanent minimum capital requirement, a quarter of their fixed overheads for the preceding year, or the sum of their requirement under a set of risk factors tailored to investment firms (‘K‐factors’) which sets capital in relation to the risks in specific business areas of investment firms. The K-factor requirement calculations are entirely new and unique to the new regime and will require significant analysis (and potentially increased levels of capital held) when compared against the existing CRD framework for MiFID investment firms.
Concentration risk
All investment firms should monitor and control their concentration risk, including in respect of their clients. However, only investment firms which are subject to a minimum own funds requirement under the K‐factors should report to competent authorities on their concentration risks.
Liquidity
All investment firms should have internal procedures to monitor and manage their liquidity requirements. Those procedures are intended to help ensure that investment firms can function in an orderly manner over time, without the need to set aside liquidity specifically for times of stress. To that end, all investment firms should hold a minimum of one third of their fixed overheads requirement in liquid assets at all times.
Reporting
Reporting requirements for investment firms should concern the level and composition of their own funds, their own funds requirements, the basis for the calculation of their own funds requirements, their activity profile and size in relation to the parameters for considering investment firms to be small and non‐interconnected, their liquidity requirements and their adherence to the provisions on concentration risk.
Public Disclosure
In order to provide transparency to their clients and the wider markets, investment firms which are not considered to be small and non‐interconnected should publicly disclose their levels of own funds, own funds requirements, governance arrangements, and remuneration policies and practices.
Other Points to Note
Remuneration
The IFR / IFD prescribes certain remuneration requirements that will apply to investment firms. Article 51 IFR provides that firms must disclose certain aspects of their remuneration policy and practices, including aspects related to gender neutrality and the gender pay gap, for those categories of staff whose professional activities have a material impact on investment firm’s risk profile
A Final Word on UCITS ManCos and AIFMs
Despite being primarily concerned with MiFID investment firms, the IFD also makes changes that will affect UCITS management companies and alternative investment fund managers. In short, those changes ensure that such entities can never hold own funds of less than the IFR’s fixed overhead’s requirement.
Transitional Provisions
The wording of the IFR has some saving features for those firms hit hardest by the changes being implemented. Article 57 sets out that investments firms may apply lower capital requirements for a period of five years from 26 June 2021 so that they limit the amount held to:
- twice their existing capital requirement under the CRR / CRD IV where the firm would otherwise be required to hold more than double its existing capital when compared with the existing framework
- twice the fixed overhead requirement for firms that did not exist before 26 June 2021 (i.e. they were not subject to CRR / CRD IV)
- twice the initial capital requirement where the investment firm previously only had to hold initial capital under CRR / CRD IV).
Brexit
Given the timing of their implementation, IFR / IFD will be impacted by the likely outcome of the Brexit withdrawal process. In this context, the UK will not be required to apply the new prudential rules unless the UK is still in the EU or in the transition period by June 2021. However, the IFR / IFD were included as “specified EU financial services legislation” in the Financial Services (Implementation of Legislation) Bill, which indicates that the UK Government would look to implement them in the event of a 'No Deal' Brexit scenario. There are also references to IFR / IFD in the FCA’s Business Plan 2019/20 published in April 2019, which stated that the FCA intended to publish a consultation in the second half of 2019 on these regulatory changes, though no such consultation has been issued at the time of writing in January 2020.
Concluding Remarks
The implications of the new rules for investment firms are numerous and extensive. For specific advice on any aspect of this new regime please feel free to contact Tom Dunn or your usual Burges Salmon contact.