www.pwc.co.uk/fsrr
January 2016
Stand out for the right reasons
Financial Services Risk and Regulation
Hot topic
New prudential framework
for EU investment firms
Background
Highlights
The prudential regime for investment firms is undergoing a fundamental review for the
first time in 20 years. This briefing note is relevant to all non-bank firms undertaking
investment services and activities regulated under the Markets in Financial Instruments
Directive (MiFID), including firms that may come into the scope of MiFID II.
The European Commission
is undertaking a complete
overhaul of the prudential
regime for investment firms Over the years, the prudential regime for MiFID investment firms has grown into a
This will have important
implications on the capital
and liquidity of the firms
affected
There is a tight timeline to
develop the new
framework, with complex
interactions between EU
regulations
complex framework primarily designed for banks – the Capital Requirements Directive
and Regulation (CRD/CRR) – which has become overly burdensome for non-bank
investment firms and does not address their specific risks. In light of this, the CRR
provisions allowed for the European Commission to undertake a fundamental review
of the overall prudential framework for investment firms in consultation with the
European Banking Authority (EBA).
As the first output of this work, the EBA published its initial report on the investment
firm review, produced in collaboration with the European Securities and Markets
Authority (ESMA), on 14 December 2015. Highlighting the complexity of the existing
framework, the report sets out the background on how investment firms are categorised
for prudential purposes. It then analyses the firms’ risks, current requirements and how
they apply across different firm types, their inconsistencies and shortfalls, as well as
potential policy options. The EBA proposes three recommendations for the next stage:
1. Establish a new framework for categorising firms based on their risks and systemic
importance, distinguishing between ‘bank-like’ firms to which the full CRD/CRR
would apply, ‘non-systemic’ firms and firms with ‘non-interconnected’ services
2. Develop a new prudential regime for ‘non-systemic’ and ‘non-interconnected’ firms
3. Extend the CRR exemption for commodity trading firms until the new regime is in
place or, at the latest, until 2020.
We highlight below selected areas of the EBA’s report and practical challenges that arise
from interactions with other EU legislation such as the (Bank) Recovery and Resolution
Directive (RRD), MiFID II, CRD IV and the forthcoming Basel developments.
Firm population
Scope and prudential categories
The investment firm review covers non-bank firms
that undertake MiFID investment services and
activities. There are currently over 7,000 investment
firms carrying out MiFID activities in Europe, of
which 51% are UK authorised. These firms vary
greatly in terms of nature, size, complexity and
systemic importance, and their classification for
prudential purposes is not straightforward.
As a starting point, a firm’s prudential regime is
determined by its prudential categorisation, which is
mainly based on the regulated activities it undertakes.
MiFID investment firms are currently categorised
under the CRD/CRR framework according to the
MiFID activities listed below:
Table 1 - MiFID investment services and activities
A1
Reception and transmission of orders in relation
to one or more financial instruments
A2
Execution of orders on behalf of clients
A3
Dealing on own account
A4
Portfolio management
A5
Investment advice
A6
Underwriting and/or placing of financial
instruments on a firm commitment basis
A7
Placing of financial instruments without a firm
commitment basis
A8
Operation of multilateral trading facilities (MTFs)
At this stage, the EBA has only analysed the prevailing
regime. It has not yet considered the changes arising
from MiFID II, such as the introduction of activity A9,
operation of organised trading facilities (OTFs).
The report highlights that under the current
CRD/CRR framework, investment firms can be
classified into at least 11 prudential categories, each of
which is subject to a different regime. This varies from
a simple minimum capital requirement of €50,000 to
the full CRR regime (e.g. an ‘IFPRU full scope’ firm in
the UK).
As the CRD/CRR is based on the Basel framework,
most investment firms are required to perform the
same complex calculations and processes as banks,
even though these requirements do not always
address the risks relevant to their business. The
current situation is the result of a process that started
in 1993, when banks and firms in scope of the
Investment Services Directive (ISD) became subject to
2 | Hot Topic | Financial Services Risk and Regulation
uniform requirements via the Banking Consolidation
Directive (BCD) and the Capital Adequacy Directive
(CAD).
The EBA’s report covers firms that are:
-
exempt from MiFID, but potentially coming into
the scope of MiFID II
in scope of MiFID but exempt from the CRR,
these firms are subject to a lighter regime
in scope of MiFID and subject to different types of
requirements under the CRR.
Issues with the current framework
The first issue with this system is the inconsistent
interpretation of MiFID across jurisdictions, which
results in firms carrying out the same activities being
treated differently by national regulators.
For example, executing client orders where the firm
acts as ‘riskless principal’ could arguably be classed as
activity A2 or A3 (under CRR Article 96(1)), although
the resulting prudential treatment would differ
significantly. Likewise, the holding of client money
and assets is subject to different national
interpretations, accounting and prudential practices.
The current system also does not adequately capture
the risks of investment firms’ business models. For
example, it does not take into account the size of the
funds managed for firms undertaking activity A4.
Another example is the fact that MTFs are subject to
the €730,000 initial capital requirement by default,
because the CRD does not explicitly address activity
A8. This also means that MTF operators are caught by
the RRD and will have to prepare recovery and
resolution plans, although it is arguable whether the
risks of activity A8 alone would justify this.
EBA’s recommendations
It follows that the EBA’s first conclusion is the need
for a new approach to categorising firms, with the
general objective of enhancing proportionality
through indicators related to systemic importance. It
proposes to distinguish between:
-
-
-
a small minority of ‘bank-like’ firms, which are
deemed to be systemic: these firms would be
subject to the full CRD/CRR regime
‘non-systemic’ firms for which a less complex
regime is to be defined, addressing market, credit,
operational and liquidity risks, and
smaller and ‘non-interconnected’ firms, which
could be subject to a simplified regime based on
fixed overheads and large exposure requirements.
Both qualitative and quantitative parameters for
determining the new categories are yet to be defined.
Meanwhile, the EBA proposes to extend the CRR
waiver for commodity trading firms until the new
regime is in place, but no later than 2020. Indeed,
certain commodity dealers that are in scope of MiFID
currently benefit from an exemption from the CRR
(under Articles 493 and 498) which is due to expire in
2017. The extension would also apply to firms trading
in commodity derivatives that will come into the
scope of MiFID II. In the UK, this means the firms
affected would continue to remain in the regime set
out in IPRU-INV chapter 3 for the interim period.
Prudential risk analysis
The second part of the EBA’s report provides a
comprehensive review of the existing prudential
standards and the risks posed by investment firms,
regardless of where they currently fit under the
CRD/CRR. We highlight below some of the risk areas
examined in the report.
Market risk
Market risk is not only relevant to firms engaged in
proprietary trading, it can also arise under other
circumstances: for example, where a portfolio
manager is running box positions or an agency broker
is left holding positions due to failed trades.
In the case of firms that solely deal on own account,
the lines can be blurred between two distinct regimes.
Where a firm meets the CRR definition of a ‘local
firm’, it is not deemed to be an investment firm for
CRR purposes and will only be subject to the
minimum requirement of €50,000. On the other
hand, a firm falling under Article 96(1)(b) of the CRR
(referred to as ‘IFPRU limited activity’ firm in the UK)
would be subject to a much more onerous regime. Yet
both types of firm do not generally serve external
clients and share common features such as
transactions guaranteed by a clearing institution.
For both categories the EBA recommends a new
prudential regime which could build on the guarantee
offered by clearing members. The haircut or margin
provided to clearing members is based on trading
positions, so this already operates as a capital charge
on the investment firm’s trading exposures. To
capture ‘tail-end risk’, which in this case is the risk
that the investment firm will fail, the EBA
recommends that a prudential factor be applied to
obtain an ‘own funds haircut requirement.’ It also
recommends that transactions that do not take place
3 | Hot Topic | Financial Services Risk and Regulation
under the responsibility of the clearing member be
subject to risk sensitive and proportionate provisions
on credit and market risk.
For smaller or more specialised firms, although the
Basel Fundamental Review of the Trading Book
(FRTB) revises the approach to market risk, the EBA
does not believe that this would address small and
medium-sized firms’ specific issues. Therefore it
suggests the following alternative options:
-
the FRTB sensitivity-based approach (SBA)
developing a standardised ‘basic’ approach e.g.
based on a clearing house margin
developing a standardised approach based on
scenario matrixes with more dimensions defined
developing an internal model approach based on
the internal approaches available in the CRR, but
proportionate to small and medium-sized firms.
The EBA believes that a basic approach would reflect
the preference of some firms to hold more capital rather
than develop internal models and/or reporting tools.
Large exposures and concentration risks
Large exposure risk can be particularly relevant for
firms that operate in small niche markets – and are
therefore more susceptible to client concentrations –
and firms with smaller balance sheets for which large
exposures can arise simply from depositing cash with
a bank. The EBA provides an overview of the current
large exposures regime, discusses upcoming
developments at the EU and Basel levels, and
highlights a number of issues to be considered in the
investment firm review.
One of the issues discussed is whether it would be
appropriate to exempt certain types of firms from the
requirements. In the past, asset managers argued that
their large exposures would normally arise from
accrued client fees, and that the rules therefore
penalised success. However these firms would still be
exposed to the failure of their clients and that of the
banks where their funds are deposited.
As a potential solution, the EBA proposes granting an
exemption to certain types of exposures under specific
conditions, rather than a blanket exemption to certain
types of firm. A lighter regime would be applied to
‘non-systemic’ and ‘non-interconnected’ firms, while
the full regime would apply to ‘bank-like’ firms.
Another issue raised is the treatment of investment
firms’ exposures to clearing members. The question is
whether there should be an exemption/exception
similar to the treatment of firms’ exposures to central
counterparties and recognised exchanges. Here the
EBA suggests an increase in the exposure limit above
25%, which could be limited to smaller firms and/or
those with no external clients. As for firms’ exposures
to clearing members where the clearing member
holds the assets of the investment firm, the EBA
suggests a potential exemption for bankruptcy remote
assets. This would be similar to the treatment allowed
for the calculation of credit risk under Articles 305
and 306 of the CRR.
Liquidity risk
The current Liquidity Coverage Ratio (LCR) is not fit
for purpose for investment firms and the European
Commission recognised this by excluding investment
firms from the requirement, unless they are part of a
prudential consolidation group. In the UK, the LCR
only applies to investment firms regulated by the
Prudential Regulation Authority (‘PRA-designated
investment firms’). Nevertheless the EBA indicates
the need to regulate liquidity risk and therefore it
proposes three options:
-
-
not apply LCR
adapt the current LCR framework by removing
banking activity-related items and inserting
additional provisions on investment firm-specific
issues, such as the link with clearing members or
liquidity needs for transactions operated on
behalf of clients
apply LCR proportionally, with smaller firms
complying instead with a liquidity standard
derived from simpler stock or flow-based liquidity
measures.
Client money and securities requirement
Client money as a prudential risk is not currently
dealt with in the CRR. This is a major gap the EBA
wants to address, particularly under the new regime
for ‘non-systemic’ firms.
Historically, the only prudential relevance of a firm
holding client money was the level of initial capital –
set at €125,000 instead of €50,000 – but even then
the prudential treatment did not vary according to
how much client money a firm held. The main change
introduced by CRD IV is the requirement to treat any
MiFID firm that holds client money as an ‘investment
firm’ for CRR purposes, thereby bringing them in
scope of the CRR. However, the CRR is primarily
designed for firms with material balance sheet risks
and exposed to losses arising from this. It does not
cover client money risk since client money does not
belong to the firm by definition.
4 | Hot Topic | Financial Services Risk and Regulation
From an accounting perspective, the EBA points out
that the rules are not prescriptive. Certain firms do
not record client money on their balance sheets, while
others recognise an asset to reflect client money
deposited in a bank account and a corresponding
liability to reflect the firm’s obligation to the client.
Considering client money risk from a prudential angle
would depend on the emphasis put on the firm’s
liability towards the holdings of its clients, which
varies considerably between jurisdictions. Indeed,
certain countries require firms that hold client money
to assign claims and liabilities to the client accounts
on their balance sheets and to contribute to a
guarantee scheme. In such cases, those client money
holdings are materialised as a prudential risk which
can be taken into account in the event of the firm’s
failure/wind-down.
In order to design a uniform prudential requirement
for client money risk, the EBA would need to have a
clear insight into the treatment of client money
holdings across jurisdictions. It also proposes to
examine the risks arising from controlling (without
holding) client money.
Pillar 2 and wind-down requirements
Pillar 2 is designed to address risks not adequately
captured by Pillar 1. As such, it is particularly
important for investment firms as Pillar 1 does not
always cover their specific risks. Indeed, although
investment firms are not considered to be as systemic
as banks, they can pose significant risks to their
customers and market integrity, and affect market
confidence in the event of their failure.
The EBA explains that supervisory approaches vary
across jurisdictions depending on whether the
supervisor focuses on preventing the risk of failure or
allowing the firm to fail. In the first case, the
preference may be setting higher capital
requirements. In the second case, the focus would be
ensuring an orderly wind-down with minimum
market disruption.
Most investment firms are required to carry out stress
tests, reverse stress tests and draw up a wind-down
plan as part of their Pillar 2. In the UK, the Financial
Conduct Authority (FCA) requires ‘significant’ IFPRU
firms to perform stress tests, whereas ‘non-significant’
IFPRU firms are only expected to perform reverse
stress tests. The FCA generally requires CRD III and
CRD IV firms (BIPRU and IFPRU firms) to prepare a
wind-down plan as part of their ICAAP, although
it has indicated that this is more relevant to the firms
that are not in scope of the EU recovery and resolution
framework (RRD).
On the wind-down requirement, it appears that this is
also the approach recommended by the EBA. The
justification is that even agency-based portfolio or
asset managers would need to perform a timely
handover or liquidation/wind-down of investments.
The EBA points out that most firms take longer than 3
months to wind down and 12 months would not be
unusual. This shows that the current requirement of
25% of annual fixed overheads is insufficient. The
EBA also suggests that early intervention measures
contained in the RRD could be further examined for
these firms.
A potential format for the wind-down plan could
include:
-
-
the likely period of time required to wind down
regulated activities including notice periods in
relevant contracts with clients and suppliers
the likely costs to be incurred during wind-down
appropriate cash inflows/outflows taking account
of stressed conditions
appropriate provision for additional
losses/liabilities that could crystallise during the
wind-down period
Therefore, overall, a firm’s total capital requirements
could be set as the higher of:
-
Pillar 1 + Pillar 2 and
The amount of capital/liquidity required to
support wind-down
The EBA also believes that the wind-down
requirement is likely to be more relevant for the vast
majority of investment firms, as they are deemed
‘non-systemic’ and therefore the focus should be on
orderly wind-down.
Finally, whilst national regulators are currently in the
process of implementing the new CRD IV changes in
Pillar 2, the EBA also recognises that the role of Pillar
2 will need to be revisited in due course in light of the
new regime for investment firms.
implementation also raises a number of issues about
interactions with other EU regulations. Indeed, when
MiFID II comes into force, a number of new firms
would come into the scope of MiFID and potentially
CRD IV and the RRD as a result.
Example: High-frequency trading (HFT) firm
If an HFT firm that deals on own account was
previously exempt from MiFID, it would likely lose its
exemption under MiFID II. As firms that deal on own
account are normally subject to a €730,000 initial
capital requirement under the CRD/CRR (referred to
as ‘730k firms’), they would also fall into the scope of
the RRD. So certain HFT firms could go from an
exempt status to the highest treatment under the
CRR, and they will also be subject to the RRD. It
should be noted however that if the firm still meets
the CRR definition of a local firm as discussed above,
it would not have to become a 730k firm and could
stay outside of the scope of the CRR and the RRD.
Under the new framework for investment firms, those
HFT firms will probably be classified as ‘nonsystemic’ or ‘non-interconnected’ and would not be
subject to the CRD/CRR or the RRD. But when will
the new regime be in place? MiFID II is currently
scheduled to come into effect from 3 January 2017,
based on the Level 1 text as it stands. However, ESMA
has indicated that it might be necessary to delay until
2018 or beyond. In this context, it will be interesting
to see how national regulators will handle the
interaction between the various EU regulations.
More generally, firms that are in scope of CRD IV still
have the challenge of complying with new technical
standards and new areas of the rules that are
transitioned in, such as capital buffers and Pillar 2. In
addition, those firms will be affected to some extent
by the forthcoming Basel developments. In light of
the EBA’s report, firms that believe they are ‘banklike’ should continue to focus on CRD IV and Basel.
We believe the UK firms that are likely to fall under
this category will include PRA-designated investment
firms and possibly the larger FCA solo-regulated
‘investment banks’, although these firms may also
have entities in the group that would be classed as
‘non-systemic’.
Timeline and interactions
Challenges ahead
At the moment the EBA has not indicated a timeframe
for the new regime, although this is a priority on the
regulators’ agenda. It would seem unlikely however
that a new framework could be implemented in less
than two years from now. The timing of
At this stage the review raises more questions than
answers and it is still unclear what the new
framework will look like. Although regulators aim to
address the shortfalls of an overly complex system, it
is difficult to imagine to what extent it would be
5 | Hot Topic | Financial Services Risk and Regulation
possible to make an inherently complex situation
simpler.
Next steps
First, it is evident that the new framework should
allow for some flexibility to address changes from
other EU regulations as they arise. For example, if
MiFID defines new regulated activities in the future,
will there be provisions to deal with such situations?
The EBA will now focus on developing the new
categorisation framework for all investment firms in
scope, and the prudential regime for ‘non-systemic’
and ‘non-interconnected’ firms.
There should also be room for a certain level of
national discretion, given the idiosyncrasies of the
investment firm population in different EU member
states, even though this is to be balanced with the
need for consistent cross-border treatment.
Finally, how can the new regime for ‘non-systemic’
firms be more tailored to their specific risks and the
variety of their business models? The new, simplified
regime would need to build in an adequate level of
granularity in order to be suitable for all types of ‘nonsystemic’ firms.
So perhaps the complexity will be unavoidable, but
there is no doubt that the new regime can still
improve the status quo by building in proportionality
and addressing the issues specific to investment
firms, the risks they face and the risks that they pose
to consumers and the financial system.
6 | Hot Topic | Financial Services Risk and Regulation
As part of policy development it will collect additional
data from firms to support the calibration of this new
regime. A second, more in-depth, report will include
further research and more detailed policy options.
In due course the EBA will no doubt seek input from
the industry and consult on specific questions. All
firms affected should follow developments to consider
whether the proposed policy options will be suitable
for them. It has been 20 years since the prudential
regime for investment firms was last revised. It will be
important to get it right.
What do firms need to do now?
1
All non-bank investment firms that are in scope of MIFID or may fall within the scope of MiFID II
should review the EBA’s early proposals and see whether they have any concerns or suggestions. We
would recommend that UK firms raise any red flags identified with their trade bodies or FCA supervisor,
even if the EBA/FCA have not yet formally requested input from the industry.
2
For now, firms coming into the scope of MiFID II, such as OTF operators, should plan for compliance
with the prudential regime they will fall under based on the current CRD/CRR framework. Firms that
will become 730k will also need to comply with the requirements of the Recovery and Resolution
Directive.
3
Groups with entities and operations in different EEA countries should consider the issues raised by the
EBA in the context of the different interpretations and practices of the countries in which they operate.
They should also get ready and find out how MiFID II is being interpreted and transposed into national
law in those countries, as this will impact the firms’ categorisation and their prudential treatment.
We can help you stay up to date with prudential developments for non-bank investment firms, understand
what they mean for your business and assess their impact on your regulatory capital and strategic planning.
Contacts
Nigel Willis
Hortense Huez
Phuong-Tram Nguyen
[email protected]
+44 (0)20 7212 5920
[email protected]
+44 (0)20 7123 3869
[email protected]
+44 (0)20 7213 4807
7 | Hot Topic | Financial Services Risk and Regulation
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