Introduction
On 29 September 2017, the European Banking Authority (EBA) published an opinion on the design of a new prudential framework for investment firms. The new regime will apply to all MiFID firms, including those that will be brought into scope by MiFID II.
The EBA makes a total of 62 recommendations in the following areas:
| · Capital and liquidity requirements | · The need of macroprudential tools |
| · Consolidated supervision | · Remuneration requirements |
| · Reporting requirements | · Governance rules |
| · Commodity derivatives firms |
The EBA believes that implementation of its recommendations will simplify current structures and promote a proportionate and risk-sensitive approach whilst simultaneously:
New Classification for Investment Firms
The rules define three new ‘classes’ of investment firm[1]:
- Class 1: “global systemically important institutions” (G-SIIs) and “other systemically important institutions” (O-SIIs) which are exposed to the same types of risk as credit institutions;
- Class 2: Other non-systemic investment firms above specific thresholds, including larger investment firms, trading firms and firms that hold client money/assets; and
- Class 3: Small and non-interconnected investment firms providing limited services in terms of number and size, which would have a lower impact if they failed.
At a high level, the recommendations seek to develop a consolidated single rulebook for all Class 2 and Class 3 firms. Class 1 firms will remain subject to almost all of the requirements of the Capital Requirement Regulation[2] (“CRR”) and the CRD IV Directive[3] (“CRD”). Overall, the EBA anticipates that (a) there will be approximately 9 Class 1 firms, and (b) roughly two-thirds of the ‘non Class 1 market’ would be in Class 2, whilst the remaining one-third will fall to be classified as Class 3 firms.
The EBA insists that the new framework is not designed to “increase capital requirements significantly beyond the currently level in the overall system”. Rather, it is to create “clear and transparent rules with a stronger link to risk-sensitivity”. As such, and in order to ensure a stable transition to the new regime, increases in capital requirements will be limited to twice the level applicable under the current regime for a three-year transitional period.[4]
K-Factors
Perhaps the most significant development proposed by the EBA is the introduction of a new type of risk proxy – the “k-factor”. K-factors are quantitative criteria used to classify firms as either Class 2 or Class 3. To this extent, it is recognised that both classes of firm will have to monitor their k-factors on a continuous basis.
There should be no overlap between k-factors, so no risk of double-counting of capital requirements. Some classification factors are assessed on a solo basis, whereas others are viewed on a consolidated basis. This is to guard against the risk that a group may deliberately structure itself in a way as to avoid classification as a Class 2 firm. In addition, the EBA recommends that competent authorities should have the power to consolidate any investment firm-only group[5] where (a) they have evidence that the group has deliberately structured itself into separate entities to avoid higher capital requirements based on solo k-factors, or (b) where the group is “inter-connected” in terms of its operations or its risk-management.[6] Non-investment firm-only groups[7] should be subject to the new prudential regime on a solo basis as well as the CRR requirements on a consolidated basis.[8]
K-factor Classification
If a Class 3 firm exceeds any k-factor, it will be classified as a Class 2 firm. [9] Upward reclassification can occur either immediately[10] or after a three-month grace period. [11] Class 2 firms must meet the criteria for Class 3 firms for at least 6 months before downward reclassification occurs.[12]
The full list of k-factors are detailed in Annex 2 to this article. Of note is the fact that the EBA regards the holding of client assets and own-name trading as activities which involve increased risk. As such, a number of k-factors which can be regarded as proxies for this type of activity have a zero threshold. Therefore, any firm holding any amount of client money or conducting any volume of own-name trading will automatically qualify as a Class 2 firm.
K-factor Capital Requirements
K-factors are also used to determine on-going capital requirements for investment firms. They are designed to be relatively simple to calculate, relevant to the nature of investment business and proportionate to the risk that an investment firm can have on customers and markets. In order to avoid high volatility in terms of capital requirements, most (but not all) k-factor calculations are to be based on rolling averages.
‘Other’ Factors
In addition to ‘k-factoring’, the EBA felt it appropriate that ‘large firms’ should be classified as Class 2 firms due to their increased potential impact. As such, it has included additional classification thresholds based on “total gross revenues” and “balance sheet size”.
IC, PMC and FOR
Initial Capital (IC)
Revised initial capital requirements will apply to all investment firms and are summarised in Annex 3.
Permanent Minimum Capital (PMC) [13] and Fixed Overhead Requirements (FOR)
The EBA envisages that PMC and FOR will act as a floor below which overall capital requirements cannot fall.[14] PMC requirements are EUR 5 million for Class 1 firms and equal to initial capital requirements for both Class 2 and Class 3 firms. FOR is a minimum of 25% of the previous year’s fixed overheads and is designed to allow investment firms to be wound down in a more orderly manner.
However, FOR requirements have relevance as more than simply regulatory capital minima. They also relate to the overall recommendations of the EBA with respect to liquidity. Liquidity requirements demand that a firm keep a proportion of regulatory capital invested in liquid assets. This is to enable the firm to have sufficient liquidity to keep operating for a limited period of time, if only to wind-down. The EBA opinion proposes that this should be one-third of the investment firm’s FOR. In effect, this means that an investment firm would have to hold one month’s worth of regular expenditure in the form of a ‘buffer’ of liquid assets. Investment firms should be allowed to use the liquidity buffer only in “exceptional and unexpected” circumstances and should rebuild it within 30 days.
Conclusion
The EBA’s recommendations may well result in a more streamline prudential framework for investment firms. Certainly CRD IV is a complex beast, representing a sledgehammer to crack a nut in the case of many smaller market participants. Nonetheless, there is likely to be quite a lot of work involved in adjusting to the new rules, and regulatory classification and capital levels will have to be monitored even during any transitional period. Moreover, in placing two-thirds of investment firms within Class 2, it is questionable whether the EBA has drawn the dividing line in the correct place. Putting all firms which hold client money into Class 2, whatever the amount and even if they have delegated actual custody of that money to another entity also seems rather harsh. Whilst one imagines that the new rules will not become law before the early part of 2019 at the earliest, this is definitely a conversation to watch as it develops.
A summary of the EBA’s main recommendations is provided in Annex 2 below.
Annex 1, Part 1: K-Factor Investment Firm Classification
| K-Factors[15] | ‘Other’ Factors[16] | ||||||||||
| K-AUM | K-COH | K-ASA | K-CMH | K-NPR | K-CMG[17] | K-DTF | K-TCD | K-CON | Balance Sheet | Total Gross Revenues[18] | |
| K-Factor Grouping | RtC[19] | RtM[20] | RtF[21] | N/A | N/A | ||||||
| K-Factor Threshold | EUR 1.2 bn | Cash trades[22]: EUR 100m pd
Derivatives[23]: EUR 1 bn pd |
Zero | Zero | Zero | Zero | Zero | Zero | None specified | EUR 100 m | EUR 30 m |
| Basis of K-factor assessment | Group wide | Group wide | Solo | Solo | Solo | Solo | Solo | Solo | Not specified | Group wide | Group wide |
Annex 1, Part 2: K-Factor Investment Firm Capital Requirements
| Capital Requirement Calculation (CRC) | ||||||||||||
|
CRC = RtC + RtM + RtF
|
||||||||||||
|
CRC = {(CK-AUM x K-AUM) + (CK-CMH x K-CMH) + (CK-ASA x K-ASA) + (CK-COH x K-COH)} + {Max (K-NPR, K-CMG[24])} + {(CK-DTF x K-DTF) + (CK-TCD x K-TCD) + (CK-CON x K-CON)}
|
||||||||||||
| K-Factors | ‘Other’ Factors | |||||||||||
| K-AUM | K-COH | K-ASA | K-CMH | K-NPR | K-CMG | K-DTF | K-TCD | K-CON | Balance Sheet | Total Gross Revenues | ||
| K-factor coefficient (CK) [25] | 0.02% | Cash: 0.1%
Derivs: 0.01% |
0.04% | 0.45% | None specified | Not specified | Cash: 0.01%
Derivs: 0.01% |
None specified[26] | None specified | Not applicable | Not applicable | |
| Deferral Period[27] | 3m | 3m | 3m | No lag | No lag | Not specified | 3m | No lag | No lag | Not applicable | Not applicable | |
| Averaging | 12m Average | 3m Average | 3m Average | 3m Average | No Averaging | Not specified | 3m Average | No Averaging | No Averaging | Not applicable | Not applicable | |
| Observation Point | Last day of month | Daily trading flow | End of day | End of day | End of day | Not specified | Daily trading flow | End of day | End of day | Not applicable | Not applicable | |
| No of Observations | 12 | No working days in relevant month | No working days in relevant month | No working days in relevant month | N/A | Not specified | No working days in relevant month | N/A | N/A | Not applicable | Not applicable | |
| K-AUM: | assets under management (both discretionary and non-discretionary); | |||||||||||
| K-COH: | client orders handled (calculated by adding the absolute amount of buys and sell and including both (a) reception and transmission, and (b) execution)[28] | |||||||||||
| K-ASA: | assets safeguarded and administered (including assets under safekeeping and administration even if these have been formally delegated to another firm, as well as assets under safekeeping and administration that have been formally delegated to the firm) | |||||||||||
| K-CMH: | client money held (this would not include securities belonging to clients, which would be dealt with under K-ASA) | |||||||||||
| K-NPR: | net position risk, calculated at the end of each day | |||||||||||
| K-CMG: | clearing member guarantee – the highest total intra-day margin posted by the firm with a clearing member in the previous 3 months | |||||||||||
| K-DTF: | daily trading flow (total value of transactions where the firm is trading in its own name calculated by adding the absolute amount of both buys and sell) | |||||||||||
| K-TCD: | trading counterparty default (i.e. counterparty credit risk) in relation to OTC derivatives, long settlement transactions and securities financing transactions | |||||||||||
| K-CON: | single name concentration risk for firms which trade in their own name | |||||||||||
Annex 2: Comparison of Proposed EBA Prudential Framework for Investment Firms
| Class 1 Firms | Class 2 Firms | Class 3 Firms | |
| CRD/CRR applicable? | Yes | No | No |
| K-factors applicable? | No | Yes | Yes |
| K-factor upward reclassification | N/A | Not specified | Immediate/3-months[29] |
| K-factor downward reclassification | Not specified | After six months[30] | N/A |
| Minimum Capital Requirements | As per CRD/CRR | Max (PMC, FOR, K-FAC)[31] | Max (PMC, FOR)[32] |
| Capital structure composition | As per CRD/CRR | CET 1=> 56%
Additional Tier 1 <= 44% Tier 2 <= 25% |
CET 1=> 56%
Additional Tier 1 <= 44% Tier 2 <= 25% |
| PMC Requirement[33] | EUR 5 million | PMC = IC | PMC = IC |
| Transitional period to PMC compliance[34] | None | None | 5 years |
| FOR Requirement | Min 25% previous year’s fixed overheads | Min 25% previous year’s fixed overheads | Min 25% previous year’s fixed overheads |
| FOR requirement transitional period[35] | None | None | 5 years |
| Liquidity coverage requirements (LCR) applicable? [36] | Yes, Subject to Commission Delegated Regulation (EU) 2015/61[37] | Yes, must have internal rules and procedures to monitor, measure and manage exposures and liquidity[38] | Yes, must have internal rules and procedures to monitor, measure and manage exposures and liquidity[39] |
| Basis of LCR measurement[40] | Solo, unless centralised liquidity management function exists | Solo, unless centralised liquidity management function exists | Solo, unless centralised liquidity management function exists |
| LCR requirements | As per CRD | One-third of FOR[41] | One-third of FOR[42] |
| LCR Eligible Assets | (a) “High quality liquid assets” of Level 1, 2A and 2B[43], and (b) unencumbered cash | (a) “High quality liquid assets” of Level 1, 2A and 2B, and (b) unencumbered cash | (a) “High quality liquid assets” of Level 1, 2A and 2B, (b) unencumbered cash,
and (c) trade debtors and fees/commissions receivable within 30 days (up to a limit of one-third of LCR requirements) [44] |
| LCR Eligible Asset Haircuts | TBD, except that cash benefits from a zero haircut
|
TBD, except that cash benefits from a zero haircut
|
TBD, except that cash benefits from a zero haircut
trade debtors and fees/commissions receivable within 30 days will be subject to a 50% haircut |
| Concentration limits applicable? | Firms required to identify, manage and monitor concentration risk | Firms required to identify, manage and monitor concentration risk | Firms required to identify, manage and monitor concentration risk |
| Basis of concentration limits measurement[45] | Solo basis | Solo basis | Solo basis |
| Concentration Risk Restrictions[46] | As per CRD/CRR | When firm trading on own account or executing client orders in its own name, 25% exposure limits apply, unless exposure is to a credit institution/investment firm (where exposure limit is Min [100%, Max (EUR 150m, 25%)]) | N/A |
| Concentration Risk Reporting[47] | As per CRD/CRR | Regulatory reporting on counterparty credit risk, institutions where client assets and firm’s own cash deposited and source of earnings | No reporting requirements |
| Regulatory reporting[48] | Subject to same reporting as credit institutions under CRD/CRR | Subject to simplified reporting framework: capital, capital requirements and k-factors to be reported.
More granular reporting envisaged as compared to Class 3 firms, including capital composition, capital calculations, liquidity requirements and concentration risk |
Subject to simplified reporting framework – capital, capital requirements and k-factors to be reported.
|
| Public disclosure requirements[49] | As per CRD/CRR | Limited to level of capital and capital requirements | None |
| Remuneration[50] | Subject to remuneration framework set out in CRD | Should be subject to provisions similar to Articles 92 to 94 of CRD WRT material risk takers
Disclosure of data WRT high earners is recommended. |
Only subject to remuneration provisions of MiFID |
Annex 3: Initial Capital Requirements (IC)[51]
|
Investment Services and Activities undertaken[52] |
Capital Requirement (EUR) | |
| Holding client money or assets | Not holding client money or assets | |
| Reception and transmission of orders in relation to one or more financial instruments; | 150,000 | 75,000 |
| Execution of orders on behalf of clients | 150,000 | 75,000 |
| Dealing on own account | 750,000 | 750,000 |
| Portfolio management | 150,000 | 75,000 |
| Investment advice | 150,000 | 75,000 |
| Underwriting of financial instruments and/or placing of financial instruments on a firm commitment basis | 750,000 | 750,000 |
| Placing of financial instruments without a firm commitment basis | 150,000 | 75,000 |
[1] Recommendation 3
[2] Regulation 575/2013
[3] Directive 2013/36/EU
[4] Recommendation 2
[5] A group which does not include any credit institutions or Class 1 investment firms (Recommendation 8(a))
[6] Recommendation 9
[7] Groups which include one or more credit institutions and/or Class 1 firms
[8] Recommendation 10
[9] Recommendation 5
[10] Although the calculation of capital requirements will be based on smoothed k-factors so as to limit any ‘cliff-edge’ effect
[11] 3-month period only applies where the K-factor thresholds for K-AUM or K-COH are exceeded
[12] Recommendation 7
[13] Recommendation 21
[14] Recommendation 19
[15] End-of-day values to be used, except for K-CMH where the holding of client money AT ANY TIME will result in the firm exceeding the threshold for Class 2
[16] As per the end of the previous financial year
[17] The inclusion of K-CMG is said to be “subject to a prior decision by the relevant competent authority and a number of conditions” – see Annex to EBA opinion, para 152
[18] Annual operating income linked to the MiFID activities of the firm
[19] “RtC” is the potential risk that individual investment firms can pose to their customers
[20] “RtM” is the potential impact an investment firm can have on the markets in which it operates, should the firm fail or otherwise need to exit that market
[21] “RtF” is any risk to the investment firm itself
[22] Absolute gross settlement (Recommendation 28)
[23] Notional amount (Recommendation 28)
[24] The inclusion of K-CMG is said to be “subject to a prior decision by the relevant competent authority and a number of conditions” – seen Annex to EBA opinion, para 152
[25] Recommendation 34
[26] The capital requirement is calculated as Exposure* CRR risk factor
[27] “Deferral” refers to the timelag between the date of the calculation of capital requirements and the date on which the capital requirements take effect
[28] The operations of an MTF/OTF will not be counted as K-COH by the MTF/OTF operator
[29] 3-month period only applies where the K-factor thresholds for K-AUM or K-COH are exceeded
[30] Recommendation 7
[31] Recommendation 24
[32] Recommendation 25
[33] Minimum capital buffer required on an on-going basis which cannot be replaced by professional indemnity insurance – see Recommendation 21
[34] Recommendation 22
[35] Recommendation 22
[36] Recommendation 37
[37] Recommendation 37
[38] Recommendation 38
[39] Recommendation 38
[40] Recommendation 11
[41] Recommendation 39
[42] Recommendation 39
[43] See Commission Delegated Regulation 2015/61
[44] Recommendation 43
[45] Recommendation 11
[46] Recommendation 48
[47] Recommendation 46 and 47
[48] Recommendation 51
[49] Recommendation 53
[50] Recommendation 59
[51] Capital required in the authorisation phase – see Recommendation 20
[52] Taken from Section A of Annex I to MiFID II (Directive 2014/65/EU)
