European Union: The Impact Of The European Commission´s Proposals For A New Prudential Capital Framework On MiFID Investment Firms

Last Updated: 25 July 2018
Article by Michael Huertas, Katja Michel and Markus Schrader

How does the Commission's proposed legislative package impact investment managers in the EU-27 and what pre-emptive steps can stakeholders take to stay ahead of the curve?

In December 2017, the European Commission (the Commission) issued the legislative proposals for prudential requirements for investment firms: the Investment Firms Regulation (IFR) and the Investment Firms Directive (IFD). The aim of the proposals is to create a new simpler and more risk-sensitive prudential capital regime for MiFID investment firms built around quantitative metrics, called K-Factors, that define regulatory capital levels.

It is anticipated that the proposed package comes into force in mid to late 2019 at the earliest. However, the shift in prudential requirements may merit many needing to take early pre-emptive action to either source new regulatory capital or to put in place arrangements to limit risks that could flow into the K-Factors, which might lead to looking at rearranging regulated activities and who does what where.

This Client Alert highlights the Commission´s December 2017 legislative proposals to establish a more tiered and proportionate1 prudential capital regime for certain "Investment Firms" as such term is used in the context of the CRR/CRD IV Framework and ultimately the MiFID II/MiFIR Framework that entered into force on 3 January 2018. With supervisory policymakers having intimated during the spring of 2018 that the K-Factors are an important future supervisory tool, this is a development that affected firms ought to watch let alone take preparatory action to be ready to seize opportunities.

In summary, the proposed legislation aims to create a more risk-focused regime that is tailored and reflective of the activities of an Investment Firm rather than to continue to treat all Investment Firms in an identical fashion. Two core changes to how prudential requirements apply to Investment Firms are at the heart of the proposal:

  1. Creation of classes of Investment Firms. These can be distinguished between those that are:

    1. Class 1 = systemic firms that undertake bank like activity and which will be reclassified as credit institutions and continue to be subject to the full CRD IV/CRR Framework. The IFR/IFD regime will not apply to them;
    2. Class 2 = other non-systemic Investment Firms whose activity places these above quantitative thresholds that are used to categorise Class 3 entities;
    3. Class 3 = smaller and non-interconnected entities to which a simplified version of the regime applies;
  2. Setting of capital requirements in a manner that is more proportionate to the risks specific to the Class of Investment Firms. This is done using specific methodology in each of the "K-Factors", which are described in the table below. In practice, this may translate into many firms needing to raise capital to meet such new relevant regulatory capital requirements or cause many to reconsider how and into which Class of Firm their activities cause them to fit into.

Supervisory objectives – tailoring rules yet widening supervision

The practical aim of this new regime is to ensure that the prudential i.e. the regulatory capital framework applicable to Investment Firms" better captures and regulates risks2 that are specific to MiFID business". Such a new regime equally aims to differentiate itself from the prudential regulation framework for banks, including as applied in the Eurozone-19's Banking Union in which the European Central Bank leads in the Single Supervisory Mechanism (ECB-SSM). However, the differentiation is not complete as Class 1 Investment Firms that undertake "banking sector comparable activities" will be exempt from the new rules and will continue to fall under the CRR/CRD IV prudential regime for banks. For firms headquartered in the Banking Union, this will mean being supervised by the ECB-SSM. This is aligned with the intention of the Eurozone bank supevisor which, in the context of BREXIT-relocations and otherwise, has stated that it should have supervisory oversight over "investment banks" i.e., often firms that are MiFID Investment Firms, in order to ensure a level playing field.

Whilst most of the proposed Recommendations apply to all Class 2 and 3 Investment Firms, some apply specifically only to those that are "Commodity Derivatives Investment Firms" (CDIFs) i.e., as such term is used within the meaning of the MiFID II/MiFIR Framework. The proposals do not apply to funds and their managers that fall within the AIFMD or UCITS Frameworks. That being said, the proposed legislation will impact any group that includes one or more Investment Firms, categorised as Class 2 or 3. Both banking and fund sector participants often split MiFID business either by choice or because regulatory requirements make it an obligation to do so into MiFID Investment Firms that are then affiliated entities in the same group. Consequently, a number of groups may want to check their legal entity structuring and possibly the options on how to optimise their regulatory capital requirements.

The affected Investment Firms, including their counterparties, may want to take note of the economic and regulatory costs of the new rules. Those considerations are however not self-contained. Rather, they will have a host of spillover effects including in what this might mean for various financial models and financing needs. However, these proposals may also present opportunities to streamline or optimise financing or standby-facilities prior to the relevant changes applying and a host of competitors needing financing.

What is certain is that any change in the prudential regulation of Investment Firms will likely redraw the map for existing as well as new market participants. These potential changes come on top of any MiFID II/MiFIR compliance priorities that will continue to impact "change the business" along with run the business" workstreams as well as strategic projects for Investment Firms.

How do the K-Factors amend the landscape?

The Commission recognised the wide-reaching scope of application of the regime and breadth of changes required to implement the new rules by granting a three year transition period. During this period, the capital requirements will be limited to twice what they would have been under the old regime.

The new proposed prudential capital rules are likely to be of relevance to those Investment Firms within the EU-27, including the Eurozone-19 and ultimately those relocating, whether from the UK or elsewhere, to the EU.

A move to a much more tiered and proportionate capital regime will potentially be costly. Aside from regulatory capital in terms of minimum own funds, it will equally place a greater emphasis on firms and their risk controls so as to minimise individual risk types with an aim to reduce their risk capital. This is especially the case given the importance Investment Firms' exposures to certain risks will play in calculating regulatory capital needs in this new regime. These risk types are referred to as "K-Factors" and are based on quantitative indicators.

The "Class" that an Investment Firm will fall into will trigger the relevant minimum amount of regulatory capital levels. The allocation to a specific Class is driven by both the type of MiFID Investment Activity (i.e., qualitative consideration) and the K-Factor values (i.e., quantitative considerations). For many firms, especially for so called "exempt CAD" advisory firms such as those relocating from the UK, the regulatory capital could go from EUR 5,000 to 75,000. For the breadth of other Investment Firms, the increases could go from EUR 50,000 to 75,000, possibly 150,000 up to a maximum of EUR 5 million for so-called Class 1 Investment Firms and/ or credit institutions.

In short, K-Factors are clearly costly in terms of increased own fund requirements but will also likely be costly in terms of investment in systems and resources needed to identify, mitigate and manage risks generally as well as those specifically relevant to the K-Factors. A number of affected firms will most likely look to recoup the costs elsewhere.

Below is an overview of the K-Factors, which have been grouped into three catagories, reflecting three risk types:

K-Factor type proposed in IFR Overall K-Factor(s) – relevant components and coefficients not discussed Description
Risk to Customers (RtC) K-AUM Assets under management – under both discretionary portfolio management and non-discretionary (advisory) arrangements.
K-CMH Client money held.
K-ASA Assets safeguarded and administered.
K-COH Client orders handled - execution only in name of customer and reception and transmission of orders.
Risk to Market (RtM) K-NPR Net position risk - based on the market risk requirements of the CRR II Proposal and made appropriate for investment firms (only applicable to trading book positions).
K-CMG Clearing member guarantee – amount of initial margins posted with a clearing member, where the execution and settlement of transactions of an investment firm dealing on own account take place under the responsibility of a general clearing member.
Risk to Firm (RtF) K-DTF Daily trading flow - value of transactions where the firm is trading on own name (on own account or in execution of client orders) (only applicable to trading book positions).
K-TCD Trading counterparty default - based on the BCBS proposals for counterparty credit risk and simplified for investment firms (only applicable to trading book positions). Takes into account OTC derivatives (presume this is ought to be MiFID II instruments), "long-settlement transactions" (undefined), "repurchase transactions" (repurchase and reverse repurchase transactions but not those that are Securities Financing Transactions for the purposes of the same named Regulation), and "securities or commodities lending or borrowing transactions" (again - no clarity on whether these include Securities Financing Transactions for the purposes of the same named Regulation).
K-CON Concentration - taking inspiration form the CRR large exposures regime for trading book and simplified for investment firms (only applicable to trading book positions).

How does this interlink with BREXIT and Investment Firms' preparations?

Many Investment Firms may want to consider varying their permissions or apply for new permissions prior to these new rules taking effect and the prudential capital regime possibly making business "more expensive". These rules should also be read in conjunction with the supervisory principles on relocation (SPoRs) as collectively these developments will affect BREXIT-proofing plans in terms of strategy as well as which legal entities will do what where and with whom.

This is the case not only for those standalone Investment Firms that are subject to ESMA's SPoRs and the ESMA SSOs, but also to those Investment Firms that are part of a group with a banking licence and subject to EU-27 relevant supervisory expectations. More importantly these considerations also apply within the Eurozone-19 and firms will need to assess how these changes interact with the supervisory priorities and expectations of the Banking Union and its Single Supervisory Mechanism (SSM) led by the European Central Bank.

How can affected Investment Firms stay ahead of the curve?

The continous regulatory changes, including amendments to the CRD IV/CRR Framework as well the SPoRs will keep Investment Firms extremely busy. Thus, sourcing and allocating committed resources will be a priority and one that will help market participants to stay ahead of the curve.

Setting-up dedicated internal project teams and early channels of communication to counsel should ease the compliance burden. It will also help scenario plan all various impacts of the K-Factors and how to calibrate risk controls to reduce both conduct of business but more directly the prudential capital charges.

Linking these priorities into BREXIT-proofing workstreams, might mean that Investment Firms may wish to consider retaining appropriate legal and regulatory specialists, both within internal and external project teams that can draft, implement and ensure compliance with EU, Eurozone, respective national levels as well as third-country regimes. This dedicated workstream, whilst needing to be interoperable with regulatory authorisation applications and relocation workstreams, might be beneficial in running separately so as to ensure it has a sufficient degree of independence and an ability to challenge assumptions made by those advising on the relocation plans.

So any chance that this will all go away? Quite unlikely. This workstream has been a longstanding supervisory priority and one that also delivers on the overarching convergence goals as part of the wider Capital Markets Union project. That being said, the EU legislative process takes time. The timeline is likely to be protracted as a lot of the fine details are ironed out in the Regulatory Technical Standards. As other regulatory reform projects have shown, forward planning helps stay ahead of the curve and can be done with a view to what already exists in other areas where similar regulatory/supervisory concepts exist.

So will supervisors have enough resources to police? One point that is not clear from the September Opinion is whether the reference to competent authorities" is deliberate. Typically, in EU regulatory parlance the reference to competent authorities refers to these as those national bodies. If this oversight is deliberate then is this a nod towards centralised oversight of Investment Firms by a pan-EU authority rather than national supervisors? Given that the September Opinion takes a forward-looking view on a number of developments, is this the anchoring of concepts pending institutional reform of supervisors and their mandates? As above, if other policymakers and supervisors enter the fray, any final regime building on the September Opinion's Recommendations could change further.

Moreover, it is worth noting that in the margins of the ESMA Annual Conference on 17 October 2017 in Paris, statements indicated a policy consideration whereby Class 1 Investment Firms, possibly some Class 2 Investment Firms could become subject to centralised supervision at some future undefined date. That would be a massive change and reintroduces wider questions on whether a single Capital Markets Union supervisor comparable to the Banking Union and its SSM might be a longer-term supervisory policy goal in delivery or merely at the planning stage. Indeed, the European Banking Authority's (EBA) General Opinion on Supervisory Principles on Relocations3, which is aimed at improving supervisory convergence in light of BREXIT, specifically calls for Class 1 Investment Firms to be subject to centralised supervision and proposes that the ECB-SSM is in the lead.

In conclusion, the IFR and IFD proposal is the beginning of the end of a long process to make Investment Firms subject to prudential regulatory capital levels that are more reflective of their actual and potential risk profile. It comes on top of a full agenda and merits early action especially if this workstream is a building block for more widespread change that remains on the policymakers' agendas as they progress the completion of the Single Market, the Single Rulebook and delivery of the Capital Markets Union.

To read this article in full, please click here.


1. Applying a greater degree of proportionality in regulatory reform is now a key priority for policymakers when advancing supervisory convergence across the EU. See specifically statements from Roberto Gualtieri, MEP, Chair of the Committee on Economic and Monetary Affairs (ECON), European Parliament in a Keynote Speech given at the ESMA Annual Conference on 17 October 2017 in Paris. This also assists in the overarching aim to get to the desired ,end-state' of how financial services are regulated across the EU, with a much more, level playing field' driven by a Single Market built upon a Single Rulebook that is much more uniform

2. including an ability to account for an orderly wind down.

3. See a full list of our Client Alert series on the SPoRs available from our dedicated Eurozone Hub resources.

Dentons is the world's first polycentric global law firm. A top 20 firm on the Acritas 2015 Global Elite Brand Index, the Firm is committed to challenging the status quo in delivering consistent and uncompromising quality and value in new and inventive ways. Driven to provide clients a competitive edge, and connected to the communities where its clients want to do business, Dentons knows that understanding local cultures is crucial to successfully completing a deal, resolving a dispute or solving a business challenge. Now the world's largest law firm, Dentons' global team builds agile, tailored solutions to meet the local, national and global needs of private and public clients of any size in more than 125 locations serving 50-plus countries.

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