The new prudential regime for investment firms: ten key points to know now

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The prudential regime for investment firms in the UK and EU is expected to change significantly in just over a year’s time, resulting in changes that firms need to understand and prepare for now.

From 26 June 2021, it is expected that the Investment Firms Regulation (the “IFR”) and the Investment Firms Directive (the “IFD”) will apply, subject to certain transitional provisions. The new regime is intended to address the specific risks faced by investment firms in a more appropriate and proportionate manner than the current regime, which is largely based on the international regulatory standards set for large banking groups. However, some investment firms may need to make significant and complex changes, including in relation to their governance and remuneration arrangements, as well as facing increases to their capital requirements, which may be phased in over time for existing investment firms.

The UK Financial Conduct Authority (“FCA”) was heavily involved in the development of the EU IFR/D regime and as such we expect the UK to introduce a broadly similar regime despite Brexit, though there are likely to be some points of detail that are different. Groups with investment firms in both the UK and the EU will need to monitor this closely, though the UK is not expected to diverge too far if it is to seek “equivalence” from the EU in the future.

In this context, we set out ten key points that you need to know now. We will be following this article up with a series of “deep dives” into topics of interest as our clients continue to prepare for IFR/D.

Ten key points to know now

1. What are “Class 1”, “Class 2” and “Class 3” firms?

Investment firms will be divided into categories under the IFR/D, which are often referred to as “Classes”,1 based on their activities and certain quantitative criteria. The most systemically important, “bank-like” firms will be Class 1 firms, some of which will need to become authorised as “credit institutions”. Other firms will be Class 2 or, if an investment firm satisfies the tests for a “small and non-interconnected investment firm”, Class 3. Class 1 firms will continue to be subject to the CRR/CRD IV regime (which is also subject to change), whereas Class 2 firms will be subject to the full IFR/D regime. Class 3 firms are smaller investment firms (by the relevant metrics) and as a result will be subject to a “lighter touch” version of the IFR/D regime.

All firms will need to identify which “Class” they fall into at the outset of their IFR/D transition project, which many firms have already started doing. This is because an investment firm’s Class will determine which rules it needs to be preparing to comply with.

Going forwards, investment firms will need to monitor and notify their competent authorities as/when they trip over a threshold and into a new Class, which will likely result in much more frequent reassessments of, and changes to, an investment firm’s capital requirements than is currently the case.

For UK purposes, note that the Classes are expected to replace the existing prudential categories and that, for example, it is expected that the “exempt CAD” and “BIPRU firm” categories will cease to exist. However, it should be noted that just because a firm is currently exempt CAD, it will not necessarily be a Class 3 firm, and relevant firms will need to apply the relevant tests for “small and non-interconnected investment firms”.

2. Increased capital requirements

The initial/minimum capital requirements for investment firms are being increased as summarised below. Compliance with the increased capital requirements is subject to transitional provisions which will phase in increases for certain investment firms that are in existence before 26 June 2021.

  • Investment firms that are authorised to deal on own account and/or to underwrite financial instruments and/or place financial instruments on a firm commitment basis will be subject to an initial capital requirement of EUR 750,000 (up from EUR 730,000).
  • Investment firms that are authorised to receive and transmit orders in relation to one or more financial instruments, to execute orders on behalf of clients, to carry out portfolio management, to provide investment advice and/or to place financial instruments without a firm commitment basis, and which are not permitted to hold client money or securities, will be subject to an initial capital requirement of EUR 75,000 (up from EUR 50,000).
  • Investment firms other than those referred to above will be subject to an initial capital requirement of EUR 150,000 (up from EUR 125,000). For example, this includes investment firms that are authorised to execute orders on behalf of clients and are permitted to hold client money or securities. Note that the IFR/D does not include an equivalent to the provision in CRD IV, which allows firms to hold financial instruments for their own account where this results from a failure to match client orders precisely, without being subject to the higher EUR 730,000/750,000 initial/minimum capital requirement.

Class 1 firms will continue to determine capital requirements under the CRR/CRD IV. Class 2 firms will determine capital requirements under the IFR/D, setting own funds at the higher of the firm’s fixed overheads requirement (“FOR”), permanent minimum capital requirement or “K-factor” requirement.[2] Class 3 firms will determine capital requirements under the IFR/D, setting own funds at the higher of the firm’s FOR or permanent minimum capital requirement. The IFD also has an impact on UCITS management companies and alternative investment fund managers, mandating that such firms’ own funds shall never be less than the amount required by the FOR under the IFR.

Investment firms that are currently subject to a minimum/initial capital requirement of EUR 50,000 (including exempt CAD and BIPRU firms) will no longer be permitted to meet their capital requirements with professional indemnity insurance, which could lead to such firms being required to raise further capital.

3. Liquidity requirement

For the first time, many investment firms will become subject to a binding requirement to hold an amount of liquid assets equivalent to at least one third of their FOR, although competent authorities may exempt Class 3 firms from this requirement if they choose to do so. There are detailed rules as to which assets can be used to meet this requirement.

4. MTF and OTF operators

Investment firms authorised to operate multilateral trading facilities (“MTFs”) and/or organised trading facilities (“OTFs”) will be subject to an initial capital requirement of EUR 150,000, unless, in the case of an OTF operator, the operator also engages in dealing on own account or is permitted to do so, in which case it will be subject to an initial capital requirement of EUR 750,000. For many current and prospective MTF and OTF operators, this will result in a significant decrease in their initial/minimum capital requirement, which is currently set at EUR 730,000 under the CRR/CRD IV regime (though their FOR may well be above their initial/minimum capital requirement).

5. The group capital test and prudential consolidation

The IFR/D includes a prudential consolidation regime that is similar to the scheme of the CRR/CRD IV, in that certain “investment firm groups” may be required to comply with certain parts of the IFR on the basis of their consolidated situation. However, competent authorities may allow the application of a “group capital test” in the place of prudential consolidation, provided that certain conditions are satisfied, including that there are no significant risks to clients or to the market. It remains to be seen what approach competent authorities including the FCA will take here.

6. ESG risks

From 26 December 2022, under the IFR certain larger investment firms will be required to disclose information on their environmental, social and governance (“ESG”) risks, including physical risks and transition risks, on a biannual basis. Under the IFD, the European Banking Authority (the “EBA”) is required to submit a report to the European Parliament, Council and Commission by 26 December 2021. The report is required to define “ESG risks”, which will assist investment firms with their disclosure obligations, and may lead to guidelines to introduce criteria related to ESG risks into the supervisory review and evaluation process (“SREP”), by which competent authorities review and confirm capital requirements. It remains to be seen whether the UK will adopt a similar or different approach to defining ESG risks for these purposes.

7. Remuneration and governance

In the absence of a stricter requirement under local law, investment firms themselves will be required to set “appropriate ratios” between the variable and the fixed component of total remuneration in their remuneration policies, which is contrasted with the fixed ratios approach under the CRR/CRD regime (the “bonus cap”).

The IFR/D requirements are similar in many respects to the current CRR/CRD IV regime, including the requirement to establish a remuneration policy and make certain disclosures. However, some investment firms may find themselves required to make changes, including to establish a remuneration committee, or to make changes to their existing remuneration committee, for example. The IFR/D includes express references to gender neutrality and the gender pay gap and requires firms to have a gender neutral remuneration policy.

Class 3 firms will be exempt from the IFR/D remuneration and governance requirements.

8. Third country firms and equivalence

Similar to the current position under the CRR/CRD IV regime, and the forthcoming changes to be introduced by CRD V, the IFD requires EU Member States to allow for “appropriate supervisory techniques” where two or more investment firms in the EU have the same “third country” (i.e. non-EU) parent undertaking which is not considered to be subject to “equivalent supervision”. In such circumstances, competent authorities may require the establishment of an investment holding company or mixed financial holding company in the EU. Clearly, in the context of Brexit and increased regulatory scrutiny, this may have implications for European groups that should be carefully considered, including when making acquisitions, establishing a new EU entity and/or general restructuring.

9. What are the next steps?

Further secondary legislation known as Regulatory Technical Standards (“RTS”) and Implementing Technical Standards (“ITS”) will set out much of the detail as to how the IFR/D will apply in practice (e.g. the criteria to work out which staff are “risk takers” for the purposes of the remuneration regime).

On 4 June 2020, the EBA published a comprehensive Roadmap, setting out the EBA’s expected timeline for the delivery of various RTS and ITS under the IFR/D up until 2025. The EBA also published various Consultation Papers related to RTS and ITS forming part of the first phase (including on prudential and remuneration requirements), which will need to be submitted to the European Commission before being finalised.

10. How will Brexit affect the position in the UK?

Because the UK has now left the EU, and because the IFR/D and any RTS and ITS made under it will not apply before the end of the Brexit Transition Period, the whole package will not automatically apply in the UK (unless the Brexit Transition Period is extended to after 26 June 2021).

In March 2020, HM Treasury confirmed that it intends to implement “a new” prudential regime for investment firms through the forthcoming Financial Services Bill and will launch a consultation “in due course”. We are also expecting an FCA Consultation Paper in Q3 2020, though this is subject to any COVID-19 related delay. The UK/FCA will not be bound to follow the EU approach however, in practice, in order to secure and retain “equivalence” and EU market access for UK firms,[3] the UK will need to have equivalent organisational and prudential regimes, so it is to be expected that the UK/FCA might closely align with the same outcomes (if not the precise detail of the EU requirements). There is still some uncertainty as to whether the timing of the implementation of the UK regime will mirror or diverge from the implementation of the EU regime, though this should be clarified in the forthcoming HM Treasury and FCA papers.

On the basis of the above, UK and EU investment firms should prepare on the basis of the text of the IFR/D and, in relation to EU investment firms, on the basis of the EBA materials published to date. UK investment firms should await further materials from HM Treasury and the FCA, though they may find the EBA materials informative as to the potential direction of travel.

[1] Although the term “Classes” is not used in the IFR/D itself, it was used in the earlier papers on the design and implementation of the new regime and is a useful shorthand.

[2] The IFR introduces a new regime of “K-factors” which are proxies used to more closely reflect the risks that investment firms are exposed to. The detail of the K-factors is beyond the scope of this current article.

[3] Article 63 IFR amends the third country/equivalence regime under Regulation (EU) No 600/2014 (“MiFIR”), which was designed to enable access to EU wholesale markets for third country firms subject to “equivalent” rules (although it has yet to be brought into practical effect).