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1.   A new prudential framework for investment firms consistent with the principle of proportionality

1.1.   A wide range of activities within investment firms

Alongside credit institutions, investment firms offer a very wide range of services that enable investors to access securities and derivatives markets. These include, for example:

  • Underwriting financial instruments and/or placing of financial instruments on a firm commitment basis;
  • Proprietary trading;
  • The operation of an Organised Trade Facility (OTF);
  • Receiving and transmitting orders for one or more financial instruments;
  • Executing orders on behalf of clients;
  • Investment advice;
  • Portfolio management;
  • The placement of financial instruments without a firm commitment.

1.2.   The shortcomings of the current situation

Investment firms authorised under MiFID (Directive 2014/65/EU) vary considerably in terms of size, business model, risk profile, complexity and interconnectedness, ranging from one-man firms to large groups active internationally.

Currently, the prudential treatment of investment firms is set out in the CRD and CRR. However, some investment firms are exempted from the full application of the CRD / CRR requirements due to their size and the specificity of the services they provide.

1.3.   Objectives of the IFR/IFD package

The new prudential framework for investment firms is set out in the IFD and IFR package published in the Official Journal of the European Union on 5 December 2019 and entered into force on 26 December 2019.  It aims to adapt the prudential framework for investment firms in accordance with the principle of proportionality.

There are now three categories of investment firms:

  1. Investment firms (IFs) which are subject to the same prudential regime as banks:
    • IFs that provide “bank-like” services, such as proprietary trading or underwriting of financial instruments and whose consolidated assets exceed EUR 30 billion.  These firms automatically fall under the Capital Requirements Regulation and the 4th Capital Requirements Directive (CRR/CRD IV);
    • IFs with “banking-type” activities and consolidated assets between EUR 15 and 30 billion or solo assets of EUR 5 billion (solo) may also be subject to CRR/CRD IV by their supervisor, in particular where the size of the firm or its activities is such as to give rise to risks of financial stability.
  2. Mid-sized investment firms :
    • These firms are not They will be subject to the new IFR/IFD supervisory framework.
  3. Small non-interconnected investment firms :
    • These companies will be subject to the new IFR/IFD prudential framework with very light provisions due to the low risk they represent in accordance with the proportionality principle.

Competent authorities are able to allow banking requirements to continue to apply to certain firms on a case-by-case basis to avoid disrupting their business model. This option will be accompanied by a safeguard to prevent regulatory arbitrage. Overall, a transition period of five years is foreseen to mitigate the impact of the regime change.

2.   The mission of the EBA

The Investment Firms Directive (IFD) (Directive (EU) 2019/2034) and the Investment Firms Regulation (IFR) (Regulation (EU) 2019/2033) provide the EBA with a significant number of mandates covering a wide range of areas related to the prudential treatment of investment firms.

These mandates include 18 Regulatory Technical Standards (RTS), 3 Technical Implementation Standards (TIS), 6 sets of guidelines and 2 reports.

In addition, the EBA must maintain a list of eligible capital instruments, a database of administrative sanctions and can issue notifications in various areas relating to the new prudential package.

The EBA has published a roadmap on the prudential package for investment firms which details the main principles and strategy for implementing its mandates.

3.   Four principles structuring the development of the first phase of the Regulatory Technical Standards

3.1.   Proportionality

The RTS aim to ensure proportionality in relation to the regulatory requirements for investment firms of different sizes and complexity.  Proportionality of regulatory requirements is a key aspect of the new regime, considering the links between the CRR / CRD and the IFR / IFD.

3.2.   Continuity in the transition between different prudential regimes for investment firms

Some systemically important investment firms will be directly subject to the banking framework from the date of implementation of the IFR, while others will be subject to the new prudential regime though may move to the banking framework as their business develops.

The RTS should allow the transition to occur without significant disruption whilst ensuring adequate coverage of the main risks to clients, the market and investment firms.

3.3.   Respect for the principle of fair competition between banks and investment firms

The principle of fair competition between investment firms and credit institutions should be taken into account. Particular attention should be paid to net position risk, trading counterparty default and concentration of trading book positions, in relation to the specific risk structure and risk factors of the individual or group of investment firms.

3.4.   Harmonisation of the prudential framework

The RTS also aims to strengthen a harmonised regulatory environment further, in order to promote a level playing field on European level between different types and categories of investment firms.

4.   The scope of the RTS

4.1.   modification of the procedures for obtaining authorisation to reclassify certain investment firms as credit institutions

The EBA must specify the information to be provided to the competent authorities for authorisation as a credit institution in accordance with the new definition.

In order to ensure a smooth transition between the CRD / CRR and the framework introduced in parallel by the application of the IFR and IFD, the draft RTS consist of a subset of the information necessary for the authorisation of a credit institution and a set of requirements proposed in the EBA RTS / 2017 / 08.

4.2.   Capital requirements for investment firms at the individual and consolidated level

4.2.1.    How to calculate overhead requirements

The EBA must specify the deductions to be applied for the calculation of fixed costs, which are the basis for the calculation of the fixed overhead requirement. The concept of a “material change” is also specified, according to which the competent authority may allow the adjustment of a fixed overhead requirement.

4.2.2.    How to calculate requirements based on K-Factors

The EBA specifies the methods for measuring K-factors, where they are not already fully detailed in the IFR. The draft RTS provides clarification on the measurement of most customer risk K-factors (CRR) and some business risk K-factors (FRK).  Market risk K-factors (MRK) are either defined as references in the CRR or detailed in the IFR and therefore require no further specification.

EBA also clarifies the concept of segregated accounts by setting out the conditions for their identification for the purpose of calculating the K-factor capital requirement “in respect of client monies held” (K-CMH).

EBA specifies the adjustments to be made to the “daily trade flow” coefficients of the K-factor (K-DTF) in the event that, under stressed market conditions, the K-DTF requirements appear to be too restrictive and detrimental to financial stability.  The EBA defines stressed market  only where they lead to increased trading volumes.

The EBA also defines how to calculate the amount of total margin needed to calculate the K-CMG margin and the criteria to avoid regulatory arbitrage when the K-CMG approach is used.

Finally, the EBA specifies the quantitative thresholds above which an investment firm should be considered to be of systemic importance.

References

https://www.eba.europa.eu/sites/default/documents/files/document_library/Publications/Draft%20Technical%20Standards/2020/RTS/961461/Final%20draft%20RTS%20on%20prudential%20requirements%20for%20Investment%20Firms%20%28EBA-RTS-2020-11%29.pdf

Abbreviations

  • CRD: Capital Requirements Directive
  • CRR: Capital Requirements Regulation
  • EBA: European Banking AuthorityIFD: Investment Firms Directive
  • IFR: Investment Firms Regulation
  • K-factor (actuarial) : the ratio of the value of deferrable expenses to the value of estimated gross profits
  • OTFs: Organised Trade Facility
  • RTS: Regulatory Technical Standards
  • Systematically important: A systemically important financial institution is a bank, insurance company, or other financial institution whose failure might trigger a financial crisis