For most MiFID investment firms, this new regime replaces the current Capital Requirements Directive/Capital Requirements Regulation framework. This is intended to be an exercise in simplifying the current prudential regime, for example reflecting that a majority of MiFID investment firms are ‘agency’ in nature and do not deal on own account, underwrite financial instruments or hold client money or assets. However certain firms will become subject to more stringent requirements as a result, for example firms that are currently classified as ‘Exempt CAD’.
Alternative Investment Fund Managers (AIFMs) that perform other services that are akin to MiFID services and activities, and are currently subject to either the FCA’s ‘BIPRU’ or ‘IFPRU’ framework, are considered to be ‘in-scope’ and therefore are subject to the changes. However for full-scope UK AIFMs, the prudential framework prescribed by AIFMD (detailed in the FCA handbook at IPRU(INV) Chapter 11) shall continue to apply. This article focuses on affected firms that are domiciled in the UK.
Unlike the current framework, which has a plethora of categories, the new regime will have three main categories:
• Category 1 applies to firms that are deemed to be systemically important (for example large, multi-national investment firms). Such firms remain subject to the current framework for prudential purposes albeit certain facets of the new regime may apply. This is likely to affect a significant minority of investment firms
• Category 2 is a ‘default’ category for firms that do not fall into one of the other 2 categories
• Category 3 applies to small and non-interconnected firms. Such firms are subject to a lighter touch framework
Unless Category 1 applies, a firm will be a Category 2 firm if it meets certain criteria. The relevant criteria depends upon the activities conducted by the firm, and its group arrangements. For example:
• If a firm conducts discretionary portfolio management and/or non-discretionary investment advisory activity, it is a Category 2 firm where the AUM (discretionary or advisory) exceeds €1.2 billion.
• If a firm conducts ‘agency brokerage’ activity (i.e. receives and transmits orders and executes client orders but does not hold client money, safeguard/administer client assets or deal on own account), it is a Category 2 firm where the value of client orders exceeds €100 million (cash trades) or €1 billion (derivatives) daily.
• A firm falls into Category 2 if its balance sheet total exceeds €100 million
• A firm falls into Category 2 if its annual gross revenue from investment services exceeds €30 million
Regarding each of the above, the threshold applies on a consolidated basis if the firm is part of a group.
Furthermore, a firm cannot be a Category 3 firm if it holds client money, safeguards/administers client assets or deals on own account.
Retention of ‘Three Pillars’ Approach
Firms currently subject to BIPRU or IFPRU will be familiar with the ‘three pillars’ approach. Pillar 1 is the minimum capital requirement, reached by applying prescriptive rules. Pillar 2 provides a framework to enable firms and regulators to consider firm risks, for example in order to determine whether the minimum capital requirement per Pillar 1 is sufficient. Pillar 2 includes the Internal Capital Adequacy Assessment Process (‘ICAAP’). Pillar 3 is a disclosure regime.
Under the new regime the minimum capital requirement is the higher of:
• A ‘base’ capital requirement. For most portfolio managers and investment advisers, plus brokers that do not deal on own account this will be €75,000. However this is subject to a transitional period of 5 years, over which the requirement will rise from €50,000 to €75,000. For other firms, the ‘base’ capital requirement will be either €150,000 or €750,000
• A fixed overheads requirement of 25% of the firm’s annual fixed expenses
• Requirements based upon ‘K-factors’ (this is not applicable to Category 3 firms)
K-factors are quantitative coefficients that reflect risks to customers, markets or firms. The relevant K-factors depend upon activities conducted. For example:
• ‘K-AUM’ = 0.02% of value of assets under management
• ‘K-COH’ (‘Client Orders Handled’) = 0.1% of value of cash trades or 0.01% of notional value of derivatives
There are also K-factors inter alia for firms that hold client money, safeguard and administer assets and deal on own account.
ICAAP and Supervisory Review and Evaluation Process (SREP)
The new regime shall retain the ICAAP and the SREP (which is the supervisory review of compliance with the regime). Category 3 firms are not subject to this, unless the national regulator elects to impose it. (It is not clear at present whether the FCA would do so.)
Category 2 firms are subject to public disclosure requirements that may cover (dependent upon the firm type):
• Risk management objectives and policies
• Corporate governance
• Regulatory capital and capital requirements
• Remuneration and investment policies
• Environmental, social and governance (ESG) risks
• Country-by-country reporting
• Voting rights and voting behaviour (large firms only)
Category 3 firms that issue certain capital instruments (e.g. convertible bonds) are subject to a disclosure regime that covers capital held, capital requirements and risk management policies and objectives. Otherwise the disclosure requirement does not apply to Category 3 firms.
Reporting to regulators
Category 2 firms must make regulatory disclosures on a quarterly basis that cover regulatory capital information. This includes regulatory capital and regulatory capital requirement, concentration risk and liquidity requirements. Category 3 firms are subject to an annual reporting requirement.
On the premise that this will replace the current ‘GABRIEL’ returns on prudential topics, firms may find that the frequency of reporting may increase or decrease.
The remuneration regime does not apply to Category 3 firms. Key elements of this regime are:
• Establish and maintain remuneration policies that are proportionate to the size, nature and complexity of the firm.
• Remuneration requirements apply with respect to staff (including senior management) whose professional activities have a material impact on the firm
• Requirement for firms to set – and publish – appropriate variable remuneration to fixed remuneration ratios, ensuring that fixed remuneration is a ‘sufficiently high proportion’ of total remuneration
• Proportion of variable remuneration deferred or in the form of non-cash assets (e.g. shares in the firm) unless firms have a balance sheet value of no more than €100 million or the individual concerned has variable remuneration of no more than €50,000 and this does not represent more than 25% of their total remuneration
• Establishment of a remuneration committee (larger firms only)
• Public disclosure and regulatory reporting requirements
These elements are similar to those already in place for firms subject to BIPRU, IFPRU or AIFMD. However Exempt CAD firms may be unfamiliar with certain concepts.
Some additional facets of the new regime include:
• Imposition of capital ratios:
o Common Equity Tier 1 (the highest quality of capital) to comprise at least 56% of total capital
o Additional Tier 1 (e.g. convertible bonds) to comprise 44% or less of total capital
o Tier 2 (e.g. subordinated loans) to comprise 25% of less of total capital
• Liquidity requirements – liquid assets must exceed the liquid asset requirement, which for many firms will be 1/3 of the firm’s fixed overheads requirement (i.e. one month of fixed overheads). National regulators have the discretion to exempt Category 3 firms from the liquidity requirements
The new regime has some similar facets to the current framework. However some firms – including Exempt CAD firms – will become subject to certain additional requirements regarding both the complexity of the regulatory capital calculation (and an associated increase in the regulatory capital requirement) and other obligations concerning, for example, remuneration, public disclosures and liquidity arrangements.
As is the case with all pending EU legislation, the impact of Brexit remains uncertain. However in our view, it is likely that even in the event of a no deal / no-transition Brexit, the framework will be adopted in the UK in part to retain ‘equivalence’ with the EU framework.