New prudential regime for investment firms

The introduction of a tailored Investment Firms Prudential Regime (IFPR) will overhaul the existing prudential framework for most UK investment firms providing MIFID services. In addition to prudential change, firms will also need to prepare for potentially significant restrictions on their remuneration structures. This page provides access to our thoughts on how firms will be impacted and ought to prepare for implementation and also includes FAQs below.

FAQs

What is IFD and IFR and why is it relevant to me?

The Investment Firm Directive (IFD) and the Investment Firm Regulation (IFR) are new legislative changes which are being implemented in the EU and are currently expected to apply from 26 June 2021. They make significant changes to the way MiFID investment firms will be regulated for prudential purposes and the remuneration rules to which those firms are subject.

As the UK has now left the EU, IFD and IFR will not apply to UK authorised firms which conduct MiFID investment services. In practice, though, the FCA has confirmed that the changes accord with its intended outcomes and objectives and it appears likely that the UK will adopt a new prudential regime which substantially reflects the new EU regime. The rest of this Q&A assumes the FCA adopts the approach currently mooted in its initial Discussion Paper (DP 20/2).

What does Class 1, Class 2 and Class 3 refer to and how do I know which class I am in?

The classes reflect firms categorisations and determines the extent to which a firm will be subject to the IFD/IFR. The classifications are based on a firm’s activities, systemic importance, size and interconnectedness.

Class 1 firms are the largest and most interconnected investment firms (i.e. firms which have business models and risk profiles that are similar to those of significant credit institutions). Class 1 firms will remain subject to the prudential requirements of CRD IV (although certain threshold reporting requirements under IFD/IFR will apply). Broadly, an investment firm will be a Class 1 firm where it is an own account dealer / underwriter and has consolidated assets (or is part of a group with consolidated assets) of €15 billion or more.  Firms may also elect to be a class 1 firm where they are part of a group containing an EU credit institution, are subject to consolidated supervision under the CRR and the FCA is satisfied that the election does not result in a reduction in own funds held under the IFR.

Class 2 firms are all other investment firms save for those which meet the criterial to be a small and non-interconnected investment firms (SNI) (class 3 firms). Class 2 firms are within the full scope of the IFD/IFR.

Class 3 firms are firms which are deemed to be small and non-interconnected investment firms (SNI Firms). Please see question below - I’m a MiFID firm but only a small one, and our activities are very low risk, will I be excluded from the most onerous parts of the regime?

I think my firm is a MiFID firm and so will be impacted. How do I check?

One quick way to check your firm does qualify as a MiFID investment firm is to look on the FS Register at your firm’s entry. If your entry shows that your firm has passported under the MiFID Directive into the EEA, (look under the heading “What can this firm do in the EEA?”) then you will be a MiFID firm.

If your firm has not exercised passporting rights under MiFID (so the heading above does not appear), you may still be a MiFID investment firm if the “Restrictions” on your permissions profile indicate that you are any of the following:

  • Exempt CAD
  • BIPRU firm
  • IFPRU firm

If there are no restrictions you can check if you are performing MiFID services by comparing your permissions profile against the services which are MiFID services, described further in the following guidance in the FCA Handbook: PERG 13.3. There is a useful table tracking UK regulated activities to the following MiFID services using the following link.

We’re not a MiFID firm, do we need to worry about whether these new rules will be applied to us?

Generally speaking, we expect the answer to this to be “no”. However, at this stage, the FCA has only given initial views of its plans in a Discussion Paper (DP 20/2) and a first consultation paper is awaited. There are also some exceptions for the asset management industry.

At the current time it appears that one type of non-MiFID firm which may be impacted by the proposals are collective portfolio management investment firms (CPMI firm). These are firms with permissions to manage an alternative investment fund and/or permission to manage a UCITS fund which also have what are known as “MiFID top up” permissions. These firms are not MiFID firms as such but they do have permissions to conduct certain activities which are within scope of that Directive.

If you are a CPMI firm, you will have a restriction on your permissions profile (a CPMI restriction) on the FS register which makes this clear. Please refer to the Restrictions heading in your entry on the FS register.

CPMI firms are likely to be brought into scope of the new proposed regime although it is not yet clear if this will be for the whole of the firm’s business or just its additional MiFID business. At the current time, it appears the detail of the new prudential rules will only catch the “top up” business but the requirements for remuneration remain unclear.

For UCITS and AIF managers which do not have MiFID top ups, IFD/IFR is not generally expected to apply. However, there is one further change which impacts all UCITS managers and AIFMs regardless of MiFID top ups. This is the cross reference in IFD to the UCITS Directive and to AIFMD, such that own funds must be held by these firms which is no less than the FOR (fixed overheads requirement) calculated under Article 13 of the IFR.

When will the new rules apply?

There is some uncertainty about this as the FCA has had to delay some of its rule making agenda as a result of Covid. The FCA has said that it is planning the same or similar legislative timetable as IFD/IFR (which is June 2021) but at the time of writing there is no fixed date for the consultation paper (CP) it needs to issue on its plans. The FCA has said the CP will be issued later in 2020. It remains possible that firms will need to be ready by the second half of 2021.

 

I’m a MiFID firm but only a small one, and our activities are very low risk, will I be excluded from the most onerous parts of the regime?

Certain firms under the regime known as “small and non-interconnected investment firms” or SNIs benefit from additional proportionality and have less onerous prudential obligations, as well as reporting, disclosure and remuneration requirements. Figure 3.2 in the FCA’s DP sets out the threshold tests, based on financial criteria, to be considered an SNI firm and 3.3 provides a useful flowchart. We suggest checking those charts to determine your likely status.

The SNI test is not a static or one off test and is not based on activity type; a current Exempt CAD firm, for example, will not necessarily be treated as an SNI. A firm which is not an SNI but subsequently becomes one will need to meet the conditions for a period of six months on a continuous basis in order to be treated as an SNI under the regime.

You can also find a quick summary guide of the difference between being an investment firm under IFD/IFR and an SNI firm in the table in 3.31 of the DP.

 

I’m a CPMI firm, how does this impact me?

Please refer to the question above, “We’re not a MiFID firm…” which explains the position for CPMIs at the current time of writing.

In practice, how much capital will I have to hold?

This depends on whether you are an SNI firm or non-SNI. The difference is explained in [the answer to the question on smaller MiFID firms that carry out low risk activities ] above.

If you are non-SNI, your initial capital requirement will be the higher of the fixed overhead requirement (FOR), the permanent minimum requirement (PMR) and the K factor requirement (KFR). If you are SNI, then your capital requirements will be the higher of the FOR and the PMR.

  • The PMR is basically the initial capital as described in [the answer to the question on how much initial capital does your firm need to hold] above.
  • The FOR is one quarter of the fixed overheads for the previous financial year. The calculation of the FOR is expected to be subject to
  • The KFR is entirely new and is a new way of calculating the potential for harm in a firm (including its risk to clients and the market). Please refer to [the K-factor question] below.

Although theoretically the KFRs don’t apply to SNI firms. In reality, SNIs will need to assess their firm against these metrics to ensure that they remain an SNI. This is because the K factor tests are in practice relevant to the thresholds for remaining an SNI.

The above explains the calculation for what is known as “Pillar 1” capital. Firms which are not SNI firms will also have to perform an additional Pillar 2 assessment and this may require them to hold additional capital. Please refer to [ICARA question] below.  

People are talking about the “K factors”. What are these?

This is a completely new approach to determining the minimum own funds requirement. It is intended to reflect harm and is very different from the historic calculations done under the old regime. For many firms, some of the K factors will not be relevant and the calculation methods are designed to be straightforward.

The KFR is the sum of each of the K factors that apply to the business of the investment firm.

Figure 6.1 of the DP sets out the K factors and chapter 6 explains how to calculate them.

In brief, the K factors are divided into three categories:

  • Risks to client (RtC)
  • Risks to market (RtM)
  • Risks to firm (RtF)

Not all K factors will have to be considered by each firm however. For instance if a firm does not hold client money or assets then two RtC K factors for client money held (K-CMH) and assets safeguarded and administered (K-ASA) can be ignored.

 

Is there a transition period to give me time to change?

Yes, there are some provisions in the IFR intended to ease the change to the new regime. These vary depending on the current status and size of the relevant firm and in many instances allow a more lenient calculation of the PMR and the own funds requirement (described above in [In practice, how much capital will I have to hold?]) for a short term period.

What will change so far as remuneration is concerned?

Implementation of the IFD/IFR will be likely to mean the deletion of the IFPRU and BIPRU Remuneration Codes which will consolidate instead into a single combined Code. The IFD/IFR approach to remuneration will be based upon the same core remuneration principles as exist currently but there will be some differences particularly on proportionality. The position will also change for exempt CAD firms which are not currently subject to any Code and will now be brought within scope for the first time.

However, remuneration obligations under IFD/IFR do not apply to SNI firms. Consequently, exempt CAD firms which qualify as SNI firms under the new regime will continue not to be subject to any Code. In addition, small non-SNI firms (assets of EUR 100 million or less) are entitled to disapply three variable remuneration requirements on pay-out, deferral and retention and these obligations are also disapplied for individuals with annual variable remuneration below EUR 50,000 and which represents 25% or less of total remuneration (i.e. a significant lowering of the current threshold which excludes individuals with total remuneration of no more than £500,000 of which no more than 33% is variable remuneration).

In addition, perhaps the most fundamental change of all is that the broad brush approach of dis-applying the pay out process rules as a BIPRU firm, on grounds of proportionality, is likely to be swept away. This is explained in the DP at 13.44 onwards.  

Further details are set out in our detailed notes which you can find here.

 

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