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 IFPR and why is it relevant to me?

The UK Investment Firm Prudential Regime or IFPR is a new streamlined and simplified regime for the prudential regulation of investment firms in the UK. The IFPR is being introduced by the Financial Conduct Authority (FCA) in accordance with the new Financial Services Bill and new Part 9of the Financial Services and Markets Act 2000.

It is intended to come into force on 1 January 2022 following a package of FCA consultation papers. The first of these, CP20/24 (CP), was released by the FCA in December 2020 and followed an earlier FCA Discussion Paper, DP20/2 (DP).

In broad terms, the new prudential regime will be aligned with changes proposed in the European Union under the Investment Firm Directive (IFD) and the Investment Firm Regulation (IFR). This is legislation which came into force on 26 December 2020 and will take effect in the EU on 26 June 2021. Although Brexit means that the IFD and IFR will not apply in the UK, the FCA was a key advocate of, and heavily involved in policy discussion on, the new EU regime before the UK’s exit from the EU. Unsurprisingly, therefore, the IFPR is heavily influenced by these EU changes.

In its first CP, the FCA makes clear that the intention of the new IFPR regime is to refocus prudential requirements away from the risks firms face, to take adequate account of the potential for harm to consumers and markets. The new proposals will also strip away much of the complexity in the existing prudential framework and this is to be welcomed.

However, the new rules will also make significant changes to the way UK investment firms will be regulated for prudential purposes and the remuneration rules to which those firms are subject and consequently, we expect that significant resource and planning will need to be devoted by firms in 2021 in order to be ready for the early 2022 implementation date.

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 €15bn 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 an investment firm and so will be impacted. How do I check?

The following firms will be caught by the new regime:

  • investment firms subject to BIPRU and GENPRU;
  • full scope, limited activity and limited licence firms subject to IFPRU and the CRR;
  • local” investment firms;
  • matched principal traders;
  • exempt CAD firms;
  • investment firms which previously were exempt under Article 3 of MIFID but opted in; and
  • various specialist commodities derivatives investment firms.

You can check if you are performing investment services, and therefore amount to an investment firm, 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 an investment 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, it appears that one type of firm which may be impacted by the proposals are collective portfolio management investment firms (CPMI firms). These are firms with permissions to manage an alternative investment fund (AIF) and/or permission to manage a UK UCITS fund which also have what are known as “MiFID top up” permissions. These firms are not investment firms as such but they do have permissions to conduct certain activities which are "investment services".

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 may only catch the “top up” business but the requirements for remuneration remain unclear. The FCA stated in the CP that it would explain how its draft rules would apply to CPMI firms in a subsequent consultation in the course of 2021.

For UCITS and AIF managers which do not have MiFID top ups, IFPR is not generally expected to apply. However, there is one further change in IFD 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. It may be that a corresponding change will be made in IFPR in line with the above, in IFD. However, this will be addressed, it is expected, in a later FCA consultation paper.

When will the new rules apply?

It is expected that firms will need to comply by 1 January 2022. This is, however, subject to appropriate progress and amendments to the Financial Services Bill which was introduced by the UK Government on 20 October 2020The passage of the Bill through Parliament may result in changes to the new Part 9C of the Financial Services and Markets Act 2000 and it is not impossible this may require subsequent changes to the new IFPR regime before it is introduced.

The FCA has said that it will be monitoring the relevant legislative developments and it will reflect those in subsequent consultations, where required.

I’m an investment 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. Table 2 in paragraph 2.10 in the FCA’s CP sets out the threshold tests, based on financial criteria, to be considered an SNI firm and figure 1 in paragraph 2.12 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. This is explained in paragraph 2.13 of the CP.

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 an investment firm, do we need to worry about whether these new rules will be applied to us?" 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 "I’m an investment 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?" question 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 above.
  • The FOR is expected to be one quarter of the fixed overheads for the previous financial year, although the details for calculation are not covered in the CP and the FCA will address this in its subsequent consultation papers.
  • 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 "People are talking about the “K factors”. What are these?" 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 the "My firm has to prepare an ICAAP (Internal Capital Adequacy Assessment Process). Is that being scrapped now?" 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. The K-factor capital requirements are essentially a mixture of activity and exposure-based requirementsIt is intended to reflect harm and is very different from the historic calculations 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); and
  • 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.  

For the time being, the CP only addresses the K-factors relevant to firms which deal on own account and the remaining K factors are to be explained in a further consultation. However, the detail of the other K factors are also considered in the DP and in the group consolidation context under chapter 3 of the CP.  

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

Yes, there will be certain provisions in the IFPR intended to ease the change to the new regime. It is expected that these will vary depending on the current status and size of the relevant firm and may 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?

 

The detail of this is not set out in the CP and will be covered in the second consultation paper expected at the start of Q2 of 2021.

However, based on the DP and IFD/IFR it seems likely the new regime will involve deletion of the IFPRU and BIPRU Remuneration Codes which will consolidate instead into a single combined Code. The IFD/IFR approach to remuneration is based upon the same core remuneration principles as exist currently but there are some differences particularly on proportionality. It is expected that 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, it is expected that remuneration obligations will 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, based upon IFD/IFR small non-SNI firms (assets of €100m 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 €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. 

 

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