EBA consults on IFD/IFR implementation: New prudential regime for investment firms

The European Banking Authority (EBA) consultation paper EBA/CP/2020/06 seeks submissions in respect of nine draft Regulatory Technical Standards (RTS) related to the implementation of a new prudential regime for investment firms under the Investment Firms Directive and Investment Firms Regulation (IFD/IFR). Summaries of each set of RTS are detailed in this article. Interested parties have until 4 September 2020 to submit responses.

1. Draft Regulatory Technical Standards on the information to be provided for the authorisation of investment firms as credit institutions (Article 8a(6) point a) of the CRD) 

This draft RTS deals with information to be provided by an investment firm in an application for authorisation as a credit institution. 

This arises under IFD/IFR which requires certain systemically important investment firms to re-authorise as credit institutions where they deal on own account and/or underwrite or place financial instruments on a firm commitment basis and who have average of monthly total assets, calculated over a period of twelve consecutive months exceeds €30bn; or (if below €30bn) where the undertaking is part of a group in which the total value of the consolidated assets of all undertakings in the group exceeds €30bn. 

Based on these criteria, we expect very few existing investment firms to be affected by this requirement. Firms that believe they may be affected will be conscious to monitor developments in this area.

This draft RTS is based on the existing EBA RTS 2017/08 on the information to be provided for the authorisation of credit institutions to ensure consistency and harmonization. Competent authorities can also waive certain information by considering the size, nature, scale and complexity of the activities of the applicant credit institution.  

Details of the required information is set out in the draft RTS and there is a requirement that an applicant credit institution shall comply with eight specified requirements from EBA RTS 2017/08. It provides for the provision of additional information, where proportionate and relevant for the purposes of the authorisation assessment. It also provides that relevant information does not need to be provided if already held by the competent authority, once re-certified. Lastly, it also provides that certain information may be omitted, if not relevant to the activities, once the reasons for such omission are cited. 

2. Draft Regulatory Technical Standards on the methodology for calculating the EUR 30bn threshold required to be authorised as a credit institution (Article 8a(6) point b) of the CRD) 

As referred to above, investment firms who may be required to re-authorise as a credit institution will be interested in the mechanics of the calculation of average of monthly total assets, calculated over a period of twelve consecutive months exceeds €30bn; or (if below €30bn) where the undertaking is part of a group in which the total value of the consolidated assets of all undertakings in the group exceeds €30bn.

This draft RTS provides definitions of relevant activities and relevant third country branches and sets out the accounting standards and relevant exchange rate to be used by the relevant undertaking. There is also detail on the treatment of assets of branches of third country groups and the definition of assets where the total value is equal to or exceeds the €30bn threshold, on an individual and group level. Finally, there is also guidance on the relevant undertakings that should be included for the purposes of the group test. 

The draft RTS outlines the calculation for the total value of the consolidated assets and outline the calculation for the combined total value of the assets of all the undertakings of a group. A narrow approach has been taken in the calculation of consolidated assets so as to avoid the double counting of assets.

3. Draft Regulatory Technical Standards to specify the calculation of the fixed overheads requirements and to define the notion of a material change (Article 13(4) of the IFR)

IFR provides that investment firms shall at all times have own funds which amount to at least the highest of one of the following: i) their fixed overheads requirement; ii) their permanent minimum capital requirement; or iii) their K-factor requirement. This means that every investment firm has to calculate their fixed overheads requirement to identify whether it is relevant to the determination of their own funds requirements. Therefore the methodology of calculating the fixed overheads requirement becomes important. 

The draft RTS clarifies that the calculation of the fixed overheads requirement shall be based on the investment firm's most recent audited annual financial statements after distribution of profits or in annual financial statements where audited statements are not available. If the financial statements do not reflect a 12 month period, the calculations shall be divided by the number of months that are available and then multiplied by 12 so as to produce an equivalent annual amount. It also clarifies how to calculate employees', directors' and partners' shares in profits, staff bonuses and other remuneration, fixed expenses incurred on behalf of the firm by third parties and other items for deduction including fees, interest, expenditures from taxes, losses and other payments. 

The approach for calculating the fixed overheads requirements in the draft RTS is a 'subtractive approach'. Variable cost items are deducted from the total expenses as calculated in accordance with the applicable accounting framework. 

There is guidance on the calculation of fixed overhead requirements for commodity and emission allowance dealers noting that they may deduct expenditure on raw materials in connection with an investment firm trading in derivatives of the underlying commodity. 

IFR permits regulators to make adjustments in own funds requirements where there is a material change in the business activities of the firm. The draft RTS specifies that a material change shall be considered to have occurred where either of the following conditions are met: 

1. an increase or decrease of 30% change or greater in the firm's projected fixed overheads of the current year
2. an increase or decrease change in the firm's own funds requirements based on projected fixed overheads of the current year equal to or greater than €2m

The IFR has no clear definition of what constitutes a material change, so in order to ensure that the competent authorities apply the same conditions across the EU, it was necessary to establish criteria on what constitutes a material change. 

4. Draft Regulatory Technical Standards to specify the methods for measuring the K-factors (Article 15(5)(a) of the IFR)

Under IFD/IFR investment firms that are not to be treated as credit institutions are required to calculate capital requirements with reference to k-factors. K-factor requirements are a means to calculating a directly proportional capital requirement for each firm's risk profile.

Some of the K-factors are clear and do not require further specifications, for example, the K-NPR (Net Position Risk) and K-CON (Concentration Risk). Other K-factors, such as Rtc K-factors are not as clear and have been specified in the draft RTS. There are also details for measuring other k-factors such as the assets under management in the case of discretionary portfolio management, client money held and assets safeguarded and administered.

5. Draft Regulatory Technical Standards on the notion of segregated accounts (Article 15(5)(b) of the IFR)

IFR requires the development of draft RTS to specify the notion of segregated accounts. This relates to a capital requirement related to holding client money. Firms who hold client money in a segregated account can use a different coefficient when calculating their capital requirements. 

The draft RTS provides that the notion of segregated accounts shall mean that the investment firm must meet all of the following five: 

1. keeping records and accounts that distinguish assets held for one client from assets held for any other client and from their own assets
2. maintaining records and accounts in a way that ensure their accuracy, clearly identifies funds held for clients and that may be used as an audit trail 
3. conducting regular reconciliations between internal accounts and records against third party records
4. taking necessary steps to ensure client funds deposited are held in accounts identified separately from any accounts used to hold funds belong to the investment firm
5. introducing adequate organisational arrangements to minimise the risk of loss or diminution of client assets,  or any connected rights, as a result of mis-use, fraud, poor administration, inadequate record-keeping or negligence

6. Draft Regulatory Technical Standards to specify adjustments to the K-DTF coefficients (Article 15(5)(c) of the IFR)

IFR provides that K-DTF is equal to the daily trading flow (DTF) measured in accordance with Article 33 of the IFR, multiplied by the corresponding coefficient set out in Article 15(2) of the IFR. The calculation as is, does not provide for the possibility of adjusting the coefficient on a daily basis, nor can more than one coefficient be used for any given monthly calculation. Any adjustments need to be carefully considered as otherwise it would apply to the whole calculation. The draft RTS proposes a proportionate approach to the adjustment of the DTF. 

The Recitals to the draft RTS suggests that the calculation of the DTF is constrained by default capital requirements, which could be detrimental to the financial stability of an investment firm. The Recitals further suggest that it is during such circumstances of extreme volatility that the K-DTF coefficients should be adjusted to i) incentivize trading activities and ii) a smaller coefficient. 

Article 1 provides for the adjustments to the K-DTF coefficients noting that in stressed market conditions, the requirements "seem overly restrictive and detrimental to financial stability", the adjustments shall be determined by the formula laid out therein. 

Article 2 provides that 'periods of extreme volatility' shall be the situations referred to in Article 3(a) of the Delegated Regulation. It clarifies that the start and end times of such periods shall be when the trading venue makes such occurrence public as per Article 3(a) of the Delegated Regulation and when it resumes normal trading as per Article 4 of the Delegated Regulation. 

7. Draft Regulatory Technical Standards to specify the calculation of the amount of the total margin for the calculation of K-CMG (Article 23(3) of the IFR) 

This draft RTS addresses the calculation of the amount of the total margin required and the method of calculation of K-CMG (Clearing Member Guarantees). IFR states that the Risk to Market (RtM) K-factor requirement shall either be calculated by K-NPR (Net Position Risk) or K-CMG. The RtM K-factor requirement applies to "all trading book positions, which include in particular positions in debt instruments (including securitisation instruments), equity instruments, collective investment undertakings (CIUs), foreign exchange and gold, and commodities (including emission allowances)". 

Definitions are provided for trading desk, the calculation of the amount of the total margin required as being the required amount of collateral in the collateral account as required by the clearing member's margin model. Clarification is provided that where the clearing member updates the total margin more than once during the day, the total margin required shall be the highest of those amounts during the day. The draft RTS also provides for the method of calculation of K-CMG in case of multiple clearing members.

IFR provides that the competent authority must have assessed that the choice of the portfolio(s) subject to K-CMG have not been made with a view to engaging in regulatory arbitrage of the own funds requirements in a disproportionate or prudentially unsound manner.

The draft RTS seeks to prevent arbitrage. It sets out five conditions which must be met in order for the conditions under IFR to be deemed to be met. The investment firm must prove that: 

1. it applies the same methodology to all the positions of that trading desk 
2. that it uses the K-CMG consistently across similar trading desks
3. that it has policies and procedures in place showing that the portfolios subject to K-CMG appropriately reflect the risks of an investment firm's trading book positions
4. that it makes use of the outcome of the K-CMG calculation in its risk management framework and regular compares the results to the margins required by clearing members
5. that it has compared the capital requirements calculated by K-CMG with the capital requirements calculated by K-NPR for each trading desk, and the difference is justified. 

The draft RTS provides two further conditions that must be met:

1. That the investment firm has used the K-CMG calculation for a continuous period of at least 24 months, or the portfolio can be considered a different trading desk due to the extent of change
2. In addition, that when the investment firm compares the capital requirements calculated between the K-CMG and the K-NPR in the two specified cases that the difference is justified

8. Draft Regulatory Technical Standards on the criteria for subjecting certain investment firms to the CRR (EUR 5bn threshold) (Article 5(6) of the IFD)

Under IFD, investment firms may be regulated under the Capital Requirements Directive and Regulation at the option of competent authorities where they have consolidated assets of €5bn or more and meet other criteria relating to their significance and the systemic risks posed in the event of their failure. Such firms are referred to as "Class 1 minus" firms.

This draft RTS addresses identifies the criteria for assessing whether an investment firm's failure or distress could meet the threshold for systemic risk.   
Exceeding any of the following thresholds will amount to the firm being considered to be on such a scale that the failure or distress of the investment firm could lead to systemic risk:

1. total gross notional value of non-centrally cleared OTC derivatives of €50bn
2. total value of financial instruments underwriting and/or placing of financial instruments on a firm commitment basis of €5bn
3. total value of granted credits or loans to investors to allow them to carry out transaction of €5bn
4. total value of debt securities outstanding of €5bn

The consultation paper suggest that the four thresholds should not be considered an exhaustive list of indicators for competent authorities to consider in order to use the discretion to require a firm to be regulated under CRR/CRD IV.

The draft RTS also provides the requirements related to the provision of clearing services.

9. Draft Regulatory Technical Standards on the methods of prudential consolidation of investment firms (Article 7(5) of the IFR)

This draft RTS specifies the details of the scope and methods for prudential consolidation of an investment group, in particular for the purpose of calculating the fixed overheads requirement, the permanent minimum capital requirement and the K-factor requirement on the basis of the consolidated situation of the investment firm group. The draft RTS defines 'union parent undertaking' and 'capital ties' and 'group undertaking' and set out the circumstances where an undertaking can be regarded as the union parent undertaking. 

The draft RTS also provides for proportional consolidation. The group supervisor may permit proportional consolidation according to the share of capital held of participations in investment firms, financial institutions, ancillary services undertakings or tied agents managed by a Union parent undertaking together with one or more undertakings not included in the consolidation provided three conditions are met – limited liability, subject to prudential supervision and solvency is satisfactory. 

Consolidation of own funds requirements are also addressed. The draft RTS provides that that the amount of own funds of a Union parent undertaking on a consolidated basis may not fall below the highest of either: a) the fixed overheads requirement; b) the permanent minim capital requirement; or c) the K-factor requirement.

In relation to the consolidated fixed overheads requirement, a hierarchical approach is taken. The draft RTS provides that the consolidated fixed overheads requirement shall amount to at least one quarter of the fixed overheads of the Union parent undertaking of the preceding year on a consolidated basis and shall use expenditure figures. If the consolidated expenditure of the Union parent is not available then the consolidated fixed overheads requirement shall amount to: a) the expenditures of the Union parent investment firm at the individual level; b) the expenditures of the group undertakings that are fully consolidated, at the individual level; and c) the expenditures at the individual level of the group undertakings that are consolidated proportionally. 

There is also provision for the consolidated permanent minimum capital requirement. This shall amount to the sum of the minimum capital requirement of the Union parent investment firm at the individual level, the permanent minimum capital requirement at the individual level of all group undertakings that are fully consolidated and the permanent minimum capital requirement at the individual level of those group undertakings that are consolidated proportionally. 

The consolidated K-factor requirement is also required to be calculated by adding together all different K-factors requirements calculated on a consolidated basis in accordance with the guidance and methods set out in the draft RTS.

For more information contact, Dario Dagostino, Kevin Allen and Patrick Brandt, Financial Regulation Partners and Sinéad Prunty, Financial Regulation Knowledge Lawyer.

Date published: 3 September 2020