New UK prudential regime for MiFID firms

The Financial Conduct Authority's (FCA's) first consultation (CP20/24) on the proposed rules to introduce the UK's Investment Firm Prudential Regime (IFPR) closed on 5 February 2021.

The consultation paper follows the FCA's June 2020 discussion paper and the inclusion of measures to enable the implementation of the new regime within the Financial Services Bill (designed to establish post-Brexit statutory frameworks for certain aspects of financial services regulation).

Solo-regulated MiFID (Markets in Financial Instruments Directive) investment firms as well as AIFMs (alternative investment fund managers) or UCITS (undertakings for collective investment in transferable securities) management firms with MiFID permissions should continue to assess the likely scope and consequences of the new regime. Specifically designed for investment firms for the first time, the new regime will represent a significant overhaul of the current rules, both in terms of the way investment firms are categorised from a prudential perspective and in terms of the requirements to which they are subject.

Background

The new regime will be based on the Investment Firms Directive (IFD) and the Investment Firms Regulation (IFR), EU legislation published on 5 December 2019. Investment firms and competent authorities in EU Member States must comply with the IFD and IFR from 26 June 2021.

As the new EU regime only applies after the end of the transition period, the UK will not be bound by it, but the Treasury has explained that the UK played an instrumental role in the introduction of the regime at EU level, negotiated it as a Member State, and is supportive of its intended outcomes. The FCA has echoed this, stating that it believes introducing UK-specific rules intended to achieve the same overall outcome would be fully consistent with its statutory objectives and mission.

The Financial Services Bill will enable the majority of the new regime to be specified through rules made by the FCA. The Bill details the areas for which the FCA must introduce rules: for capital, liquidity, exposure to concentration risk, reporting, public disclosure, governance arrangements and remuneration policies.

In the first consultation paper to be published on IFPR, the FCA builds on the June 2020 discussion paper and sets out its proposals for aspects of the new regime relating to the categorisation of investment firms, prudential consolidation, own funds and own funds requirements, concentration risk monitoring and reporting requirements. The FCA intends to establish a new prudential sourcebook for the new regime – the prudential sourcebook for MiFID investment firms (MIFIDPRU) – and draft rules are appended to the consultation paper.

Categories of firms

Following the IFD and IFR, existing prudential categories of investment firms will fall away to be replaced by a simpler distinction between:

• small and non-interconnected investment firms (SNIs) that must satisfy criteria – set out in a draft MIFIDPRU 1.2 – in order to benefit from less onerous prudential requirements under the new regime; and
• all other investment firms that are neither subject to the CRD/CRR nor qualify as SNIs.

The reference to firms subject to the Credit Requirements Directive (CRD) and the Capital Requirements Regulation (CRR) covers systemically important investment firms and other non-systemic large investment firms that deal on own account and/or underwrite on a firm commitment basis. These firms will fall outside the new prudential requirements based on the IFD/IFR since they present risks more akin to those posed by large credit institutions.

The consultation paper also provides a helpful flowchart to assist firms in determining whether they may qualify as an SNI. The test turns on the nature of the MiFID activities carried out by the firm, whether the firm holds client money and/or safeguards client assets and quantitative thresholds taking into account the scale of the activities.

As for AIFMs or UCITS management firms with MiFID permissions (collective portfolio management investment, or CPMI, firms), the FCA's view in the discussion paper was that they should be subject to the same prudential requirements for their additional MiFID business as a MiFID investment firm would be for its MiFID business. The FCA has stated in the consultation paper that it will explain how its draft rules will apply to CPMI firms in a subsequent consultation.

Capital requirements

The definitions of the different classes of capital are taken from the CRR. However, the discussion paper noted some differences specified by the IFR. The consultation paper also confirmed that for investment firm that have not previously applied the CRR, the removal of the concept of Tier 3 capital (short-term subordinated debt), for example, will represent a change.

The levels of initial capital required for authorisation – £75,000, £150,000 or £750,000 – still depend on the investment services and activities an investment firm applies to undertake, but will represent an increase for many firms. However, the consultation paper does set out several transitional provisions to ease the move to the new regime.

The minimum own funds requirement under the IFR is the higher of:

• The permanent minimum requirement (PMR). This is the same as the initial capital the firm requires to be authorised with its current permissions.
• The fixed overheads requirement (FOR). The basic formula is currently the same as under the existing regime, but the IFR now applies the FOR to all investment firms. The consultation paper states that the FCA will cover how an FCA investment firm should calculate the FOR in a subsequent consultation.
• The K-factor requirement (KFR). This is an innovation of the IFR, based on the type and scale of the investment firm’s activities. A requirement is calculated for each activity and the sum of these is the KFR. For example, K-AUM (assets under management) is the K-factor requirement related to the risks associated with managing assets for clients, while K-CMH (client money held) is the K-factor requirement related to the risk of an investment firm causing potential harm to clients where it holds their money. The consultation paper only covers the K-factors that apply to investment firms that have permission to deal as principal and the remaining K-factors will be covered in a subsequent consultation.

However, where the investment firm is an SNI, the minimum own funds requirement is the higher of the PMR and the FOR only. That is not to say that SNIs can ignore the KFR, since it will be relevant to whether they remain under the relevant thresholds for classification as an SNI.

Other important  areas

Group risk: The discussion paper addressed consolidated supervision, in other words the rules looking beyond the investment firm to its wider group for prudential assessment purposes. An important change for firms to be aware of is the way obligations under the new regime may fall upon a potentially unregulated parent undertaking rather than the authorised subsidiary.

The consultation paper confirmed that prudential consolidation will apply where there is an investment firm group, except where the FCA has granted permission to that group to use the alternative group capital test. The application must satisfy the FCA that the investment firm group has a sufficiently simple structure to justify applying the group capital test and that there is no significant risk of harm to others that means that the investment firm group should be supervised on a consolidated basis.

The consultation paper sets out the FCA's proposals for where an entity should be considered a subsidiary or a connected undertaking and clarifies that rules which may apply directly to unregulated parent undertakings will catch a relevant parent undertaking only where it has a sufficient territorial connection to the UK.

Concentration risk monitoring: There will be specific concentration risk requirements which apply to the trading book exposures of an FCA investment firm that is dealing on own account, including an additional K-factor that could lead to an increased own funds requirement. There will also be new monitoring requirements for concentration risk that will apply to all FCA investment firms, including in relation to the location of client money, client assets, the firm's own cash deposits and the sources of its earnings.

Although reserved for subsequent consultation papers, the other key areas of the new regime set out in the discussion paper include:

Liquidity: Currently, not all UK investment firms need to meet quantitative liquidity requirements. The IFR sets minimum quantitative liquidity requirements for all investment firms and the discussion paper indicated that the FCA is willing to support a similar approach. The requirement is to hold an amount of certain types of liquid assets equivalent to at least one third of the amount of the FOR.

ICARA: The IFD introduces the internal capital and risk assessment (ICARA) process and the discussion paper made clear that, while on the face of it similar to the existing ICAAP, there are key differences. These include, for example, an increased focus on assessing adequate levels of liquid resources (including additional liquidity beyond what is set out as a minimum requirement under the new rules) and a new emphasis on wind-down planning.

Remuneration: A UK approach similar to the IFD would entail the deletion of the existing IFPRU (prudential sourcebook for investment firms) and BIPRU (prudential sourcebook for banks, building societies and investment firms) remuneration codes and non-SNI investment firms would be required to comply with a new domestic regime, which, among other things, is likely to entail a more restrictive approach to the principle of proportionality.

Looking ahead

While the Treasury's June update initially indicated that the UK will endeavour to introduce the new regime by summer 2021, in line with the application of the IFD/IFR, a joint statement from the Treasury, PRA and FCA in November 2020 named a revised target implementation date of 1 January 2022 following feedback from industry.

The FCA intends to publish two further consultations in 2021, at the start of Q2 and Q3, addressing the remaining areas of the new regime (including liquidity, risk management and governance, the ICARA and remuneration), consequential amendments to the Handbook, and any gaps or issues identified through the consultation process.

In the meantime, the discussion paper and first consultation paper remain a good starting point for assessing the main features of the changed prudential landscape which UK investment firms will need to learn to navigate.