Which firms?
There are over 6,500 investment firms in the EU under the MiFID and the majority are in the UK. The new regime puts all these firms into one of three classes.
Class 1
These are large systemic investment firms which take on principal trading risk and have assets over €15 billion; they will remain subject to the current CRD/CRR regime as their risk profiles are considered to be similar to those of significant credit institutions. Very large Class 1 firms with total assets over €30 billion will even be treated, and be required to apply for authorisation, as credit institutions. Commodity and emission allowance dealers are excluded from Class 1 - these are firms which undertake a main business which is exclusively providing services or engaging in activities in relation to certain MiFID commodity derivatives contracts and emissions trading. In addition, investment firms which are part of banking groups will be allowed (subject to regulatory approval) to continue to apply the CRD/CRR regime.
Class 2
These are firms which do not meet the large firm test for Class 1 or the small firm test for Class 3 (see below). They will be broadly subject to the full range of new measures under the IFD/IFR regime.
Class 3
Small firms are seen as lower risk and so are subject to a reduced burden under the new regime relative to Class 2 firms. The following conditions must all be met in order to qualify:
- Client money held is zero.
- Assets safeguarded and administered are zero.
- Assets under management (AUM) are less than 1.2 billion.
- Client orders handled (COH) are less than €100 million a day (cash trades) or €1 billion a day (derivatives).
- Principal trading (known as daily trading flow) is zero.
- Trading book position is zero.
- Clearing margin given is zero.
- Trading counterparty default exposure on OTC derivatives (and various other trade types) is zero.
- Balance sheet (on and off) total is less than €100 million.
- Total annual gross revenue from investment services/activities is less than €30 million (average of previous two years).
Note that the conditions for AUM, COH, balance sheet size and annual gross revenue are applied on a combined basis for all investment firms that are part of the same group (this is to reduce the incentive for groups to restructure operations between multiple entities); the other conditions are applied on an individual entity basis.
What are the capital requirements?
There is a permanent minimum capital requirement (PMCR) of €750,000, €150,000 or €75,000 which applies to firms in Class 2 and 3 depending on their activities.
Firms which are authorised to take principal risk are subject to a PMCR of €750,000. Those which are not authorised to take principal risk, do not operate a trading facility (multilateral or organised) and do not hold client money/assets are subject to a PMCR of €75,000. All other firms have a PMCR of €150,000.
Class 3 firms are subject to the PMCR as an absolute minimum but their own funds requirement will be higher if the fixed overheads requirement (FOR) exceeds this figure. The FOR is calculated as one quarter of the fixed overheads in the preceding year.
Class 2 firms have an own funds requirement which is the higher of the PMCR, FOR and K-Factor Requirement.
The K-Factor Requirement is one of the biggest changes in the new regime and applies a series of percentages to specific risks, including: risk to client (AUM, client money held, assets safeguarded and administered, and daily trading flow); risk to market (net position risk or clearing margin given); and risk to firm (trading counterparty default, daily trading flow and concentration risk).
Another big change is the imposition of the FOR at one quarter of fixed overheads on all firms that are subject to the new regime. This will hit many firms, such as those which are currently classified as exempt CAD (certain advisers/arrangers) and other firms which enjoy a €50,000 flat capital requirement under the CRD/CRR regime.
What counts as capital?
Own funds will comprise Common Equity Tier 1 capital (CET1), Additional Tier 1 capital (AT1) and Tier 2 capital (T2) - these definitions will continue to follow the CRD/CRR regime. As a proportion of the own funds requirement, CET1 must be at least 56 per cent, and CET1 plus AT1 must be at least 75 per cent. This means that subordinated loan and other T2 capital can amount to no more than 25 per cent of a firm's own funds when meeting its own funds requirement.
When?
The IFD/IFR were published in the Official Journal on 5 December 2019; the new regime will take effect from 26 June 2021.
Comment
There are likely to be several firms which see a significant increase in their capital requirements as a result of the new regime. One clue to the potential impact can be found in the transitional provisions, which are designed to limit the impact for firms for which "own funds requirements...would more than double". Broadly, the transitional provisions limit the own funds requirements under the new regime to twice what they were under the CRD/CRR regime (for a period of five years).
Firms should take action to ascertain the class into which they will be categorised and calculate the likely impact on their capital requirements. In addition, firms should note that there are likely to be further significant developments when the technical standards and guidance are released. The technical standards will clarify such matters as: the scope and methods for prudential consolidation; the calculation of fixed overheads; and measuring the K-factors and other matters where detail will be important. In the UK, other points to consider include the impact of Brexit and also the Financial Conduct Authority's consultation on implementation (which should follow shortly now that the IFD/IFR have been published in final form).
Client Alert 2019-284
