Investment firms have very different business models and risk profiles to credit institutions. They facilitate savings and investment flows by providing professional services such as investment advice, portfolio management, trading in financial instruments and fund raising for companies. As they do not accept deposits or provide loans, they are generally not exposed to default risk, deposit withdrawals at short notice or bank-runs, which could lead to systemic knock-on effects.
As part of its Action Plan to strengthen the Capital Markets Union (CMU) in the European Union, the European Commission (EC) made a proposal on a bespoke regime for investment firms in 2017. This was because, due to the fundamental differences between banks and investment firms, the EC did not consider it sensible to apply the same requirements to them. The former prudential regime of the Capital Requirements Regulation and the Capital Requirements Directive (CRR/CRD) was designed primarily for banks.
More specifically, it was based on Basel standards designed for globally active systemically important banks with the objective of depositor protection and did not take into account the specific situation of investment firms. Accordingly, the former regime required most investment firms to comply with the prudential requirements set out in CRD3 or CRD4. Given that investment firms do not serve depositors that need to be protected, the former regime was not designed to take into account the risks posed by investment firms to their clients and the markets in which they operated. As a result, it was a source of excessive complexity and compliance costs for investment firms.
Following a lengthy consultation process, the European Parliament approved the new prudential regime for investment firms in December 2019. The new framework, which comprises the Investment Firms Regulation (IFR) and the Investment Firms Directive (IFD), applies to the Markets in Financial Instruments Directive (MiFID) investment firms across the EU from June 2021. This represents a significant reform in the EU regulatory framework for investment firms as the new prudential regime (“IFD/IFR”) has been designed specifically with investment firms and their business models in mind.
The new regime introduces complex and onerous requirements with respect to capital, liquidity, risk management, remuneration, group consolidation, disclosure, and reporting. In addition to changes in capital requirements through the new K-factor approach and the levels of initial capital required for authorization, the regime also applies liquidity requirements to investment firms across the board. It also deviates from the strictly services-based categorization under the MiFID II and introduces quantitative indicators known as K-factors that reflect the types of risks that the new prudential regime intends to address.
Compared to the former regime, specific rules set forth under the new regime are better aligned to investment firms’ business models, introducing radical changes to most firms in scope. While the regime contains numerous shortcomings particularly in the field of financial risk, it is generally expected to support well-functioning of capital markets by providing more risk-sensitive and proportionate prudential requirements for investment firms. The most significant impact of the regime has been on adviser/arranger firms (“BIPRU” firms and “Exempt CAD” firms) which saw a material increase in their capital requirements as well as having to comply with prudential consolidation and remuneration rules.
Given the IFR came into force after the end of the transition period for the United Kingdom (UK) leaving the EU, it did not apply in the UK. However, the Financial Conduct Authority (FCA) was a key driver in the development of IFR and had long advocated for a bespoke prudential regime for investment firms. Furthermore, it was heavily involved in the policy discussions at the EU level, while the UK stakeholders had contributed significantly to the relevant consultation processes. Therefore, although the UK left the EU in January 2020, the FCA has adopted the Investment Firms Prudential Regime (IFPR), a substantially similar regime. While the IFPR is quite similar to the IFR/IFD, it includes certain amendments to account for the specifics of the broad range of UK investment firms in terms of their number and size, as well as the nature of the UK market structure and how it operates.
Divergence of the UK version of the regime from the IFR/IFD raises the possibility of regulatory arbitrage which could undermine the effectiveness of the new framework, cause unlevel playing field between the UK and the EU investment firms, trigger a race to the bottom and jeopardize the stability of the European financial markets.
Regardless of the reasons for and the extend of divergence between the two versions, any differences between the two EU and the UK versions of the new prudential regime are worth investigating, particularly given that the UK represents by far the largest market in Europe with a diverse group of around 3,600 investment firms in the UK that serve consumers with products including workplace or personal pensions, investment ISAs and platform for trading stocks.
In the UK, the new regime applies to all MiFID investment firms including IFPRU investment firms, BIPRU firms, exempt-CAD firms and Collective Portfolio Management Investment Firms (CPMIs). These firms provide a range of services and activities to investors in financial markets, which are essential for the functioning of the financial markets and include, among others, the reception and transmission of orders, the provision of investment advice, discretionary portfolio management and trading on own account. The UK regime labels the systemically important investment firms as “PRA designated investment firms” and subject them to the supervision of the Prudential Regulation Authority (PRA).
Excluding the UK which is now a non-EU country, there are around 4,500 investment firms in the EU, most of which are small to medium-sized companies with unsophisticated business models. The majority of these investment firms focus on offering investment advice, receiving, transmitting and executing orders, and managing portfolios. Together with the Alternative Investment Fund Managers Directive (AIFMD) and Undertakings for the Collective Investment in Transferable Securities (UCITS) firms that undertake MiFID activities and services, the total number of investment firms in the EU exceeds 5,700 firms.
In some countries investment firms predominantly operate a multilateral trading facility, while others only perform deals on own account and do not hold client funds or securities of external clients. Apart from the absolute dominance of the UK-based investment firms in all types of services provided, for majority of the remaining firms, the main jurisdictions in Europe are Germany, Netherlands, Cyprus and France.
A significant number of systemically important large investment firms continue to be headquartered in the UK despite the country’s departure from the EU. However, most of the UK-based investment firms have relocated certain parts of their operations to the EU Member States in order to preserve EU market access post Brexit. These firms control around 80% of all investment firm assets in the EU.
In finalizing the IFPR, the FCA’s baseline approach has been consistency with the EU regime, the IFPR takes into consideration the specifics of the UK market. The regime streamlines and simplifies the prudential requirements for solo FCA-regulated investment firms in the UK. While the IFPR diverges from the IFR/IFD in several key aspects, particularly in terms of the scope of the regime and the application of proportionality, the FCA expects the IFPR to achieve the same overall prudential outcomes as the IFD and IFR.
Categorization of firms
The IFR/IFD has introduced a new classification system for investment firms, based on their activities, systemic importance, size and interconnectedness. The UK framework deviates from the EU rules as the UK systemic investment firms are not required to be re-authorized as credit institutions. In addition, investment firms as a group are not subject to CRD V or any subsequent update to the EU banking regime.
Under the EU version, on the other hand, systemic investment firms (Class 1A) are required to be re-authorized as credit institutions under CRR, with the exception of commodity and emission allowance dealers, collective investment undertakings or insurance undertakings. This category comprises systemic investment firms or investment firms that are exposed to the same types of risks as banks to which the full CRR/CRD applies. This requirement applies to firms that meet certain criteria.
Among other changes, the IFR amends the definition of credit institution laid down in the CRR, capturing investment firms that carry out certain MiFID activities, namely dealing on own account and underwriting/placing of financial instruments on a firm commitment basis, and at the same time where either (i) the total value of consolidated assets is equal to or more than €30 billion; (ii) the firm is part of a group where at least one other investment firm also carries out the above MiFID activities and each individual investment firm has a total value of consolidated assets of less than €30 billion; or (iii) the firm has a total value of assets less than €30 billion, but is part of a group that includes another investment firm that also carries out the above MiFID activities with a total value of the consolidated assets of equal to or more than €30 billion, where the relevant supervisory authority decides to require the first investment firm to also become subject to the CRR.
However, certain firms remain authorized under MiFID but are subject to CRR, with the exception of commodity and emission allowance dealers, collective investment undertakings or insurance undertakings. This means that are not required to be authorized as a credit institution under CRD. Under the IFR/IFD, investment firms with assets of at least €15 billion remain subject to the CRR/CRD framework like banks. These firms remain as investment firms and are referred to as Class 1B.
The criteria for defining Class 1B firms captures firms dealing on own account and underwriting/placing of financial instruments on a firm commitment basis, and/or where either (i) the total value of consolidated assets is equal to or more than €15 billion; (ii) the firm is part of a group where at least one other investment firm also carries out any of the above MiFID activities, each firm has a total value of consolidated assets of less than €15 billion, but where the total value of the consolidated assets of these investment firms is equal to or more than €15 billion; or the relevant supervisory authority requires the firm to be subject to the prudential requirements of the CRD/CRR.
Supervisory authorities are allowed to apply the CRR/CRD framework to systemically important investment firms with assets worth at least €5 billion. More specifically, the IFD gives competent authorities the discretion to require firms that carry out any of the aforementioned MiFID activities and where the total value of consolidated assets does not exceed €15 billion to apply the CRR, depending on a systemic risk assessment. As an exception, a derogation introduced under the IFR allows the competent authority to use discretion in the case of investment firms that carries out any of the above MiFID activities to subject them to the CRR, regardless of the value of their consolidated assets, provided that they are included within the consolidated supervision of a credit institution under CRR.
Class 2 firms are subject to the full scope of the regime as they comprise non-systemic investment firms that do not carry out dealing on own account or underwriting activities. On the other hand, the new framework categorizes small and non-interconnected firms as Class 3 firms, applying less stringent rules commensurate with the level of risks that they pose to markets. However, all in-scope firms are required to measure and report against the new thresholds.
In the UK, on the other hand, the Class 1A categorization was not adopted and the pre-existing “designation regime” was preserved. This means that certain investment firms that are considered to be systemically important in the UK are authorized and regulated by the PRA. The UK version of the regime classifies systemic investment firms as “PRA designated investment firms” and subject them to regulations equivalent to the CRR and the PRA Rulebook. This means that, while in the EU those firms that should be subject to the prudential requirements of the CRD/CRR are determined based on certain size thresholds and certain MiFID activates, in the UK this is subject to the PRA’s discretion as per its assessment of the systemic importance of firms, and not based on any quantitative thresholds or predetermined criteria.
While the IFR/IFD introduces proportionality where the prudential requirements scale with the size and complexity of the firm, the UK version provides additional proportionality for firms for the smallest and least complex investment firms in terms of the calculation of prudential requirements, but also disclosure and remuneration rules. The FCA has introduced two broad categories of FCA investment firms, namely small and non‑interconnected (SNI) firms and non‑SNI firms. Accordingly, their prudential requirements are designed to scale with their size and complexity.
Firms are classified either as SNI or not, where SNI firms correspond to Class 2 firms under the EU version of the new regime. Under the IFPR, firms that do not carry out activities that have the potential to cause harm to its customers or to the markets in which it operates, and those firms that do not carry out any activities on such a scale that would cause significant harm to customers or to the markets in which they operate are classified as SNIs. On the other hand, firms that deal on its own account, whether for itself or on behalf of clients, and therefore have the potential to cause particular harm to traded markets are classified as a non-SNI.
Similar to the EU version, the IFPR introduces quantitative thresholds, in addition to the requirement that the FCA investment firm must not be permitted to deal on own account, to ensure that those investment firms with potential to cause greater harm do not take advantage of the less onerous requirements. These thresholds are assessed on a group basis, taking account of the MiFID activities of the relevant firms.
Under the IFPR, in order to classify as a SNI an investment firm should meet all of the quantitative criteria listed in Table 2 and should not have permission to deal on own account. In practice this means that, to be classified as an SNI, a firm must not hold client assets or client money. It must also satisfy other activity-related criteria and stay under certain assets under management, balance sheet, earnings and other thresholds. For instance, assets under management must be less than £1.2 billion, balance sheet size must be less than £100 million and total annual gross revenue from investment services must be less than £30 million. Group consolidation also matters as thresholds are applied on a group basis. The thresholds are consistent with those implemented in the EU, where the numerical thresholds are the same but are denominated in euros.
Liquidity
In order to ensure that investment firms have sufficient resilience to sudden liquidity shocks and can continue to function or otherwise exit the market without disruption, the new regime introduces for the first time minimum quantitative liquidity requirements to investment firms. Accordingly, firms in scope are required to hold an amount of certain types of liquid assets, such as central bank exposures, national government claims and high quality covered bonds, equivalent to at least one third of the amount of their FOR. Under the former regime the FOR was applicable only to a subset of investment firms. The IFR requires all investment firms to calculate their FOR. Firms in scope are also required to consider their liquidity as part of an internal capital adequacy and risk assessment (ICARA) process.
The IFR/IFD allows certain investment firms, which are not exposed to liquidity risk because of their size or the nature of their activities to be exempted from the liquidity requirements subject to the approval of the competent authority. Nonetheless, this exemption is contingent on certain conditions. For instance, the regime allows competent authorities to exempt only investment firms that meet the conditions for qualifying as Class 3 investment firms. In addition, the firm should be included in the supervision on a consolidated basis in line with the CRR or the IFR. Also, it should have a parent undertaking that, ensures sufficient liquidity on a consolidated basis for all firms within the group, including any sub-groups that have an exemption. Besides, the free movement of funds between the parent undertaking and the investment firm should be secured legally by contracts, subject to supervisory approval.
While it is true that small and non‐interconnected investment firms do not hold clients’ assets, sufficient level of liquidity is needed to ensure that an investment firm maintains a sufficient level of liquid assets for its potential orderly wind-down. The EBA published guidelines in 2022, specifying the criteria under which competent authorities may exempt SNI investment firms from liquidity requirements. The guidelines specify that the exemption should be based on the assessment of liquidity needs also taking into account an orderly wind-down of the investment firm. In order to decide whether to exempt an investment firm from the liquidity requirements, the competent authority should perform the minimum review set out by the EBA’s guidelines.
In the UK, the IFPR applies a stricter approach than the EU by requiring SNIs to comply with the basic liquid assets requirement. The IFPR applies this requirement to all investment firms, invalidating any existing intragroup waivers or modifications granted under BIPRU, in order to ensure all investment firms have a minimum stock of liquid assets at all times to be used in the event of a wind-down. Hence, the FCA considers it prudent for all FCA investment firms to hold a minimum amount of core liquid assets to allow firms to fund the initial stages of an orderly wind-down.
Likewise, the FCA requires all firms to have internal procedures to monitor and manage their liquidity requirements. In practice, this means that the UK investment firms are required to hold certain types of liquid assets to an amount of at least a third of their fixed overhead requirement, plus 1.6 per cent of any guarantees given to clients, with hair-cut applying to certain assets. Furthermore, the UK strict definition of liquid assets means that UK firms are required to meet liquidity rules with either cash or highly liquid assets.
Remuneration
Aiming to ensure that all investment firms have in place remuneration policies that promote effective risk management, the remuneration regime under IFR/IFD is based on the same core remuneration principles as CRD, where investment firms were subject to the CRR/CRD remuneration requirements as credit institutions. However, the new regime creates remuneration rules proportionate to the size and nature of firms, discouraging excessive risk-taking and promoting effective risk management.
Under the EU version of the regime, Class 1 firms are subject to the CRD IV’s remuneration requirements whereas Class 3 firms are exempt from the remuneration requirements. On the other hand, Class 2 firms are required to apply specific requirements to their Material Risk Takers (MRTs) including variable pay in instruments, deferral of a proportion of variable pay, malus and clawback. They are also required to publicly disclose certain aspects of their remuneration policy and may need to establish a remuneration committee.
The UK version is based on the IFD provisions and generally mirror the structure of the existing remuneration codes. However, some aspects of the IFPR remuneration rules differ from the EU version as it is tailored to reflect the characteristics of the UK investment firm landscape as finalized by the policy statement (PS21/9) and legal instrument. The new remuneration rules are set out in the FCA’s single remuneration code “the MIFIDPRU Remuneration Code”.
The Code introduces remuneration requirements for most “exempt-CAD firms” for the first time, for BIPRU firms the impact will depend on the firm’s classification. Hence, the biggest impact has been on the non-SNI investment firms that were not required to apply the BIPRU Remuneration Code (SYSC 19C) and “exempt CAD” firms that find themselves classified as non-SNI firms under the IFPR regime.
The new Code introduces a single remuneration code for all FCA investment firms, requiring them to have clearly documented remuneration policies and practices that meet minimum standards. For instance, they are required to make a clear distinction between the criteria applied to determine fixed and variable remuneration. Identification of risk takers and the pay-out rules, also require considerable implementation effort.
The Code comprises “basic”, “standard” and “enhanced” remuneration requirements depending on whether the firm is classified as SNI, non-SNI or large non-SNI firm, respectively. This means that, for remuneration purposes, non SNIs are further divided into small and large non SNIs. As a major deviation from the EU version, SNI firms are subject only to the basic remuneration requirements under the new Code. In the EU, the IFD does not apply similar remuneration requirements to equivalent firms established in the EU. Instead these EU firms remain subject to the remuneration principles implemented by MiFID II.
This means that non-SNI investment firms are required to meet the basic and standard remuneration requirements set out in the IFD with the exception of applying deferral and establishing a remuneration committee. For large non-SNIs, enhanced remuneration requirements apply. These include requirements to establish a remuneration policy, identify MRTs, specify a ratio of fixed to variable pay, apply malus and clawback, apply deferral and establish a remuneration committee. A non-SNI firm that does not exceed the financial thresholds will be subject to the basic remuneration requirements and certain additional requirements (“standard remuneration requirements”). For non-SNI firms exceeding the financial thresholds certain additional rules such as deferral of variable remuneration, payment in instruments, retention periods and certain rules relating to discretionary pension benefits apply. (“extended remuneration requirements”).
Non-SNI investment firms in an investment firm group are required to apply the IFD remuneration requirements on an individual and consolidated basis where prudential consolidation applies, or on an individual basis where the competent authority has allowed an investment firm to apply the GCT. On the other hand, SNIs are exempted from the remuneration requirements of the IFD on an individual basis with the exception of a requirement to establish a remuneration policy.
Remuneration requirements also do not apply to an investment firm group that contains SNI investment firms but no non-SNI investment firms. However, where an SNI investment firm is part of an investment firm group that includes a non-SNI investment firm, and that group is subject to prudential consolidation, then the SNI investment firm applies the IFD remuneration requirements as part of the consolidation. Furthermore, if an investment firm group contains investment firms that remain authorized under MiFID but subject to the prudential requirements of the CRD/CRR, they are required to apply the CRD remuneration requirements on both an individual and consolidated basis. On the other hand, non-SNI investment firms in the same group are required to apply the IFD remuneration requirements on both an individual and consolidated basis.
Prudential Consolidation
Prudential consolidation requires an investment firm which is part of a group to consider and manage its risks it may be exposed to due to its membership of that group. In principle investment firms are subject to regulatory requirements individually. However, under prudential consolidation those requirements are also applied on the basis of the position of a firm’s wider “consolidation group”. From a financial stability perspective, consolidated supervision is considered a very important complement to solo supervision of investment firms.
While the scope and composition of a consolidation group under the new regime are determined in a very similar way to that under the CRR, the former introduces the concept of an “investment firm group”, which does not include credit institutions. Under the new regime, investment firm groups can be prudentially consolidated in a similar way to the process under CRR. However, unlike in the case of the CRR, the IFR prudential consolidation applies regulatory requirements directly on in-scope parent undertakings so that they have to meet regulatory obligations.
In essence, prudential consolidation treats the whole investment firm group as an investment firm, to which relevant requirements are applied on the basis of the position of its wider consolidation group. In the case of investment firm groups where at least one is an EU investment firm and which does not contain a credit institution, consolidation regime is triggered if there is a relevant consolidating entity at the top of an EU investment firm group. Furthermore, under the new regime, the obligations in the case of a prudential consolidation falls upon parent undertakings, including an investment firm where it is a parent undertaking, rather than the investment firm.
As a result, parent undertakings which may otherwise be unregulated are required to meet regulatory obligations. Also, consolidated own funds requirements are determined on the basis of a consolidated permanent minimum requirement, consolidated fixed overheads requirement and a consolidated K-factor requirement. Furthermore, in addition to consolidated own funds requirements, a prudential consolidation also includes the provisions of liquidity, concentration risk, disclosure and reporting.
The regime does not apply to an investment firm group which also includes a credit institution as this would trigger the application of prudential consolidation for a banking group by that credit institution under the provisions of the CRD/CRR. The objective is to avoid the need for double consolidation of the same set of entities by both an investment firm under IFR and a credit institution under CRR. However, this does not apply where there is an investment firm subject to the IFR and another investment firm subject to the CRR but no credit institution in the same group, which would still meet the definition of an “investment firm group”.
In the UK, on the other hand, prudential consolidation applies where this is an investment firm group which comprise of UK parent, subsidiaries, connected undertaking, investment holding or mixed financial holding company. In order to consider the UK parent and all the relevant entities within the group as a single FCA investment firm and to apply certain requirements as they would apply to an FCA investment firm on an individual basis, at least one entity is required to be an FCA investment firm, regardless of whether it is the parent or a subsidiary.
The UK parent can be an investment holding company or a mixed financial holding company. However, an FCA investment firm group is not allowed to include a UK credit institution. If it does, the prudential consolidation of the group is subject to the UK CRR. Should an investment firm group contains both a PRA-designated investment firm and an FCA investment firm, group may be subject to consolidation under both the UK CRR and the IFPR, which requires the firm to meet the consolidated requirements under both regimes.
A parent undertaking is required to be included if it is incorporated in the UK or has its head office registered in the UK to ensure that parent undertakings taking shape of various structures are captured by consolidation. Those connected undertakings that are not subsidiaries are also considered as FCA investment firm group, unless the relevant subsidiary or connected undertaking is a UK credit institution.
In derogation of the standard method of prudential consolidation the new regime may permit investment firms to calculate their group-level capital requirements based on the Group Capital Test (GCT) if group structures are sufficiently simple, and provided that there are no significant risks to customers or to the market stemming from the investment firm group as a whole that would otherwise require supervision on a consolidated basis. This serves as an alternative to prudential consolidation to ensure a stable group capital structure, preventing excessive leverage and gearing within group structures.
The GCT provides firm by firm relief from some prudential consolidation requirements and is more appropriate in the case of investment firm groups otherwise subject to the prudential consolidation provisions. However, it is not a substitute for appropriately capitalizing parent companies. The GCT alternative is available only if the investment firm group has a sufficiently simple structure and there is no significant risk of harm to others. In the event that there are material connected undertakings in an FCA investment firm, the FCA is unlikely to allow the GCT option.
So what?
The regulatory environment for investment firms in Europe has recently changed significantly with the implementation of the IFR/IFD and the subsequent introduction of its UK version, the IFPR. These two versions of the new prudential regime for the European investment banks have collectively created more proportionate and risk-sensitive rules for investment firms in Europe. Therefore, it represents a significant reform in the EU regulatory framework and has had a material impact on the investment firm landscape in Europe.
Given the size of the UK investment firm sector compared to the rest of Europe, any divergence in the regulations may result in inter-jurisdiction regulatory arbitrage, as well as causing an uneven playing field for certain investment firms in terms of regulatory compliance burden and competition. As this article has identified, diverging regulatory frameworks may tilt the playing field towards either the UK or the EU investment firms depending on whether we focus on categorization, remuneration or liquidity rules.
This has important policy implications because intensifying competition between the EU and the UK firms may in the future trigger a race to the bottom as suggested by the competition-view of regulatory arbitrage, which may result in firms shifting activities from a more strictly regulated sector to more lightly regulated financial sector depending on which rules they find costlier and more challenging to comply with.
Indeed, the UK regime is likely to diverge from the IFR/IFD given its independent status after Brexit. For instance, when setting the deadline for the implementation of the IFPR, the UK had given UK firms 6 months extra time to comply with the new framework compared to the EU, which tilted the playing field temporarily towards the UK firms. This marked a milestone which could be indicative of the future regulatory divergence between the UK and the EU.
This raises the question of whether the UK authorities would be open to relaxing certain rules under the IFPR in the future. This is not a hypothetical question because the UK regulations are already expected to gradually move further away from a prescriptive, rules‑based system towards an outcomes‑based system where there is more scope for applying supervisory judgement and interpretation.
Although it seems unlikely that the UK regulators would diverge significantly from the international standards, they may of course use their post-Brexit autonomy to revisit certain parts in the future to ensure a better fit for the UK banks and investment firms. This may result in a fragmented regulatory framework for investment firms in Europe and create regulatory arbitrage opportunities. The UK regulators should carefully weigh the pros and cons of diverging too much from the EU framework noting that this may undermine the effectiveness of the new prudential regime for investment firms.
