*Note: This Update replaces our earlier Update dated January 30, 2018, on the original proposal for this new EU investment firm prudential regime.
On April 16, 2019, the European Parliament voted in its plenary session to adopt the text agreed by the European Commission (EC), the European Parliament and the Council of the EU on February 26, 2019, on a new legislative package revising the prudential framework for EU investment firms. This will take the form both of the Investment Firm Regulation (the IFR) and the Investment Firm Directive (the IFD).
The new IFR/IFD framework is expected to come into effect in Q4 2020 or Q1 2021, depending on the timing of publication of the text of the IFR/IFD in the Official Journal of the European Union — that is, after the UK leaves the EU, based on the Brexit schedule at the time of publication.
Core Features of the IFR and IFD — Capital and Remuneration
At present, investment firms in the EU are subject to a prudential framework established under the Capital Requirements Regulation and Capital Requirements Directive (CRR/CRD IV). In the UK, such firms would typically be either BIPRU1 firms or IFPRU2 firms.
The IFR/IFD package aims to create a common prudential framework that is more sensitive to the particular risks faced by investment firms than the current CRR/CRD IV framework and is intended to apply on a consolidated group basis. The new requirements are calibrated depending on the size and nature of the firm and results in systemically important investment firms’ being subject to the same prudential framework as credit institutions under CRR/CRD IV, while the remaining investment firms will be subject to tailored capital requirements, including some based on new K-factors.
In addition, the IFR/IFD revises the existing remuneration framework for investment firms, which may result in more firms being captured, and to a greater extent, than under the existing remuneration rules.
Finally, the new framework features an amendment to the recently “recast” Markets in Financial Instruments Directive (MiFID II) to ensure that third-country “equivalence” decisions will have to take into account the new IFR/IFD prudential framework.
What is an “Investment Firm?”
The IFR/IFD package defines an “investment firm” to mean an EU investment firm as defined in MiFID II. Accordingly, “investment firm” would exclude EU credit institutions but include EU securities firms/broker-dealers, custodians and investment managers.
Regarding investment managers, MiFID II only captures those that provide individual, as opposed to collective, portfolio management services. Accordingly, investment management firms that are authorized as alternative investment fund managers (AIFMs) under the EU Alternative Investment Fund Managers Directive (AIFMD), or as Undertakings for the Collective Investment in Transferable Securities (UCITS) management companies (UCITS ManCos) under the UCITS Directive, fall outside the scope of the IFR/IFD.
The new framework set out in IFR/IFD effectively results in investment firms being divided into three classes, each class capturing different risk profiles:
- Class 1 – systemically important investment firms
- Class 2 – non-systemically important investment firms above
- Class 3 – small and noninterconnected investment firms below the Class 1 and Class 2 thresholds
A specific group capital requirement would apply to groups containing only investment firms, with the parent company required to ensure sufficient capital to support its holdings in its investment firm subsidiaries.
Note that the IFR/IFD do not refer to “classes” of firms as such, but the European Commission FAQ published at the time of the proposal for the IFR/IFD refer to such classes, and the IFR/IFD package is easier to follow by using this classification.
Class 1 Firms — Systemically Important Investment Firms
A Class 1 firm is an investment firm that engages in underwriting services or deals on its own account (i.e., trades on its proprietary capital) and that meets the following criteria:
- The total value of its assets exceeds €15 billion,3
- it is part of a group in which the combined total value of assets of group entities dealing on own account or underwriting are individually below €15 billion but collectively exceed €15 billion or
- the total value of its assets exceeds €5 billion and, at the discretion of supervisors, classification as a Class 1 firm has been deemed necessary to address certain financial stability or market risks or because the firm is a clearing member of a central counterparty (CCP).
Class 1 firms will be subject to the prudential and disclosure requirements under the CRR/CRD IV framework. Given that Class 1 firms must “deal on own account” (i.e., trade using proprietary capital), typical investment managers that manage only their clients’ (rather than their own) assets would not be Class 1 firms.
In essence, Class 1 firms with total asset value exceeding €30 billion (or those that are part of a group in which the combined total value of assets of group entities dealing on own account or underwriting are individually below €30 billion but collectively exceed €30 billion) will be required to seek authorisation as credit institutions under CRR/CRD IV, becoming directly subject to the CRR/CRD IV capital framework, including supervision under the EU banking supervisory framework.
Note that, at the same time as adopting the IFR/IFD, the European Parliament voted to adopt amending texts to CRR/CRD IV, which will then become CRR II/CRD V. Most of the operative provisions of CRR II/CRD V are likely to become law in EU member states in Q2/Q3 2021.
Given that Class 1 firms will be subject to the CRR/CRD IV framework, the rest of this Update will focus on Class 2 and Class 3 firms.
Class 2 Firms — Nonsystemically Important Investment Firms Above Certain Thresholds
A firm would be a Class 2 firm where it falls above any of the following thresholds:
- assets under management (AUM) under both discretionary portfolio management and nondiscretionary (advisory) arrangements higher than €1.2 billion
- client orders handled (COH) of at least €100 million per day for cash trades and/or at least €1 billion per day for derivatives
- on- and off-balance sheet total higher than €100 million
- total gross revenues higher than €30 million
- exposure to risks from trading financial instruments (daily trading flow or DTF) higher than zero
- exposures to risks from centrally cleared or margined portfolios higher than zero
- counterparty credit risk under non-centrally-cleared over-the-counter (OTC) derivatives transactions higher than zero
- client assets safeguarded and administered (ASA) higher than zero
- client money held (CMH) higher than zero
The calculation of AUM excludes any assets the management of which has been delegated to the investment firm by another financial entity. While, unhelpfully, “financial entity” is not defined by the IFR, it would appear to include both EU and non-EU financial entities. If so, then it would appear that, for example, an EU subadviser/delegate of a U.S. investment manager would have an AUM of zero for purposes of the above AUM threshold.
The calculation of COH is to exclude transactions handled by the investment firm that arise from servicing of a client’s investment portfolio where the investment firm already calculates K-AUM in respect of that client’s investment or where this activity relates to the delegation of management of assets to the investment firm by another financial entity.
Note that, in relation to CMH, the reference is to client money that an investment firm actually “holds.” The EC’s original proposal had referred to a firm that “holds or controls” client money, which would have included many investment managers who, notwithstanding that they did not hold client money, could control client money (e.g., by directing a custodian to invest a client’s cash). Class 2 is likely to be relevant for many investment managers, although note that Class 2 would also include firms that deal on own account or engage in underwriting activities but are below the Class 1 thresholds.
The minimum capital requirement for Class 2 firms is set either as for Class 3 firms (see below) or according to the new K-factor approach for measuring risks (the K-factor requirement), whichever is higher. The K-factors specifically target the services and business practices most likely to generate risks to an investment firm, to its customers and to counterparties and, largely, correspond to the individual factors used to distinguish between Class 2 and Class 3 firms (e.g., AUM, COH, DTF, etc.).
The K-factor requirement is calculated as the sum of each K-factor multiplied by the relevant coefficient prescribed by the IFR (e.g., for K-AUM, the coefficient is 0.02 percent).
Class 3 Firms — Small and Noninterconnected Investment Firms Below the Class 1 and Class 2 Thresholds
As noted above, a Class 3 firm is any firm not meeting the above Class 1 and Class 2 thresholds.
The minimum capital requirement for Class 3 firms is the higher of the base capital resource requirement or a quarter of fixed costs (overheads) for the previous year.
Staggering of the Increase to the Base Capital Resource Requirement
The base capital resource requirement increases to €750,000 for firms that deal on own account or underwrite and/or place financial instruments on a firm commitment basis. For other investment firms, it will be €75,000.
The base capital resource requirement will be subject to incremental increases for a period of five years from the date of application of the IFR with respect to Class 2 and 3 firms (after which the capital requirements of the new framework will apply). In broad terms, the capital resource requirement increases by €5,000 per year for five years, so that the base capital resource requirement increases from the current requirement of €50,000 to the new €75,000 base capital resource requirement.
Most UK subadvisers and single managed account managers that are MiFID firms are currently subject to a base capital resource requirement of €50,000 (with their overall minimum capital resource requirement currently being the higher of their base capital resource requirement or a quarter of their annual fixed overheads). However, as a quarter of their annual fixed overheads usually exceeds their base capital resource requirement, the staggering of the increase to the base capital resource requirement under the IFR is likely to prove inconsequential.
Summary of Classes of Investment Firms
The above may be summarized as follows:
|Class 1||Class 2||Class 3|
Remuneration and Governance
The IFD includes remuneration and governance rules based on CRR/CRD IV and MiFID II. However, unlike the CRR/CRD IV framework, the IFR/IFD does not include any requirement for a bonus cap.
Remuneration — Class 2 Firms
The IFD remuneration framework for Class 2 firms follows, broadly, the framework set out in CRR/CRD IV. That is, for senior managers and those in risk-taking and control functions (and certain other highly paid roles), Class 2 firms will need to implement policies with clear criteria for determining “appropriate” fixed to variable remuneration ratios. In addition, variable remuneration would be subject to certain restrictions, including
- Noncash element — At least 50 percent of variable compensation must consist of shares, share-linked instruments, noncash instruments of a type managed by the firm or certain capital instruments of the firm (or approved alternatives for firms that do not issue such instruments).
- Deferral — At least 40 to 60 percent of variable compensation must be deferred over a three- to five-year period.
- Malus/clawback — Up to 100 percent of variable compensation must be subject to malus/clawback arrangements.
Remuneration policies must be gender neutral.
These restrictions, which are similar to those in the AIFMD and UCITS Directive are sometimes referred to as “payout process” rules.
In addition, there are specific restrictions regarding discretionary pension benefits, including that benefits must be in the form of shares or sharelike/convertible instruments and subject to a five-year retention period.
In keeping with the “proportionality” principle of the existing remuneration framework applicable to investment firms (and indeed under the AIFMD and UCITS Directive), IFR/IFD provides that remuneration policies should be proportionate to the size, internal organization and nature, as well as to the scope and complexity, of the activities of the investment firm. Additionally, the noncash element, deferral and discretionary pension benefits rules above (but not the malus/clawback rules) does not apply to
- an investment firm with on- and off- balance sheet asset values of €100 million or below (based on a four-year lookback)
- an individual whose annual variable remuneration does not exceed €50,000 (and does not represent more than a quarter of the individual’s annual total remuneration)
EU member state regulators do have the discretion nonetheless to impose the noncash, deferral and discretionary pension benefits rules even where the above factors apply and, similarly, to increase the €100 million threshold in circumstances where the investment firm meets certain other conditions.
Other requirements include the following:
- Investment firms with on- and off-balance sheet assets over €100 million over a four-year period will need to establish a remuneration committee.
- Investment firms will need to publicly disclose detailed remuneration information; see “Disclosure and Reporting” below.
- Member state regulators will be able to require an investment firm to limit variable compensation as a percentage of net revenues where that remuneration is inconsistent with the maintenance of a sound capital base.
Finally, note that firms continue to be subject to the remuneration framework set out in MiFID II, as MiFID II applies to all investment firms. The remuneration framework under MiFID II is aimed at ensuring that remuneration structures for sales staff do not incentivize those staff to recommend products that do not reflect clients’ needs.
Remuneration — Class 3 Firms
Class 3 firms are not subject to the IFR/IFD remuneration framework applicable to Class 2 firms. Rather, they would be subject solely to the existing MiFID II remuneration framework.
Other Prudential Requirements
The IFR/IFD also contains other rules for Class 2 firms relating to risk management, liquidity risk and concentration risk. Class 2 firms with on- and off-balance sheet assets over €100 million over a four-year period will need to establish a risk committee.
Member states will also be required to put in place a more detailed supervisory framework in respect of investigatory powers, administrative penalties for breaches and a detailed supervisory review and evaluation process.
Disclosure and Reporting — General
IFR will require Class 2 firms to make public details on capital, returns on assets (net profits divided by total balance sheet), risk management objectives and policies, governance arrangements and information on remuneration of staff (discussed separately below). All investment firms with on- and off-balance sheet assets over €100 million over a four-year period will also have to disclose their investment policies, including detail on voting rights attached to shares held by the firm and related voting behavior by the firm.
In particular, the remuneration information required to be published is much more granular than under the current investment firm, AIFMD and UCITS remuneration frameworks. Notably, Class 2 firms will be required to disclose information on gender neutrality and any gender pay gap.
Class 2 firms will also need to publish reports on environmental, social or governance risks, physical risks and transition risks related to the transition into a more sustainable economy, subject to a three-year phase-in period.
Separately, all investment firms will need to report to their competent authorities on their own funds, capital, levels of activity and, for Class 2 firms, concentration and, where applicable, liquidity risk. Reports are required quarterly for Class 2 firms and annually for Class 3 firms. Firms dealing on own account or underwriting financial instruments (or whose affiliate investment firms undertake these activities) must also notify their competent authorities where their assets exceed €5 billion on a group or individual basis.
Disclosure and Reporting — Remuneration
Class 2 firms must publish information on their remuneration policy and practices. Among other information, this will require Class 2 firms to disclose publicly the aggregate amount of remuneration awarded in the financial year, split into fixed and variable remuneration and broken down by senior management and members of staff whose actions have a material effect on the risk profile of the firm, and the number of beneficiaries. This is similar to the existing requirement.
Class 2 firms will also have to provide competent authorities with information on the number of natural persons that are remunerated €1 million or more per financial year (in pay brackets of €1 million), including information on their job responsibilities, the business area involved and the main elements of salary, bonus, long-term awards and pension contribution. Such reports will, however, be private,4 and the competent authorities are subject to an obligation of professional secrecy under the IFD.
Equivalence for Third-Country Firms
As explained in our Update on MiFID II, MiFID II introduces a new “third country” regime applying to non-EU (or “third country”) investment firms seeking to provide investment services to EU clients — see in particular Article 47 of MiFIR. The ability to provide such services to EU professional clients depends on an “equivalence” determination having been made by the EC in relation to the non-EU firm’s home country.
The IFR amends the MiFIR equivalence process so as to additionally require equivalence between the third country’s prudential regime and IFR/IFD. In particular, where the services provided or activities performed by third-country firms are “likely to be of systemic importance” for the EU, the EC’s equivalence determination shall be based on a “detailed and granular assessment” and may include specific conditions.
It is fairly clear that the purpose of the above provision is to ensure that following Brexit, the UK will be subjected to a rigorous assessment in order to be determined to be “equivalent.” If the UK’s local prudential framework deviates from that in the IFR/IFD, the EC could decide that the UK should not be granted such equivalent status.
EU member states may continue to permit third-country investment firms to provide services to professional clients and eligible counterparties in the absence of an equivalence decision. The possibility to provide services outside of the equivalence framework will need to be assessed on a country-by-country basis. Any third-country firms able to operate in the absence of an equivalence decision must report granular information on their EU activities to the European Securities and Markets Authority (ESMA) annually and provide ESMA with access to relevant data. They will also be subject to certain client disclosure and recordkeeping requirements.
The IFR and IFD are expected to be published in the Official Journal of the European Union during Q2/Q3 2019. The provisions related to third-country firms will apply three months thereafter. However, the new capital and remuneration requirements will not begin to apply until 18 months thereafter, hence they are likely to take effect in EU member states around Q4 2020/Q1 2021.
1 The Prudential sourcebook for Banks, Building Societies and Investment Firms.
2 The Prudential sourcebook for Investment Firms.
3 The EC’s original proposal had set this threshold at €30 billion rather than €15 billion. However, the threshold was lowered during the legislative negotiations between the European Parliament and the Council of the EU.
4 The EC’s original proposal had required public disclosure of the number of individuals who have been remunerated €1 million or more per financial year. However, this requirement was removed during the legislative negotiations.
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