Summary 
The FCA has issued its first consultation paper, CP 20/24 ( ‘CP1’) on the imminent Investment Firms Prudential Regime (hereafter ‘IFPR’) which will apply to UK investment firms, authorised under MiFID and solo regulated by the FCA (hereafter ‘firms’). The changes introduced by the IFPR will be contained in a new Handbook called ‘MIFIDPRU’. This blog sets out some key issues raised in CP1 and also discusses some of the implications of two EBA consultations issued in December 2020 on governance and remuneration under the Investment Firms Directive/Regulation (IFD/IFR).

The FCA’s CP1 follows on from the FCA’s discussion paper  in June 2020 (‘DP’), which set out the regulator’s initial views on creating a domestic regime which is intended to achieve similar overall outcomes as the EU’s IFD/IFR. The IFD/IFR will apply in the EU from 26 June 2021 and the IFPR is expected to apply in the UK from January 2022. Some of our previous blogs on IFR / IFD / IFPR can be found using the links below:

May 2019: IFR/IFD: a new made-to-measure prudential regime for EU investment firms?

June 2020: A new UK prudential regime for MiFID investment firms

November 2020: How will the new prudential regime for investment firms (IFD/IFR) impact commodities firms?

CP1 constitutes the first of a tranche of FCA consultations in relation to the IFPR. It consults on prudential consolidation, own funds resources, some of the own funds requirements, concentration risk and regulatory reporting. The proposals are broadly similar to the DP and we have summarised some of the key features below.

The next consultation due in Q2 2021 (‘CP2’) will include further consideration of IFPR application, own funds requirements and regulatory reporting.  It will also cover liquidity, risk management, governance, the Internal Capital Adequacy and Risk Assessment (‘ICARA’) process, the Supervisory Review and Evaluation Process (‘SREP’), remuneration and the interaction between the new MIFIDPRU source and other prudential sourcebooks.

The final consultation (‘CP3’) is expected in Q3 2021 and will consult on Environmental, Social and Governance (‘ESG’) disclosures, consequential amendments to Handbook and CRR technical standards and the approach to existing Bank Recovery and Resolution Directive (‘BRRD’) and Financial Conglomerates Directive (‘FICOD’) provisions.

MIFIDPRU objective
The current consultation reiterates the FCA’s objective in introducing this regime i.e. to provide a prudential regime for FCA investment firms which is proportionate in terms of the types of activities that these types of firms carry out and to prevent potential harm that can be caused to markets and consumers if they had to wind down. The FCA’s objectives in this context are in line with its wider focus on minimising harm by ensuring financial services firms have adequate financial resources – see finalised guidance FG20/1 for more details on this.   

Reporting requirements and monitoring 
The FCA intends to introduce a single suite of IFPR reporting forms for all MIFIDPRU firms. Some existing reporting will still continue under MIFIDPRU, for example balance sheet and income statement information which will be reported by all firms in the existing FCA029 and FCA030 format. The FCA has provided templates for reporting forms and published the  relevant instructions. The key new returns are listed below. The table below shows the key new returns:

MIFIDPRU return

SNI firms

Non-SNI firms

MIF001 Capital

MIF002 Liquidity

✓ (unless exempted)

MIF003 Monitoring metrics

MIF004 Non K-CON concentration risk reporting

X

MIF005 K-CON reporting

X

If applicable

MIF006 GCT reporting

If applicable

If applicable

CP1 sets out methods for calculating values that need to be reported in relation to own funds, the Permanent Minimum Capital Requirement (PMR), and the K-factors K-NPR, K-CMG, K-DTF, K-TCD and K-CON. By comparison, CP2 will provide proposals for values to be reported in relation to FOR, the liquidity requirement, the remaining Risk to Client (RtC) K-factors, remuneration, and the ICARA.

In this consultation the FCA has proposed that firms should report the relevant information quarterly on the last business day of March, June, September and December.   SNI firms will not be required to submit reports relating to general concentration risk or the K-CON requirement i.e. MIF004 and MIF005.  If an SNI firm is exempt from liquidity requirements under the IFPR, they will not be required to submit the liquidity report MIF002.

However, it should be noted that all firms including SNIs, and regardless of whether K-CON applies to them or not will be required to monitor all their sources of concentration risk including the following where applicable: trading book exposures, off balance sheet items, cash deposits, sources of earnings; and location of assets i.e. the extent to which they are concentrated at particular banks or other entities.

Where an FCA investment firm group is subject to prudential consolidation, the FCA proposes that the UK parent entity for the group should submit reports on a consolidated basis. The type of reports will depend on whether the UK parent entity is treated as an SNI or non-SNI on a consolidated basis. Alternatively, for Groups that are successful in obtaining FCA approval to apply the Group Capital Test (‘GCT’) instead of prudential consolidation, each parent undertaking in the UK that is subject to the GCT will need to submit a separate return.

If they have not done so already, firms should be considering how to source the data they will need to meet their new IFPR capital calculations and regulatory reporting obligations. For example, firms for which K-COH or K-DTF apply, will need to identify new (trade flow based) data sources for regulatory reporting on those K-factors. Some firms may also need to implement new systems, processes and or controls to support the delivery of K-factor calculations. Finally, firms should determine their approach, and consider any subsequent clarification that the FCA may provide on some of the K-factor calculations, such as the treatment of cancelled trades.

Capital requirements and K-Factors 
CP1 sets out information on the PMR and provides more detail on the K-factors that apply to firms that trade in their own name. The FCA has changed the PMR set out in the Investment Firm Directive to fixed amounts in GBP (£750k, £150k or £75k) for UK firms. We set out below some considerations on the K-factor requirements (‘KFR’) that apply to firms that trade in their own name. The FCA is expected to cover the FOR and risk to client k-factors in CP2.  By comparison, the EBA has recently finalised its draft regulatory technical standards on K-factors and the FOR.  Under the EBA’s technical standards, there will be additional allowable FOR deductions to the ones listed in article 13 IFR, including taxes which are in relation to annual profits of the firm.  On K-NPR, the FCA intends to roll forward some requirements and guidance on market risk from the IFPRU and BIPRU handbooks into its new MIFIDPRU handbook. It clarifies that only K-NPR and not K-CMG should be used for positions outside of the trading book and for settled proprietary trades (where these are not being used as collateral). The FCA did not reiterate the 5 year commitment to maintain the current CRR rules on market risk that is contained in the IFR. Instead, the FCA says that it will have regard to the UK CRR2 regime when reviewing the rules on K-NPR, which could result in a different timetable for any future changes to market risk rules.

On K-CMG, the FCA is proposing to permit an investment firm which is a clearing member of a central counterparty – where authorised or recognised under the on-shored EMIR regime – to apply for permission to use K‑CMG when it self-clears the relevant portfolio(s). It also proposes that FCA investment firms that are not direct clients of clearing members should be able to apply to use K‑CMG. The FCA provides some flexibility when defining the concept of a portfolio, and gives an example of a subset of a trading desk with similar characteristics as being capable of meeting this definition.

When it comes to calculating K-CMG, the FCA has clarified that total margin will be defined as the margin required by a CCP or clearing member’s margin model rather than the amount of margin the firm actually transfers. CP1 goes on to confirm that Total Margin includes haircuts applied to settled trades that are being used by the clearing member or CCP as collateral and introduces two minimum criteria that the margin model must meet. Where the margin model is either more or less conservative than the two minimum criteria, the FCA will allow a downward/upward adjustment to be made. The FCA also introduces governance provisions that require the individuals responsible for oversight of risk management to understand the CCP or clearing member’s margin model, and to approve the documentation of the firm’s decision to use the model. Firms should be factoring the FCA’s clarifications into their calculations and assessing the margin model used by their CCP or clearing member against the minimum criteria set out by the FCA, to determine if an adjustment mechanism is necessary. Additional governance and control arrangements will be required for firms making use of this approach and in relation to the adjustment mechanism, where used.

On K-TCD, CP1 sets out two approaches to calculating PFE, known as the hedging approach and the derivative netting ratio approach. It also clarifies that transactions relating to gold or gold derivatives must be allocated to the foreign exchange asset class. With respect to the credit valuation adjustment (CVA), the FCA clarifies that credits and loans granted to an investor for transacting in a financial instrument where the firm is also involved in the transaction, will only attract a CVA of 1 where the firm is not trading in its own name.

On K-DTF the FCA provides a clearer definition of what constitutes a cash trade and derivative trade, defining a cash trade as an order that relates to the sale or purchase of transferable securities, money market instruments, units in collective investment undertakings or exchange-traded options. An order that relates to any other financial instrument would be considered a derivative. These clarifications should enable firms to calculate and forecast the K-factors relevant to dealing on own account activity with more certainty.

Prudential consolidation 
Following on from the DP in June, CP1 sets out that prudential consolidation will apply to investment firms groups (comprised of a UK parent and subsidiaries where at least one entity is an investment firm), unless the group is given permission to use the ‘group capital test’. The rules (subject to Parliamentary approval of the legislation granting the FCA powers in this area) will be directly applicable to unregulated parent undertakings which are either incorporated or have a place of business in the UK.

The consolidation methods will follow existing requirements, with full consolidation the default method of consolidation.  Other methods will only be permitted if approved by the FCA. In particular, proportional consolidation will only be allowed if certain conditions are met, including that the liability of the parent is limited to the share of capital that it holds in the participation. Activities and expenditure of tied agents which form part of the consolidation group will need to be included in the calculation of the consolidated FOR and K-factor requirement. This is regardless of whether the tied agent is providing services for an entity within the consolidation group or a third party outside the consolidation group. However inter-group expenditure adjustments may be made for activities/services on behalf of an FCA regulated entity in the group.

Consolidated own funds will need to be calculated and should cover the consolidated own funds requirement. The consolidated own funds requirement will be the highest of the consolidated PMR, the consolidated FOR and the consolidated K-Factor requirement (where this applies). CP1 sets out the calculation of consolidated requirements including the following:

  • The consolidated fixed overheads requirement - calculated based on amounts included within the financial statements. Where audited financial statements are not available the FCA has set out other options including using the sum of fixed overheads within the group.
  • The consolidated permanent minimum capital requirement - calculated as the sum of individual PMR requirements and base own funds requirements or initial capital requirements of other relevant financial undertakings within the group (including relevant equivalents for firms not established in the UK).
  • The consolidated K-factor requirement - calculation will vary by K-factor.

Firms will also be subject to consolidated liquidity and reporting requirements. The FCA will be publishing proposals for consolidated disclosure, a consolidated ICARA process and consolidated remuneration and governance requirements separately.

Also, as previously set out in the DP in June, CP1 sets out that group which has a sufficiently simple structure, and which poses no significant risk of harm to others can apply to the FCA for application of the GCT as an alternative to consolidation.  Under the GCT, the UK parent would need to hold own funds to cover the book value of its holdings (subordinated claims and instruments) in subsidiaries and contingent liabilities in the group.

Firms that form part of an investment firm group should therefore consider the likely impact of applying prudential consolidation or alternatively, their potential eligibility for the GCT, in order to ensure compliance from the implementation date of IFPR.

Transitional provisions
The FCA has set out various transitional provisions covering the PMR for exempt CAD firms, IFPRU firms, BIPRU firms, matched principal firms and local firms. In addition, the paper also sets out transitional provisions for the gradual move to FOR or KFR for IFPRU, BIPRU, exempt CAD and exempt commodities firms.  It also sets out various transitional provisions in respect of consolidated calculations.

For non-SNI firms there is  a transitional provision on K-factors that provides two interim assessment options for firms that are missing historical data points for the months before the rules come into force, namely: (i) calculations provided in MIFIDPRU TP or (ii) the use of a reasonable estimate. Non-SNI firms are required to start collecting data a month before IFPR is in place and therefore all firms will be expected to have at least one month’s historic observed data.  Where firms enter into new activities after IFPR is in place, the FCA has proposed that projections may be used to facilitate the KFR calculations.

Firms should consider how use of these transitional arrangements may impact their calculations and forecasts, as well as the actions that will be required to source new data and implement any new process requirements.  These steps should be pursed well in advance of the IFPR effective date, to enable parallel testing and the timely identification and resolution of any potential issues.

Governance and Risk management arrangements
In December 2020, the EBA issued a consultation paper (CP 2020/27) on their draft Guidelines on Internal Governance (‘DG-IG’) under the IFD (EU 2019/2034), that they intend to apply to non-SNIs.  A key driver of the proposed guidelines is to ensure the integrity of financial markets and sustainable growth by reinforcing sound internal governance, risk strategy and risk management framework (‘RMF’) arrangements.

The UK is no longer under any obligation to apply EBA guidelines, however the FCA has confirmed that they ‘support the aims of the IFD / IFR’.  From that perspective, the DG-IG appears to set out a number of best/ good practice principles that could be of interest to UK investment firms.  This includes guidance on: the role and composition of management bodies (e.g. boards) and key committees; the development of sound integrated firm-wide risk culture, corporate values and business conduct arrangements.  The DG-IG also provides very useful insight on regulatory expectations for sound risk management across all three lines of defence, with a particular focus on the requirements for risk functions and the design and delivery of key RMF elements (e.g. risk strategy, risk appetite and executive decision making). 

We expect that many firms will find the information within the DG-IG guidelines useful in enhancing and developing their risk frameworks, and to support effective embedding of their enterprise-wide risk management arrangements. This includes, for example, the adequate resourcing and positioning of key functions, in order to ensure / maintain acceptable conduct-related (and prudential) outcomes. Firms should continue to monitor changes to the FCA’s rules and expectations in this area as updates to governance arrangements and resourcing can take time to implement and embed.

Remuneration 
UK firms
The FCA will set out its proposals for the new remuneration regime under the IFPR, which will be incorporated into a new SYSC 19G MIFIDPRU Remuneration Code, in its second consultation paper. This is expected to be published at the start of Q2 2021. Near final rules on remuneration will follow in a Policy Statement in the summer and any final points on the remuneration provisions will be clarified in a third consultation and Policy Statement in Q3 2021 (if required).

EU firms
In the meantime, the EBA launched a public consultation in December on its new Guidelines on sound remuneration policies under the IFD which apply to EU regulated non-SNI firms. The Guidelines make clear that there is no expectation that these will apply to a parent investment firm located in a third country (the UK is now considered a third country for these purposes) but if a subsidiary of a third country parent is itself an investment firm in the EU then the Guidelines will apply.  Whilst there is no requirement post Brexit for UK investment firms to comply with these Guidelines, the FCA will clarify in its Q2 consultation paper the extent to which it will reflect the Guidelines in the UK’s IFPR remuneration rules.

It is proposed that the final EBA Guidelines will apply to EU firms from 26 June 2021 and as part of the transitional provisions provided, investment firms should implement any adjustments to their remuneration policies and required documentation by 31 December 2021. These Guidelines apply in respect of the performance year starting after 31 December 2021.

The key requirements impacting Material Risk Taker (‘MRT’) remuneration structures under the IFD include:

  • Deferral – requirement to defer 40-60% over 3-5 years.
  • Payment in instruments – requirement to pay at least 50% of variable remuneration in shares or other non-cash instruments with an appropriate retention period applied following vesting of these instruments.
  • Ratio between fixed variable – there is no ‘bonus cap’ requirement but firms are required ‘set an appropriate ratio between variable and fixed remuneration.
  • Malus and clawback – requirement to apply malus and clawback to variable remuneration awards.

The EBA Guidelines are generally aligned with the initial remuneration requirements for MRTs set out in the FCA’s Discussion Paper from June 2020. However, there are some key areas where the EBA has set out more prescriptive requirements than were originally contained in the Directive. These include a minimum five year deferral period for members of the management body, a minimum 12 month retention period and a ban on the payment of dividend equivalents on deferred/LTIP awards. This contrasts to the initial guidance set out in the FCA’s Discussion Paper from June 2020, which suggested a preference for a more flexible interpretation of the IFD pay rules for MRTs.

It is also worth noting that the IFD introduces proportionality waivers, where firms may be able to disapply the requirements on deferral and payments in instruments for firms where total assets fall below a certain threshold or for individuals where they have a low level of variable remuneration. The FCA consultation paper will confirm whether the UK will apply the same thresholds that apply to EU firms.

Please contact the authors of this blog to discuss the impact of the IFPR on your organisation