The FCA has issued its second (CP21/7) of three proposed consultation papers on the new IFPR, with proposed rules that will apply to MiFID authorised firms, CPMI firms and holding companies of groups that contain one of those firms. This second CP provides details on a number of critical areas, with a particular focus on the ICARA, governance and remuneration requirements.
This second CP also retains a clear focus on the FCA’s overarching objective to minimise harm, with further emphasis on the principle of senior management responsibility for maintaining appropriate governance and risk management arrangements.
The FCA is particularly concerned with implementing a prudential regime for FCA investment firms that aligns to the way the investment firms run their business. As such, there are instances where the UK regime will diverge from the EU regime. For example this is the case for remuneration rules relating to the proportionality threshold and approach to third country subsidiaries and also the case where under the EU regime a nomination committee is not required but Risk and Remuneration Committees must fully comprise non-executives and Risk Committees requirements cannot be waived at the legal entity level.
Details of the K-factors were included in the first IFPR CP (20/24), issued in Dec 2020, and this second CP helps to clarify some of the delegation issues raised. Some points of note include:
If a firm cannot determine if certain assets should be classed as relating to their MiFID business, it is proposed that these amounts be included in the ASA calculations
Qualifying money market fund assets should be included in K-CMH
Calculations should include assets which have been delegated to the firm as well as those which the firm has delegated to others. The FCA does not consider this to be ‘double counting’ given the underlying potential risk of harm
If a firm cannot determine if certain parts of client money should be classed as relating to its MiFID business, it is proposed that these amounts be included in the CMH calculations
CMH does not include client money that arises under a CASS 8 mandate that the firm controls but does not hold
CMH will apply to both segregated and unsegregated accounts, with unsegregated being more likely to arise on consolidation from third county firms and attract a higher coefficient
AUM calculations should exclude any client money amount already included in the CMH calculation
A firm may exclude from AUM assets that have been delegated from CPM, CPMI and third country firms who have a similar AUM requirement to the K-AUM
For any sub-delegating arrangement only one party can apply relief from ‘double counting’. So, if AUM is delegated to firm B by another firm A, where firm A is also acting as a delegated manager and has not included the amount in its AUM calculation, then firm B must include those AUM in its calculation
Any delegation must be supported by a legally binding agreement and ‘advice’ and ‘management’ must be considered separately. In cases where advice is not covered by such an agreement, the management company would need to consider the assets under AUM and the entity providing the advice would need to consider those assets under its AUM
The CP makes it clear that matched principle transactions should be captured under DTF rather than COH
In response to feedback the FCA will allow an adjustment to the coefficient for the DTF in times of extreme market stress
Interaction of K-AUM and K-COH
The CP provides a number of scenarios to help firms identify when a firm should calculate K-COH rather than K-AUM with detailed provisions in the handbook draft text which help to clarify the overlap e.g.
firms who have management delegated to them to don’t need to include the assets in their AUM but if they execute the orders they will need to include it in their COH calculations. However, if the execution is passed back to the first firm or onto a third firm then they would not have any AUM or COH calculation
if client orders are received by one firm and passed to another for execution then both firms need to consider COH
Given the wide range of potential business arrangements, the FCA has proposed an overarching principle that if unsure, a firm should interpret the requirement in the light of its purpose. Firms should be able to explain why they do or do not use a K-factor requirement for the activities that they undertake.
Fixed overheads requirement (‘FOR’)
The FCA has provided details on the FOR calculation within the new CP. The calculation will be based on a quarter of ’relevant expenditure from the previous year’ (in line with existing FOR calculations under previous regimes). However, there are differences in the allowable deductions from expenditure from current regimes. Firms should check the FCA’s list of items that will be deductible (full list in paragraph 4.7 of the CP) to determine whether there are any changes that impact the FOR. A notable change for BIPRU firms for example, is that the ‘other variable expenditure’ category of expenses will no longer be an allowable deduction category, but firms will be allowed to deduct ‘non-recurring expenses from non-ordinary activities’ under IFPR (same as CRR).
Commodity firms are permitted to deduct their expenditure on raw materials where the commodity underlies the derivatives that the investment firm trades. In addition, all the expenses of tied agents must be included in the calculation, rather than 35% as set out in the CRR.
Under the IFPR, firms will be required to immediately recalculate the FOR and basic liquid assets requirement (BLAR) where there is a ‘material’ change (30% change in relevant expenditure or £2m change), subject to the firm obtaining FCA permission where the material change will result in a decrease in these requirements.
ICARA – Capital and Liquidity Adequacy Assessment Arrangements
The current CP introduces the concept of a binding Overall Financial Adequacy Rule (OFAR) which will require all FCA investment firms to hold adequate resources at all times to ensure a firm can remain viable throughout the economic cycle, address any potential harm from on-going activities and provide for an orderly wind-down. (Previously, DP20/2 referred to the binding requirement as ‘Pillar 2R’ or P2R).
The ICARA process will serve as a key tool for all FCA investment firms to assess the adequacy of its financial resources and ensure OFAR compliance. The ICARA process should demonstrate that adequate financial and non-financial resources are held to minimise the risk of all potential material harms to clients, counterparties, the market(s) in which the firm operates and the firm itself.
This will need to be supported by an effective (continuous) assessment of their strategy, business model planning and all associated regulated and unregulated activities, covering expected and stressed scenarios, from both an on-going and wind-down perspective. Larger firms or firms with complex business models will also be required to conduct reverse stress testing which includes consideration and assessment of stresses that could result in the business model becoming unviable.
This activity and outcome focussed approach aligns to the introduction of ‘impact’ focussed K-factors which form the basis of the own funds requirement for non SNI firms. Risk-based assessments will now need to be undertaken relative to various harm categories (e.g. aligned to each relevant K-factor for Non-SNI firms). This represents a substantial change from the current ‘causal’ based approach typically used for ICAAPs. Consequently, it is expected that most firms would require additional or enhanced internal assessment process designs and implementation arrangements to meet the ICARA requirements. Firms with less mature RMF arrangements or that were not previously subject to an ICAAP are likely to require significantly more time and effort to embed an effective ICARA process.
The FCA has also proposed a number of specific intervention points and additional notification information requirements to improve risk transparency, mitigation and support timely recovery or wind-down actions where required and firms should take note of these. They include a new FCA intervention point and notification requirement where there is an early warning indication that own funds resources have fallen within 110% of the Own Funds Thresholds Requirement (OFTR) or any FCA requirement; an actual OFTR or Liquidit Assets Threshold Requirement (LATR) breach; and or wind-down trigger (including where OFTR falls below the FOR or LATR falls below the BLR).
CP21/7 also sets out a number of significant new details which firms will need to incorporate in their ICARA process implementation arrangements. This includes governance alignment to the Senior Management and Certification Regime (SMCR); recovery planning; guidance on the assessment of various sources of harm; and enhanced monitoring and intervention arrangements linked to a firm’s threshold conditions.
ICARA Group Considerations
Whilst firms need to meet the overall requirement for capital and liquidity adequacy on an individual basis, the CP confirms there is an option for firms to perform a group ICARA process, (unless the FCA directs otherwise). Groups can opt for a group process if conditions around group management of businesses and risks are met. However, own funds and liquid assets derived from the assessment will need to be allocated amongst firms in the group to ensure each FCA investment firm complies with the OFAR on an individual basis. Additionally, each FCA investment firm will need to have a separate wind-down plan and associated triggers.
If operating a group process, the management of risks on a group basis must be done by either an FCA regulated investment firm entity or the UK parent. The Board of that entity will need to retain overall responsibility for ensuring compliance with the rules and approving the group ICARA document.
Under the basic liquid assets requirement (BLAR), an investment firm would have to hold an amount of core liquid assets that is at least equal to the sum of one third of the amount of its fixed overheads requirement, and 1.6% of the total amount of any guarantees provided to clients. The requirement is to apply on both an individual and consolidated basis, however, subject to conditions, the FCA can grant a waiver.
SNIs and investment firms that do not deal on own account or underwrite can include trade receivables due in less than 30 days (subject to limits and haircuts), coins and banknotes, UK government securities and investments in certain money market funds as core liquid assets.
Under the ICARA, an investment firm will need to determine if it should hold additional liquid assets to fund its ongoing business and ensure the firm could wind down in an orderly way. These additional requirements are on top of the basic liquid requirement.
Recovery Planning (RP) Arrangements
The FCA’s proposal seeks to provide a more holistic prudential framework to minimise the risk of harm. A notable new feature of this is a proposed requirement for all FCA investment firms to embed recovery planning (i.e. not just current 730k firms subject to IFPRU 11). Firms will therefore need to integrate a number of additional elements into their ICARA design to support effective recovery from a potential or actual breach of their threshold requirements. This includes the development of supporting governance arrangements, credible recovery options, proactive impediment mitigation and a suitable framework of indicators to facilitate timely initiation of the recovery plan and transition to wind-down if required.
Wind-Down Planning (WDP) Arrangements
As part of the IFPR’s OFAR, each MIFIDPRU investment firm will be required to hold sufficient own funds and liquid assets to ensure that they can wind down in an orderly manner. Each firm will need to develop and maintain its own specific wind-down plans, including an effective risk-based assessment of the amount of financial resources that it will need to hold to facilitate a (stressed) orderly wind-down.
CP21/7 also introduces the concept of specific own funds and liquid asset wind-down triggers (WDT). The proposed own funds WDT will be the higher of a firm’s FOR or FCA imposed amount while the liquid assets WDT will be the higher of a firm’s BLAR or FCA imposed amount. These FCA designated triggers represent the minimum amount of financial resources that each firm will need to ring-fence and hold at all times to facilitate a wind-down. Firms will need to develop and maintain appropriate supporting arrangements based on a prudent assessment of their potential wind-down plan and cost requirements.
Senior management should consider the extent to which existing internal arrangements and processes require enhancement to meet the proposed WDP related requirements at an entity level. They should also ensure effective design and internal consistency between their WDP arrangements and other key IFPR elements including, for example, the associated risk appetite framework, recovery plan, early warning indicators, intervention points and threshold requirements.
Harm assessment and modelling
The CP maintains the option for the use of statistical models (e.g. Capital Clarity | Deloitte UK) to determine internal own funds requirement for both SNI and Non-SNI firms as long as the following requirements are met: proper integration into ICARA process; sufficient management understanding; appropriate inputs; periodic validation; and avoiding over-reliance. However, some inputs to statistical models (e.g. the outcomes of scenario workshops), as well as the models themselves, may require adjusting in order to meet the new requirement. This may be particularly relevant for Non-SNI firms who will need to assess their own funds requirements against individual K-factor activities.
Supervisory Review and Evaluation Process (SREP)
The FCA intend to change their approach to SREPs to adopt a more ‘harm-led’ approach. It would seem likely that the largest firms in the market could still be subject to regular visits, but other visits may be across firms that share common features e.g. on a market sector basis.
The FCA will continue to have the option to apply a range of supervisory actions to firms as a result of their SREP including requiring a capital or liquidity add-ons for individual firms; performing a sectoral review to impose add-ons across that sector; and or requesting the implementation of new frameworks or improvement plans as a non-financial measure.
At group level, the FCA can also take actions on the UK parent including applying a requirement to hold an amount of capital or liquidity in cases where they feel the potential harms arising in a group can be addressed more effectively by holding resources at that level.
Firms are requested to contact the FCA to ascertain how their current Individual Capital Guidance (ICG)/ Individual Liquidity Guidance (ILG) can be transitioned to the new regime.
Governance and Risk Management
The FCA’s new requirements for governance arrangements expect to address organisational structures, effective risk management and adequate internal control mechanisms including sound administration and accounting procedures. In doing so, firms must also comply with proposed risk management rules under the IFPR, the proposed MIFID PRU Remuneration Code and the Senior Management arrangements and the Systems and Controls (SYSC) requirements.
Additionally, the largest Non-SNI firms will be required to have risk, remuneration and nomination committees, replacing the current requirement for only ‘significant IFPRU firms’ to establish these committees – meaning more investment firms will need to establish committees. Firms will need to establish the three committees at individual entity level, however if firms believe that committees at group level would be more appropriate and that entity level committees would be detrimental, they can apply to the FCA for a modification of the requirement. Modifying the committees’ requirement may be particularly relevant to FCA investment firms permitted to use the group capital test – as the ‘group level’ in this context refers to the UK parent undertaking and its subsidiaries (investment firm group) rather than the prudential consolidation group.
The FCA also proposes that 50% of the members of each of the three committees should be non-executive members of the management body, to ensure sufficient independence. The role of each committee has not been prescribed in detail but should be decided by the firms’ management bodies supported by the UK Corporate Governance Code. The new proposals also mean that a small number of firms that are not ‘significant IFPRU firms’ but are Enhanced firms under the SM&CR will need to establish committees and hence appoint a chair who would need to be approved as SMF10, SMF12, or SMF13.
Under the IFPR, the FCA will introduce a new MIFIDPRU Remuneration Code (SYSC 19G), replacing the existing IFPRU and BIPRU Remuneration Codes (SYSC 19A and SYSC 19C).
The largest Non-SNI firms (which exceed certain balance sheet thresholds), will need to meet the full or ‘extended’ requirements of the Code, which include:
- Rules on deferral (i.e. at least 40% of variable remuneration should be deferred for at least 3 years, or 60% where the variable remuneration is a ‘particularly high amount’);
- Pay-out of variable remuneration in retained instruments (i.e. at least 50% of variable remuneration must be paid out in shares, instruments or using alternative arrangements and subject to an appropriate retention policy); and
- Discretionary pension benefits.
Non-SNI firms that fall below the balance sheet thresholds will be subject to ‘standard’ remuneration requirements i.e. the MIFIDPRU Code, without the extended provisions above.
SNI firms will only need to comply with the ‘basic,’ principles-based parts of the MIFIDPRU Remuneration Code, and are not required to identify, or apply specific remuneration rules to Material Risk Takers (MRTs).
Under the ‘extended requirements’, investment firms must not pay MRTs dividends or interest on variable remuneration in respect of the period it is deferred, either during or after the deferral period ends. However, the FCA is not proposing to require firms to identify MRTs (who are subject to the pay rules) solely based on their level of remuneration awarded.
The FCA has aimed to simplify regulatory reporting requirements for all FCA investment firms. The following changes are proposed:
- A new ICARA questionnaire reporting template (MIF007) is required which will replace the current FSA019. The ICARA questionnaire will include a break-down of the assessment of additional own funds into the identified harms. Firms will need to inform the FCA of the proposed date(s) for the submission of ICARA questionnaire (minimum annual). This enables firms to initially set their own timetable for the ICARA process with ‘reasonable’ timelines from the reference date of data, the ICARA review date and the submission of the ICARA questionnaire.
- Whilst all firms should review their ICARA process at a minimum annually, larger and more complex firms should consider whether half yearly reviews would be appropriate.
- CPMIs will now be required to submit a revised FIN067 regardless of whether they are a BIPRU or IFPRU firm replacing the FIN068 form.
- Liquid assets reporting form (MIF002) is to be prepared on a quarterly basis.
- Remuneration reporting will depend on whether the firm is subject to basic, standard or extended remuneration requirements and reported on a solo or consolidated basis. Firms will have to submit a MIFIDPRU Remuneration Report and the existing Remuneration Benchmarking Information Report (REP004) replacing the High Earners Report (REP005).
Classification and requirements of Clearing Members/Firms
The CP sets out that FCA investment firms that are clearing members, indirect clearing firms or a self-clearing firm are Non-SNI firms. Moreover, if it is part of a consolidated group then the UK parent entity must comply with the obligation of MIFIDPRU 2 as if it were a Non-SNI firm.
Key regulatory applications and notifications
Specific forms are being devised for applications and new notification requirements as opposed to the generic forms currently used. Firms must submit draft applications and notifications as early as possible to be able to ensure any permissions needed are available from 1 January 2022.
Interaction of MIFIDPRU with other Prudential Sourcebooks
The FCA has provided information on how MIFIDPRU is intended to interact with other prudential sourcebooks in the regulator’s Handbook, moving majority of the existing sourcebooks under the remit of MIFIDPRU.
In particular, the category of exempt-CA firm will cease to exist and instead be subject to the prudential requirements in MIFIDPRU. However, if former exempt-CA firms carry out activities in scope of MIPRU 3.2 (which is being retained as a standard), the firm will be required to hold professional indemnity insurance which is not required under MIFIDPRU.
A significant amount of information is contained in the CP which will take time for firms to digest and consider the impacts. We encourage firms to provide feedback to the FCA on any areas where further clarification or improvement would be desirable by the deadline of 28 May 2021.
The third CP is due early Q3 this year with a first Policy Statement due late spring, detailing the response to the feedback on the first CP, and a second Policy Statement due this summer.
The IFPR regime is expected to go into force in the UK from 1 January 2022.
FCA Discussion Papers and Consultation Papers:
FCA DP20/2: A new UK prudential regime for MiFID investment firms
FCA CP20/24: A new UK prudential regime for MiFID investment firms
FCA CP21/7: A new UK prudential regime for MiFID investment firms
Unpacking the FCA’s first consultation on the imminent UK Prudential Regime
Investment Firms Prudential Regime ("IFPR") UK implementation - will you be ready?
FCA publishes draft remuneration rules under IFPR