How Can Investment Firms Navigate the Upcoming EU Capital Requirements?

From June 2021, a new, more focused capital requirements framework will be introduced in the EU, namely the Investment Firms Regulation (IFR) and Investment Firms Directive (IFD). As a result, certain European MiFID firms that are currently subject to prudential requirements set out in the Capital Requirements Directive (CRD IV) and the Capital Requirements Regulation (CRR), will be required to transition to the new rules.

Under the new framework, investment firms, (specifically MiFID investment firms, as opposed to AIFMs and UCITS), will be subject to higher regulatory capital requirements, (to be implemented over a transitional period), and a new set of complex monitoring and reporting obligations. But now doesn’t have to be the time to hit the panic button. Below, we outline how you can prepare your firm to tackle the new framework head-on. 

Which firms are subject to the new rules?

The new prudential regulations apply to Class 2 and Class 3 firms. This is a new classification framework introduced by IFR. You can see a definition of each class sub-section, and whether it’s subject to the new regime below. It’s important to note that companies will need to continuously monitor their classification based on the below criteria, regardless of the Class they currently fall into, to ensure they apply the correct capital requirements calculation.

Class 2 vs. Class 3

The requirements for firms in each Class will be based on the following criteria:

Both Class 2 and 3 firms require the highest of PMC and FOR for authorisation. In the case of PMC required for authorisation, most firms will now be set at €75,000, €150,000 and €750,000, depending on the investment activities the firm carries out. Firms will be required to hold this sum as a minimum on an ongoing basis.

For many Class 2 firms, it is likely that the FOR (one-quarter of the investment firm’s fixed overheads for the preceding year), will surpass the other items and therefore set the required regulatory capital.

The differentiating factor between Class 2 and 3 firms is the K-factor Capital Requirements asked of by Class 2 firms. This is a complex calculation based on Risk to Customers (RtC) + Risk to Market (RtM) + Risk to Firm (RtF), and as such it’s vital that firms engage with specialist advisors, such as Rochford, to ensure this is being calculated correctly. For the enthusiasts, a full breakdown of the K-Factor Capital Requirement calculations can be found at the end of the article.

The impact of Brexit

Technically, the new framework only applies to EU member states. As such, Brexit has created a degree of uncertainty as to whether the UK is required to comply with the new capital requirements. However, as we know, in terms of managing risk and sticking to regulations, it is always better to be safe than sorry and prepare for all eventualities.

The Financial Conduct Authority (FCA), published a discussion paper in June 2020, that appears to indicate a broad alignment with the IFR/IFD framework for the UK. However, this doesn’t necessarily reflect the final decision from the FCA, so there is still no certainty around whether UK firms will need to be aligned with the new rules

How to prepare for the new rules

There is a number of considerations and preparations firms need to make in order to ensure they have everything in place for the changes, set to come into effect in June 2021, so time is of the essence.

Firstly, it’s imperative that investment firms seek advice from their legal counsel, to understand the extent to which the new rules apply to the firm.

Firms that do fall under Class 1 or 2, and are therefore subject to the new requirements, should start by making an inventory of all the required data for the relevant period – this can be between six and 15 months of data, depending on the factor. Furthermore, these firms will need to establish processes to collect and report this data on a regular basis, at least quarterly.

Liquidity implications of any hedging strategies and how they interact with the liquidity of the underlying investments and regulatory demands also need to be taken into account as firms transition to the new regimes. Derivatives are likely to increase the capital requirements for firms after the new rules are implemented, consequently, dynamism will be even more important.

Fundamentally, they need to start planning for the (likely) increase in the mandatory capital requirements and understand its implications for them, keeping in mind that there will be a transition period before this is enforced – allowing firms to smooth out any kinks in the process.

Looking to 2021

Preparation is key as we look towards 2021. Despite the uncertainty of Brexit looming overhead, it will pay dividends in terms of time, restful nights and peace of mind to prepare for all eventualities. As a first step, firms will need to ensure that they’ve established an automated reporting and monitoring process, that allows them to outsource the complex and time-consuming requirements.

By working out what Class a business falls into, what the requirements mean for them, and implementing processes to comply with the regulations, firms can use the transitional period to work through any issues, creating a smooth and efficient environment for when the changes permanently take hold.

K-factor Capital Requirements Calculation Breakdown