Gem Briefing Note 21/1

A summary of the new UK prudential regime for MiFID investment firms

June 2021

Purpose of this Briefing Note 
This briefing note summarises the first two of three intended FCA consultations on a new UK regime to streamline and simplify the prudential requirements for MiFID investment firms. The Investment Firm Prudential Regime (IFPR) as it is known is due to be implemented on 1st January 2022. The FCA intends to publish one further consultation paper and then policy statements with final rules during Q3 2021. A link to the first two consultation papers can be found at the end of this briefing note for further detailed reading. 

The UK IFPR is directly derived from the EU Investment Firms Directive / Regulation on Prudential Supervision which the UK had significant input into prior to leaving the EU. As such, the UK has decided to implement a largely similar regime to initially achieve equivalency of the UK / EU financial services industries in this area. 

The IFPR is specifically designed for FCA investment firms and represents a significant change to how they will be prudentially regulated. The new requirements seek to capture the potential harm posed by these firms to their clients and the markets in which they operate. It also considers the amount of capital and liquid assets an investment firm should hold so that if it does have to wind-down or exit the market, it can do so in an orderly way.

The IFPR means that there will be a single prudential regime for all investment firms, simplifying the current approach. It should allow for better competition between investment firms. Some FCA investment firms will have meaningful capital and liquidity requirements for the first time, aligned with the potential harm they can cause.

All the current definitions of investment firms, such as BIPRU, IFPRU, exempt-CAD, will cease to exist. There will instead be two broad categories of investment firm. Firms will either be a ‘small and non-interconnected’ (SNI) investment firm, or they will not. The prudential requirements in the IFPR are designed to scale with the size and complexity of the firm. 

The IFPR will also introduce a new sourcebook; MiFIDPRU. In turn, the current BIPRU sourcebook will be deleted as well as GENPRU 2 and other related parts of GENPRU. IFPRU will also be deleted with the exception of IFPRU 11, and IPRU-INV will also have chapters deleted. The MIPRU sourcebook will be amended to remove BIPRU references. 

What firms are in scope?
The new rules will apply to:
  • any MIFID investment firm authorised and regulated by the FCA that is currently subject to any part of the Capital Requirements Directive (CRD) and the Capital Requirements Regulation (CRR) including:
    •  investment firms that are currently subject to BIPRU and GENPRU
    • ‘full scope’, ‘limited activity’ and ‘limited license’ investment firms currently subject to IFPRU and CRR
    • ‘local’ investment firms
    • matched principal dealers
    • specialist commodities derivatives investment firms that benefit from the current exemptions on capital requirements and large exposures including:
      • oil market participants (OMPs)
      • energy market participants (EMPs)
      • ‘exempt-CAD’ firms
      • investment firms that would be exempt from MiFID under Article 3 but have ‘opted-in’ to MiFID
  • regulated and unregulated holding companies of groups that contain an investment firm authorised and regulated by the FCA and that is currently authorised under MiFID and/or a Collective Portfolio Management Investment (CPMI)
It should be noted that firms that do not conduct any MiFID business, for example a firm with AIFM permissions only, will be largely unaffected by this prudential change.

Small and non-interconnected FCA investment firms (SNIs)
To qualify as an SNI, an investment firm:
  • must not carry out activities that have the greatest potential to cause harm to its customers or to the markets in which it operates, for example through dealing on its own account, and
  • must not carry out any activities on such a scale that would cause significant harm to customers or to the markets in which it operates, based on quantitative thresholds.
The proposed quantitative criteria for being an SNI are as follows:
Measure* Threshold
Assets under management < £1.2 billion
Client orders handled – cash trades < £100 million per day 
Client orders handled – derivative trades < £1 billion per day
Assets safeguarded and administered zero
Client money held zero
On- and off-balance sheet total < £100 million
Total annual gross revenue from investment services and activities < £30 million
* These thresholds, with the exception of the on- and off-balance sheet total, only relate to the MiFID activities the firm undertakes. A firm may manage assets without undertaking portfolio management or ongoing investment advice under MiFID, or hold client money or client assets in relation to non- MiFID activities. These should be excluded from the threshold measurement.

Own funds requirement
Permanent minimum capital requirement

The FCA believes that an investment firm should, at all times, operate with a minimum level of own funds based on the MiFID investment services and activities it currently has permission to undertake. This will become its permanent minimum capital requirement (PMR). There are three bandings for the PMR; £750k, £150k, and £75k. Unless a firm is dealing on its own account or operating an OTF for example, then it is likely to fall into the £75k bracket. Firms that are applying to become authorised will also have applied the PMR relevant to the permissions they are seeking to obtain from the outset.

For existing authorised firms, the minimum capital adequacy levels will increase from €50k to £75k (sterling not Euro) from January 2022. However at present the proposals are that for existing firms, this will be on an incremental basis over 5 years, therefore £50k from January 2022 and incrementally by £5k per year until £75k by 2027.

Expenditure based requirement (EBR)
Investment firms will  also be required to calculate an expenditure based requirement (EBR) which will be based on a fixed overheads requirement (FOR). The higher of the PMR and the FOR will determine what the own funds requirement level is for an SNI. For a non-SNI, there is also an additional value to consider called the K-factor requirement level. The detail of this for these types of firms has not been covered in detail in this briefing note as this will be firm specific. Please refer to the FCA consultation papers or speak with us for further information as to the application and impact of K-factors where relevant.  

The FOR is intended to calculate a minimum amount of capital that an investment firm would need available to absorb losses if it has cause to wind-down or exit the market. The expectation is that investment firms will consider in more detail the amount needed to wind-down as part of their new internal capital adequacy and risk assessment (ICARA) process. More information on this process is covered later in this note. 

The FCA has stated that an investment firm’s FOR will be an amount equal to one quarter of its relevant expenditure in the previous year. This will result from the accounting framework used by the investment firm. The figures used will be those in its most recent audited annual financial statements, and where these are not available, an investment firm may use unaudited financial statements until audited annual financial statements are prepared. When calculating the FOR certain included expenses may be deducted from the total figure, such as discretionary staff bonuses, shared commissions and fees subject to certain conditions, brokerage fees, one off expenses. 
It is understood that under the IFPR, in any given period, if the firm anticipates a major increase in operating costs (trigger of 30%+ increase), the EBR should be adjusted immediately even if this is prior to audited accounts being used. If the opposite occurs (30%+ decrease), the EBR can be decreased but only with FCA advance consent. 

K-factor requirement
The K-factor own funds requirements are essentially a mixture of activity and exposure-based requirements. The K-factors that apply to any individual investment firm will depend on the MiFID investment services and activities it undertakes. One K-factor that could  apply to some Gem client firms will be that relating to the value of assets under management (K-AUM). This is where an investment firm manages assets for its clients in connection with MiFID business, and includes:
  • assets managed on a discretionary portfolio management basis, and
  • assets managed under non-discretionary advisory arrangements of an ongoing nature
The K-AUM value is then calculated as 0.02% of its average AUM. The K-AUM must be re-calculated on the first business day of each month. The calculation approach for the mean AUM can be found in consultation paper CP21/7, Section 4.64. 

Basic liquid assets requirement
The FCA is proposing that all investment firms have a quantified liquid assets requirement. The purpose is to ensure that investment firms always have a minimum stock of liquid assets to fund the initial stages of a wind-down process, if wind-down becomes necessary. The amount of liquid assets a firm is expected to hold is at least equal to the sum of:
  • one third of the amount of its FOR, and
  • 1.6% of the total amount of any guarantees provided to clients
Core liquid assets that investment firms can use to meet the basic liquid assets requirement, and that do not require any reduction (or ‘haircut’) given their certainty of value, will include any amount of the following:
  • coins and banknotes,
  • short-term deposits at a UK bank
  • assets representing claims on or guaranteed by the UK government or the Bank of England (for example UK gilts and Treasury bonds)
  • units or shares in a short-term regulated money market fund, or in a comparable third country fund.

Concentration risk monitoring and control
Harm can arise from more than just a concentrated trading book exposure to a client. To mitigate the potential for harm that can arise from different types of concentrated exposures or relationships, the FCA propose that all investment firms should monitor and control all their sources of concentration risk, including:

  • exposures in a trading book
  • assets (for example, trade debts) not recorded in a trading book
  • off-balance sheet items
  • the location of client money
  • the location of client assets
  • the location of its own cash deposits
  • the sources of its earnings

When referring to the location of client money/assets/cash, it is meant that investment firms should monitor and control the extent to which these assets are concentrated at particular banks, investment firms and other entities. This could also manage any ‘diversification’ risks if  a firm  considers itself to be an eligible claimant under FSCS but limits on deposits apply per customer rather than per account. 

Investment firms will be required to identify not just individual clients but also groups of connected clients who may constitute a single risk because of their interconnectedness. The proposed rules offer a detailed definition of what a group of connected clients means, based on the definition currently used in the UK CRR.

Managing risks
Overall financial adequacy rule
The FCA proposes to introduce the Overall Financial Adequacy Rule (OFAR). This establishes the standard it will apply to determine if an investment firm has adequate financial resources. OFAR will require an investment firm, at all times, to hold adequate own funds and liquid assets to:

  1. ensure it can remain viable throughout the economic cycle, with the ability to address any potential harm from its ongoing activities; and,
  2. allow its business to wind-down in an orderly way

ICARA process
Underpinning this will be the Internal Capital Adequacy and Risk Assessment (ICARA) process which will replace the current ICAAP. The ICARA will be the centerpiece of an investment firm’s risk management and will be a continuous process through which a firm should:

  • Identify and monitor harms: Operate systems and controls to identify and monitor all material potential harm.
  • Undertake harm mitigation: Consider and put in place appropriate financial and non‐financial mitigants to minimise the likelihood of crystallisation and/or impact of the material harm.
  • Undertake business model assessment, planning and forecasting: Forecasting capital and liquidity needs, both on an ongoing basis and were they to have to wind-down. This must include expected and stressed scenarios.
  • Undertake recovery action planning: Determine appropriate and credible recovery actions to restore own funds or liquid resources where there is a risk of breaching threshold requirements tied to specific intervention points.
  • Undertake wind‐down planning: Set out at entity-level credible wind-down plans, including timelines for when and how to execute these plans.
  • Assess the adequacy of own funds and liquidity requirements: Where, in the absence of adequately mitigating risks through systems and controls, the firm assesses that additional own funds and liquid assets are required to cover the risk.

An investment firm will need to estimate the financial impact of any harm that is not covered by its PMR, FOR or KFR (if applicable). This will help it to determine the overall amount of own funds it will need to hold to meet the OFAR. This will be its ‘own funds threshold requirement’ and it will need to meet this requirement at all times. If it does not the FCA state that the firm will be in breach of threshold conditions.

Investment firms will be required to set their own funds threshold requirement at the higher of the i) PMR, ii) own funds necessary to cover harms from ongoing operations, or iii) own funds as necessary for wind-down. The FCA may set this as a higher amount.

SNIs also need to consider the risk of harm from the ongoing operation of their business. If the SNI decides this harm can only be mitigated by holding own funds greater than the PMR or FOR, this becomes its own funds threshold requirement.

ICARA process review
Investment firms will be required to review their ICARA process at least once every 12 months. They should also review this immediately following a material change in their business model or operating model. This review must be documented by the investment firm in an ‘ICARA document’. This document must contain:

  • A clear description of its business model and strategy.
  • An explanation of the activities it carries out, with a focus on the most material activities.
  • An explanation of why it has concluded its ICARA is fit for purpose. Or, where this isn’t the case, an explanation of the deficiencies identified, the steps taken to remedy them, and who is responsible for implementing any remedies.
  • An explanation of any other changes to its ICARA process that have occurred following the review and the reasons for those changes.
  • An analysis of the effectiveness of its risk management processes during the period covered by the review.
  • A summary of the material harms it has identified and any steps taken to mitigate them.
  • An overview of its business model assessment and capital and liquidity planning.
  • An explanation of how it is complying with the OFAR. This should include a clear break-down at the review date of available own funds, available liquid assets, and its assessment of its threshold requirements.
  • A summary of any stress testing and reverse stress testing it has carried out.
  • An overview of its wind-down planning, including any key assumptions or qualifications.

Firms will be required to report their ICARA data using an ICARA questionnaire reporting template. This will replace the current Pillar 2 reporting arrangements applying to certain investment firms.

Remuneration requirements
SNI firms will only be required to comply with a small number of the new remuneration rules when they come into force. These basic remuneration requirements focus on ensuring that firms have remuneration policies and practices meeting minimum standards and are subject to sound governance. An overview of these is as follows:

Basic remuneration requirements
A firm’s remuneration policy must: 
  • be proportionate to the size, internal organisation and nature, as well as to the scope and complexity, of its activities 
  • be gender-neutral 
  • be consistent with, and promote, sound and effective risk management
  • be in line with the firm’s business strategy and objectives, and take into account long term effects of investment decisions taken 
  • contain measures to avoid conflicts of interest, encourage responsible business conduct and promote risk awareness and prudent risk-taking
Governance and oversight: 
  • Management body must adopt and periodically review the remuneration policy, and have responsibility for overseeing its implementation. 
  • Staff with control functions must be independent from the business units they oversee, and be remunerated according to objectives linked to their functions. 
  • Remuneration of senior staff in risk management and compliance functions must be directly overseen by the remuneration committee or management body.
Fixed and variable remuneration: 
  • The remuneration policy must make a clear distinction between the criteria applied to determine fixed and variable remuneration. 
  • The fixed and variable components of the total remuneration must be appropriately balanced.
  • When assessing individual performance, both financial and non‐financial criteria must be taken into account.
Restrictions on variable remuneration: 
  • Variable remuneration must not affect the firm’s ability to ensure a sound capital base. 
  • A firm which benefits from extraordinary public financial support must not pay any variable remuneration to members of the management body.

All investment firms should have a remuneration policy in place for all staff, covering all components of remuneration covered in the new proposed MIFIDPRU Remuneration Code. The central objective of every remuneration policy must be that it is consistent with, and promotes, sound and effective risk management by aligning risk and reward. To achieve this objective, the FCA proposes that an investment firm’s remuneration policy should reflect its business strategy and objectives. These cover the investment firm’s risk appetite and risk strategy, including with regard to environmental, social and governance (ESG) risk factors, and also extend to its culture and values. The remuneration policy should also contain measures to avoid conflicts of interest, encourage responsible business conduct, and promote risk awareness and prudent risk taking.

Next steps
The new prudential rules coming into force in January 2022 are claimed by the FCA to simplify and streamline the prudential requirements for MiFID investment firms. However, this should not take away from the fact that there is still a reasonable degree of work to be done, initially and ongoing, in order to be compliant with the new MIFIDPRU rules.

This briefing note only provides an overview of what is to be expected and firms will need to assess the consultation papers, one further consultation paper and final policy statements and rules to ensure they fully understand and apply the requirements specific to their business type. As stated in this paper, it is anticipated that most small to medium sized firms will be able to classify as SNI entities which lessens the regulatory burden somewhat.

The key impact will be felt by those firms which are currently deemed ‘exempt-CAD’. These firms will now be captured under the new regime and so must ensure they are especially aware of their additional regulatory responsibilities from present.

Please contact us at Gem if you wish to discuss any aspect of the new IFPR, particularly if you think you might fall under the non-SNI classification which has only been briefly touched upon in this note, and for which there are all round more onerous requirements, and we will as always aim to assist.

A link to the first consultation paper is here: CP20/24

And the second consultation paper here: CP21/7

This briefing note contains generic information and has been generated for professional clients and associates of Gem Compliance Consulting Limited only and should not be regarded as advice. We will not be liable for loss, however caused by parties acting on the information contained herein.

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