The Investment Firm Directive and Regulation (IFD and IFR), embodying the new prudential, capital and liquidity requirements regime for European investment firms, were approved by the European Parliament in December 2019, with both the entry into force of the regulation and the transposition in local law of the directive set for June 2021.
Same as with some other European regulatory initiatives in financial services, the UK played a pivotal role in influencing the design of the new regime and capital requirements rules at the European level during the period that preceded Brexit.
The enduring importance of these rules for the UK industry, deal or no deal, testifies in the Financial Conduct Authority’s own adaptation of the rules under the new Investment Firm Prudential Regime (IFPR), set to be rolled out at the beginning of 2022 – a six months lag compared to Europe’s rules that, whether or not entirely justified by the UK’s priority of listening more closely to the needs of the domestic sector, marks a milestone in the decoupling process of the country from the 27-country bloc, and is indicative of the future shape of the dynamics between the UK and the EU.
‘Similar intended outcomes’
The foreword to the very first discussion paper on the theme of the new UK prudential regime for Mifid investment firms, issued by the FCA in 2020, offers additional interesting hints on how we can expect the future dynamic between the two geographies to be shaped.
Based on the FCA wording, the authority supports the goals of the EU embodied in IFR and IFD, yet, while the regime to be introduced in the UK will achieve “similar intended outcomes” to the European one, it will be designed to take into account the specificities of the UK internal market.
Based on this narrative, the frame of reference will remain the European one, but the new UK prudential regime will interpret and reflect the peculiarities of the actual business models present in the local industry, nevertheless allowing for the main overall goals of the corresponding EU regulation to be met.
If the concept of post-Brexit equivalence is thus taken to mean that regulatory regimes need not to be identical in the actual rules but rather achieve the same objectives – an interpretation the two sides are unlikely to agree upon – then the approach adopted by the FCA is fit for purpose. The method to follow also seems to be established: start from the EU regime, share its overall goals but then adapt the ensuing regulatory framework to the specific UK environment.
Overall, regained sovereignty after Brexit translated into a 2021 regulatory agenda filled with changes and innovations, prompting the industry to voice the need for some additional time in order to be able to effectively adjust to the new rules, which will also impose some sort of upfront implementation cost.
Why a new prudential regime for investment firms?
With the exception of a handful of large investment firms considered ‘systemic’ and that will remain under the supervision of the Prudential Regulation Authority (PRA), pretty much all investment firms will be in scope for the new prudential regime. In Europe, the existing bank Capital Requirements Directive (CRD) regime derived from the Basel Committee’s standards will apply to the same type of large investment firms, leaving all other Mifid investment firms under the newly introduced IFR and IFD.
The rationale for the new rules is clear. Investment firms do not typically have large portfolios of retail and corporate loans and do not take deposit- which leads to the general assumption that, with the exception of the few large systemic firms, failure of investment firms is unlikely to have detrimental impacts on the overall financial stability of markets.
However, the new UK framework puts a slightly greater emphasis on this distinction between rules for credit institutions and rules for investment firms, namely through two key differences compared to EU rules: UK systemic investment firms will not need to be re-authorised as credit institutions, and investment firms as a group will not be subject to CRD V or any subsequent update to the EU banking regime, from which the PRA regime will depart going forward.
By and large, the new prudential regime will have an impact on the way in-scope investment firms deal with capital and liquidity requirements, based on completely new approach pivoting on ‘K-factors’- coefficients related to risks to clients; risk to the market via the trading book; and finally risks to the firm via counterparty credit risk and large exposures. This K-factor approach will apply to so-called own funds as well as internal risk and prudential assessments. Lastly, new remuneration policies and reporting requirements will be introduced.
How the UK and EU regimes compare
As it was to be expected, the two regimes will present some divergence from each other in order to accommodate for the different business models, policy priorities and overall customs and business environments.
Reporting, for instance, will be one of the areas where we also expect to see differences between the two regimes. The differences will be on two levels. On the one hand, the frequency for the reporting requirement will be streamlined for all firms falling under the UK regime, to the contrary of two types of frequency for the reporting, tiered on the specific class of firms under the EU regime. The reporting templates are also expected to be more streamlined under the UK regime, with one template only, as opposed to the separate sets of reporting templates, again based on the actual class of firm, envisaged under the EU regime.
Also, on liquidity rules, the UK regime will provide for minimum liquidity requirements for all investment firms, including the small and non-interconnected (SNI) firms. On the contrary, the EU regime provides for some exceptions on liquidity requirements for this category of firms, leaving room for discretion to the national competent authorities of the various member states.
Lastly, firms managing collective investment portfolios will be in scope of the UK regime but not of the EU one. However, there will be adjustments down the line to the EU UCITS and Alternative Investment Fund Managers Directive (AIFMD) legislations in order to ensure that the requirements for own funds are somehow aligned with the new regime.
Elevating proportionality to the key regulatory principle
In light of the now fast-approaching January 2022 deadline for implementation, the topic of the IFPR implementation is high on the agenda for UK investment firms. The silver lining to the introduction of these new rules, though, is that the leitmotif of the new UK prudential regime for MiFID investment firms will be one of proportionality.
From reporting to disclosure and capital requirements, the potential and the promise of the new regime will be to deliver lower regulatory costs, especially for SNI firms – which the FCA expects will represent the largest slice of in-scope firms, providing for corresponding ‘lighter-touch’ requirements under IFPR.
Overall, the approach adopted by the new regime is poised to favour a much closer alignment to companies’ actual business models.
Along similar lines, panellists at the ACA Group Fall 2021 conference on Wednesday highlighted the proportionality of the new UK regime.
Henrietta de Salis, partner at Willkie Farr & Gallagher, for example explained that remuneration rules will be based on a more nuanced categorisation of firms.
“For remuneration purposes, non SNIs are further divided into small and large non SNIs,” she noted, “and it is only large non SNI that will have to comply with the extended remuneration requirements.”
Large non-SNIs will be those with assets averaging £300min over the previous four years, or with a trading book of over £150m, she explained.
“The FCA expects that there will only be about 100 of such firms, all the rest will be non-SNIs to whom just the basic and standard remuneration requirements will apply,” de Salis said.