On 4 June 2020, the European Banking Authority (EBA) published a consultation paper (PDF) on the implementation of the new prudential regime for investment firms. The EBA is required, under various provisions of the Investment Firms Directive (IFD) and Regulation (IFR) to propose draft regulatory technical standards (RTS), setting out detail as to how provisions of the IFD and IFR will apply.

This post is one of a series and summarises key points arising from the following draft RTS:

  • draft RTS on the fixed overhead requirement;
  • draft RTS on the notion of segregated account; and
  • draft RTS on K-DTF.

The EBA has requested comments by 4 September 2020.

Draft RTS on the fixed overhead requirement

By way of background, the IFD and IFR take investment firms out of the scope of application of the Capital Requirements Regulation and provides a tailored prudential regime for investment firms. Moreover, the fixed overhead requirement (FOR) is a major component of the capital requirements calculation under the IFR and the IFD. The IFR introduces a new system for investment firms to calculate own funds.  Investment firms always will have to comply with the higher of FOR, permanent minimum capital requirement or the K-factor methodology of the IFR.  As a result, firms will need to calculate the FOR to find out whether it is relevant to determine own funds requirements or not.

Under the IFR, the FOR is at least one quarter of the fixed overheads of the preceding year.  Investment firms are required to use figures resulting from the applicable accounting framework.  Where the competent authority considers that there has been a material change in the activities of an investment firm, the competent authority may adjust the amount of the FOR.

The EBA is required to draft RTS to supplement the calculation of the FOR and also to specify the notion of “material change”.

  • the ‘figures resulting from the applicable accounting framework’ refers to figures of an investment firm’s most recent audited annual financial statements after distribution of profits or in annual financial statements where audited statements are not available.  Where the investment firm’s most recent audited financial statements do not reflect a twelve month period, the firm shall use the monthly average to produce an equivalent annual amount;
  • a “material change” will be considered to have occurred where either of the following conditions are met:
  • a change (increase or decrease) of the business activity of the firm which results in a change of 30% or greater in the firm's projected fixed overheads of the current year;
  • a change (increase or decrease) of the business activity of the firm which results in changes in the firm's own funds requirements based on projected fixed overheads of the current year equal to or greater than EUR 2 million.

The draft RTS also lists additional items for deduction, how fixed expenses incurred by third parties should be treated and how staff bonuses and other remuneration should be treated.

Draft RTS on the notion of segregated account

If an investment firm is holding client money, it can assign a different coefficient to the client money K-factor (K-CMH) depending on whether the client money is held in a segregated account or not. The EBA is required to specify the notion of segregated accounts by setting the criteria in order for the segregated account coefficient to be used for the purpose of calculating the capital requirement related to holding client money.

The reason for the lower coefficient that applies to client money held in a segregated account is that segregated accounts are considered safer because the client’s money is separated from the firm’s own money. In the event of the firm’s default, it is easier to identify which funds belong to the client and the client is (at least in theory) more likely to get the money back more quickly. 

The proposal that the EBA has put forward is that in order for investment firms to apply the low coefficient, the conditions set forward in the draft RTS should be satisfied.  These conditions are aligned with those applying to client funds set out in Article 2(1) of the MiFID II Commission Delegated Directive 2017/593.  In short, the investment firm must meet all of the following requirements:

  • keep records and accounts that allows the firm to distinguish assets held for one client from assets held for any other client and from their own assets;
  • maintain accurate records and accounts;
  • conduct reconciliations on a regular basis between their internal accounts and records and those of any third parties by whom those assets are held;
  • take the necessary steps to ensure that client funds deposited are held in an account or accounts identified separately from any accounts used to hold funds belonging to the investment firm; and
  • introduce adequate organisational arrangements to minimise the risk of loss or diminution of client assets (or rights connected with the assets), as a result of mis-use, fraud, poor administration, inadequate record-keeping or negligence.

The consultation asks whether these requirements for notion of segregated accounts are sufficient and for views on whether there are any issues on segregated accounts which need to be elaborated further.

Draft RTS on K-DTF

The EBA was also asked to draft RTS specifying adjustments to the daily trading flow K-factor (K-DTF) coefficients in the event of stressed market conditions (as referred to in Commission Delegated Regulation (EU) 2017/578 (the Delegated Regulation)) when markets experience a period of extreme volatility. Given that the DTF is calculated based on the volume of transactions, the constraints that the default capital requirement for investment firms trading on own account, including market makers, bears the risk of a reduction on trading activities, leading to a risk of less market liquidity, with potential detriments to financial stability. Consequently, where circumstances lead to extreme volatility, the K-DTF coefficients should be adjusted in a way which incentivises trading activities.

The draft RTS set out a formula for the calculation of the adjusted coefficients under exceptional circumstances. Further, the draft RTS also indicates that “period of extreme volatility” refers only to the circumstances referred to in Article 3(a) of the Delegated Regulation.

The EBA is of the view that for the purposes of assessing whether any adjustment to the calculation of K-DTF is required, only a situation of extreme volatility (that triggers volatility mechanisms for the majority of financial instruments on a trading segment within the trading venue) should be relevant.

The Delegated Regulation specifies the requirements on market making agreements and schemes. Article 3 of the Delegated Regulation describes ‘exceptional circumstances’ where the obligation for investment firms to provide liquidity on a regular and predictable basis set out in MiFID will not apply.

The other situations referred in Article 3 of the Delegated Regulation either prevent the trading venue from operating effectively, or the market making investment firm is prevented from doing so. In such circumstances, it is not immediately clear how trading volumes/values could be so unusual as to lead to an overly high/restrictive K-DTF requirement.

The EBA has expressly asked for examples of situations of market stress which would not been taken into account applying the proposed approach but would be relevant for the measurement of the K-DTF.