In mid-December, the FCA issued a consultation paper (CP20/24) in which it set out the basis for the rules it intends to apply to the prudential requirements for UK investment firms authorised under MiFID II.
Much of the consultation relates to the introduction and calculation of ‘K-factors’ - risk measures which are typically inherent in small and mid-sized investment firms and which require capital support.
These have been widely publicised as components of the EU Investment Firm Regulation (‘IFR’) and the FCA’s consultation proposes that they be employed in the UK regime without amendment.
Minimum capital thresholds
Also similar to the IFR, the UK intends to recognise the modest increases to the minimum capital thresholds set out in the IFR, but expressed in Sterling rather than Euro, (ie, £75k, £150k and £750k) and to adopt the concept of a ‘Small Non-Interconnected firm’ (‘SNI’) in order to introduce a level of proportionality into the application of the rules that it makes.
Effectively, a SNI is what we currently regard as a 50k firm – it doesn’t deal on its own account and it doesn’t safeguard assets or hold client money. A SNI will continue to calculate its capital requirement as the greater of its base capital requirement or 25% of its fixed overhead.
An Overview of the Key Changes
The consultation provides helpful clarification on a number of salient points:
- Consolidated assessment – prudential assessment is required on a consolidated basis at UK parent level, not EU parent level. Therefore, a UK firm that is controlled by an EU-27 parent will only be required to report at a solo UK level. Note however that a UK firm that has EU subsidiaries must report on a consolidated basis that includes the EU business.
- Matched principal exemption – the UK regime will discontinue the matched principal exemption meaning that the permanent minimum capital requirement for matched principal broker firms will increase from £125k to £750k. The new rules provide for a 5-year transition to the higher level, in which the minimum requirement transitions to £190k in the first year following implementation, and then in increments of £140k over the following 4 years.
- Reporting – the existing COREP, FSA001 and FSA002 returns will be retired and replaced by a series of simpler returns, available here.
- Concentration risk – there is a greater emphasis on concentration risk. A soft limit of 25% of the value of own funds will apply, exposures beyond which must be individually reported to the FCA and must attract additional capital. The FCA’s interest in concentration risk extends beyond the value of client positions and exposures to perceived risks in the use of custodians and in revenue generation. The quarterly reporting requires provision of data on both matters.
This consultation paper follows the Discussion Paper 20/2: Prudential Requirements for MIFID Investment Firms which the FCA issued in June 2020 and is the first of three papers on the regulation of UK investment firms. Further papers are expected in Q2 and Q3, which will, among other things, set out the FCA’s intentions relating to supervision of remuneration and liquidity requirements.
In summary, we regard the measures envisaged for the prudential regime as pragmatic and welcome.
There are two main areas that we feel may present concerns.
- Use of custodians:
In assessing the elevated level of interest in a firm’s use of custodians, we make the reasonable assumption that the regulator would have a strong preference for a firm to hold accounts (client and proprietary) with multiple providers, not just one. Theoretically, such a concern is perfectly understandable. On a practical level however the difficulties in securing trust accounts from UK banks are well documented and we would hope that commercial reality will be a factor in the FCA’s consideration of this risk.
- Removal of matched-principal broker exemption
The removal of the matched-principal broker exemption which would require firms currently using this limitation to increase their base capital requirement to £750k. Whilst there is a 5 year transitional period, it likely presents a broader discussion on the commercial viability of running a smaller investment firm against a large regulatory capital base.
The consultation closes on 5 February, with the intended implementation date of 1 January 2022. We would encourage all our clients to respond and represent their views.
We are currently working with clients to understand the implications and prudential implications of the new regime. If you have similar enquiries, please feel free to contact one of our Investment Department experts.
This post contains a general summary of advice and is not a complete or definitive statement of the law. Specific advice should be obtained where appropriate.