Response to discussion on the potential review of the investment firms’ prudential framework
Q1: What would be the operational constraints of potentially removing the threshold?
At bwf we have no particular opinion regarding a potential removal of the EUR 5 bn threshold form the IFR text.
However, we were more than surprised that this very short and rater technical question which might be relevant only for a very small fraction of investment firms at all is the only question (and therefore possibility) for stakeholder to express their views on the comprehensive eight pages discussion of the conceptually fundamental chapter 1. “Categorisation of investment firms”.
Unfortunately, this selective/restrictive approach, whereby the EBA and ESMA determine in advance which parts of the discussion paper can be commented on and which cannot (and there is not even a field for preliminary or general remarks) is evident throughout the document and affects a number of central and fundamental issues. This includes, among other topics, the “implications of the adoption of the banking package (CRR3/CRD6)”, including highly important topics like “fundamental review of the trading book for investment firms” (FRTB) or “credit valuation adjustment for investment firms” (CVA), where EBA & ESMA (to our understanding without any recognisable mandate) express their views and possible ways forward, while stakeholders are prevented from directly reacting and expressing any opinion on such potentially far reaching remarks (sic!).
We therefore use the possibility to include an attachment (from the DP it was not even clear that such a possibility exists) to make a few supplementary comments outside the structured but in many ways incomplete questionnaire.
Q2: Would you suggest any further element to be considered regarding the thresholds used for the categorisation of Class 3 investment firms?
We understand and support in that the thresholds between Class 3 and Class 2 firms should be "zero" in instances where firms are permitted to “provide safekeeping and administration of financial instruments for the account of clients, including custodianship and related services such as cash/collateral management and excluding maintaining certain securities accounts; (…) (and) were they (are) permitted to hold money or securities belonging to their clients” (paragraph 36 DP, article 12 paragraph 1. (c) “ASA” and (d) “CMH” IFR (Regulation (EU) 2019/2033)
At the same time, we are deeply convinced that the additional “zero” thresholds, namely for daily trading flow, “DTF” (article 12 paragraph 1. (e) IFR), net position risk or clearing margin given, “CMG” (article 12 paragraph 1. (f) IFR) as well as trading counterparty default, “TCD” (article 12 paragraph 1. (g) IFR) urgently need to be revisited since even under the most prudent regulatory consideration, there is no rationale supporting such “zero” thresholds.
Most obviously, if an investment firm from the very first Euro traded on their own book (sic!), resulting in a NPR different from zero, would impose a “risk to market” which would justify all the capital- and organisational-, administrative-, reporting- and publication requirements as stipulated for Class 2 firms, consequently, any retail investor would have to be regulated the very same way because it is completely incomprehensible why, given the same economic circumstances (“one Euro invested”), a company with established business operations should, in the event of failure, represent a greater “risk to the market” than a failing individual (retail) investor.
In our view, it is more than obvious, that this these thresholds lack any economic or meaningful regulatory rationale but were purely driven by certain political interests which have finally prevailed in the course of the legislative “bargaining” process for the Level 1 text. As a result, securities trading or “sell side” firms (as long as they do not operate close to the frontier of Class 1 or Class 1- firms, what only extremely few of them do), de facto live in a “one class society” deprived of the original idea of proportionality.
We are emphasising these aspects not because our member firms, which are mostly Class 2 firms, would be unable to fulfil these requirements. In fact, most of them were classified as "fully fledged" Basel trading book institutes and CRR investment firms before the introduction of the IFD/IFR regime. This allows us to demonstrate how far we have deviated from the original legislative intent and to identify the negative consequences for the attractiveness of European capital markets. In fact, these – with all respect – ridiculous "zero" thresholds are simply barriers of entry that have not been made explicit. Not to be mistaken, in the light of the specific importance and perception of financial markets, we acknowledge and fully support that any company which is allowed to hold or has access to client money or assets “automatically” should become (at least) a Class 2 firm, which can indeed be achieved by setting “zero” thresholds for client money held “CMH” (article 12 paragraph 1. (d) IFR) and for assets safeguarded and administrated “ASA” (article 12 paragraph 1. (c) IFR). However, in all other cases, where firms have no authorisation to hold or directly access client money or assets, “zero” thresholds are not convincing and represent a disproportionate regulatory burden. –
This disproportionality becomes directly apparent when comparing “sell side” to the “buy side” firms. Portfolio managers are considered “small and non-interconnected” up to EUR 1,2 billion assets under management, “AUM” (article 12 paragraph 1. (a) IFR) and order routing firms are allowed to handle EUR 100 million cash trades or derivative trades worth EUR 1 billion every day (sic!), “COH” (article 12 paragraph 1. (b) IFR) before they become Class 2. Not to be mistaken, we do not want to criticise the AUM or COH thresholds, but they illustrate that the overall concept is unbalanced given the “DTF”, “NPR”, “CMG” and “TCD” “zero” thresholds.
In this context, it is worthwhile to remember that the original intention, and this was one important reason why the legal initiative was initially broadly supported, was to insure “a more suitable prudential and supervisory framework with lower compliance costs for investment firms (which) should help (to) (i) improve the overall conditions for businesses; (ii) boost market entry and competition in the process; and (iii) improve investors’ access to new opportunities and better ways of managing their risks” (European Commission, Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on the prudential requirements of investment firms and amending Regulations (EU) No 575/2013, (EU) No 600/2014 and (EU) No 1093/2010 Brussels, 20.12.2017, COM(2017) 790 final, 2017/0359 (COD), p. 5).
However, for “sell side” firms (but also for some “buy-side” firms which had to deal with significant higher regulatory requirements compared to the situation before IFD and IFR, e.g. portfolio managers without the authorisation to hold client money or to deal on own account, which were widely exempt from CRD/CRR requirements), such goals remained largely unfulfilled. Hence, the upcoming review would be a good chance to fulfil old promises and EBA & ESMA could play an active role in doing so. Unfortunately, it rather looks the opposite way and the DP gives rise to the concern that EBA & ESMA intend to make an already overly complex regulatory framework even more burdensome. We strongly urge EBA & ESMA but also the European Commission and generally all legislators involved, to take such concerns seriously. It is not only proportionality considerations that are at stake, but also the fact that excessive requirements put European investment firms at a disadvantage, create barriers to entry and harm the attractiveness and competitiveness of capital markets within the Union.
Q3: Do you have any views on the possible ways forward discussed above regarding the transition of investment firms between Class 2 and Class 3 should be introduced?
In response to the two questions posed in paragraph 41 DP, we regret that the EBA and ESMA have not provided any quantitative indications of practical relevance. However, if there are firms "oscillating" between Class 3 and Class 2, it would certainly be reasonable and appropriate to implement a transitional period regarding the application of prudential requirements corresponding to the categorisation as Class 2. This would be beneficial from a practical point of view (from a firm's as well as from a NCA's perspective) and would limit the frequency of regrouping. In both cases, we believe that a minimum of twelve months would be a reasonable timeframe for such a transition period, particularly given the increase in regulatory requirements that will occur when a Class 3 firm becomes Class 2. We would even support the implementation of a preceding observation period (e.g. six months) before the transition obligation (with a realistic transition timeframe) becomes effective.
Q4: Should the minimum level of the own funds requirements be different depending on the activities performed by investment firms or on firms’ business model? If yes, which elements should be considered in setting such minimum?
By reference to Article 4 and Annex 4 of Directive 93/6/ECC on capital adequacy of investment firms and credit institutions in paragraph 44 of the DP – EBA & ESMA rightly recall that the concept of the “fixed overhead requirements” (FOR) originates from the early days of the European transposition of “Basel” capital requirements for banks. From the beginning, FOR was calibrated at a level of a quarter of fixed overhead costs, which obviously equals a three-month overhead costs coverage period.
In the context of the presented DP, it is worth remembering that FOR was neither conceived nor calibrated with the peculiarities and characteristics of investment firms and their specific business models in mind – let alone differentiating between various business models (in particular “buy-side” vs. “sell-side”) among investment firms.
The DP correctly states in paragraph 46 that the three months calibration level “was set under the assumption that an investment firm would be required to hold own funds for an assumed wind down period, or a period for restructuring, of three months. The underlying idea is that this would aim at ensuring that the firms hold enough capital to close its operations in an orderly manner, as during such a period, the investment firm may not generate sufficient revenue to sustain its clients’ operations properly. This is directly relevant to mitigating the risk to clients.”
However, at the same time EBA & ESMA neglect to mention that the three months period was not the result of any specific calibration for investment firms when the concept was adopted by the IFD/IFR framework, but simply was “copied & pasted” from the original banking regulation toolbox.
It is therefore crucial to remember that a three month FOR “buffer” was originally considered sufficient for the orderly wind down of a credit institution. Regrettably, nobody came to the idea to ask whether this period could be possibly too long for certain investment firms depending on their business model. We therefore support in principal the proposal by EBA & ESMA in paragraph 49 of the DP that “it might be useful to analyse, whether the three-month period is still appropriate for all types of investment firms”. However, when taking into account that the three month period was taken from the banking-regulation toolbox, We see no convincing rationale (and EBA & ESMA do not provide any) to give rise to the concern “whether some type of firms may need a longer period” (ibid.).
For the reasons, we do expressly not support extending or increasing the current FOR period/calibration for investment firms, unless there is compelling evidence that the three-month period may be insufficient under certain circumstances. In fact, we believe that for most firms, the three-month assumption may be already excessive.
In this context, the following should also be taken given sufficient consideration: While there is a broad consensus – and we agree with this concept as such– that FOR is intended to provide a sufficient buffer to orderly wind down an investment firm under a “gone concern” (cf. paragraph 178 DP) assumption (or at least in a phase of substantial restructuring), it is less clear what “orderly wind down” from a regulatory perspective shall mean.
However, we think that it is self-evident that the period for “orderly wind down” in a regulatory sense must be determined differently from the duration of a legal insolvency procedure, which – depending on the complexity of national provisions – very often can easily take several years. Accordingly, we think that a regulatory “wind down period” should be defined by the time it realistically takes to reduce/unwind existing risks to clients or markets from the moment of failure – if not to zero, at least to a level which does not give rise to any regulatory concern anymore.
Under such an assumption and taking into account that a three-month period has been considered sufficient to wind down even a credit institution in the original concept of the rule, we are of the opinion that the current three-month period should be regarded as a ceiling which also could be lowered if sufficient regulatory caution is exercised and it could be realistically assumed (or demonstrated by the investment firm) that a three-month period would be unnecessary long. We would like to illustrate our thoughts with two examples:
- Clients of portfolio management firms, which manage their clients’ assets and take investment decisions on their behalf but neither have access to these assets (securities) or money since their clients’ deposits and accounts are secured by a separate custodian bank. In the case of failure of the investment firm there is no danger for clients of losing any money or assets. Furthermore, clients can usually mandate a new portfolio manager with immediate effect in the event of the firm's failure.
- Sell side firms, dealing on own account, e.g. as market-makers, and which possibly are also executing orders on behalf of their clients but without authorisation to hold/access their clients’ money or securities. A potential failure of such firms only pose a very limited risk to their clients and to markets which can usually be mitigated/neutralised within a very short timeframe. In practice, the clearing bank will immediately unwind/cover existing positions, non-executed client orders will be cancelled and eventually existing market making mandates might be reallocated by exchanges/market-operators to different investment firms. From a regulatory point of view, the “wind down period” should be no longer than one or at most a few settlement cycles (with standard settlement being “T+2” within the EU).
In those and similar cases, in particular where investment firms are not authorised to hold money or assets of their clients, we think that a realistic regulatory fact-finding should be exercised to determine whether the current level of FOR possibly could be already too high and could accordingly be lowered without any sacrifice to regulatory scrutiny.
Another indicator based on feedback from members and market observation is that FOR often significantly exceeds the corresponding K-factor-based capital requirements. There are no indications or evidences presented that K-factor requirements may be too low. In fact, some, such as net position risk are equal to or exceed CRR requirements and thereby mirror the requirements of credit institutions with balance sheets funded significantly by deposits. Thereof, the current FOR might be often set inadequately high. In fact, it is simply not convincing from a market practitioners’ perspective that the capital requirement set to cover a “gone concern” situation (FOR) regularly exceeds the regulatory capital to be held on a “going concern”-basis (through various phases of the business cycle).
And once again, the purpose of FOR is not to cover any “normal” insolvency risks as they appear in all business sectors. Furthermore, it should be noted that FOR neglects certain cashflows such as insolvency benefits.
Last but not least, it should be remembered, that inadequately high capital requirements are not only inappropriate from the perspective of the individual investment firm, but also undesirable from an economic perspective since, in aggregate, they can lead to welfare losses as a result of capital being employed in an unproductive or at least sub-optimal way.
Q5: Is it necessary to differentiate the deductibles by activity or by business model for the purpose of calculating the FOR? If yes, which items should then be considered and for what reasons?
While we acknowledge that the calibration of regulatory capital should be based on a sufficiently prudent and conservative approach, unnecessary high levels of capital requirements are undesirable from an economic perspective as already mentioned above.
Therefore, as a general rule in the context of FOR calculation, deductibles should comprise in particular all cost elements, which – in a “gone concern” situation would realistically not occur anymore because a firm will cease its activities (e.g. variable/direct trading costs in a situation where a firm stops trading). Though, in order to qualify as deductibles, a firm must be able to identify them sufficiently clearly and to demonstrate that such costs are indeed avoidable under a “gone concern” assumption(in particular, there must be no legally impeded, e.g. by contractual obligations which imply ongoing costs even if an activity has been ceased).
However, we agree with the concerns raised in paragraph 54 DP that it should be avoided to make FOR calculations unnecessarily complex by differentiating by activity or business model. Since nothing can be deducted which has not occurred before and every qualifying cost item can only be deducted once, we also do not see any serious danger of misuse or of regulatory arbitrage.
Furthermore, we would like to give an example that the existing rules are already very detailed: Recital 7 and article 1 paragraph 6 second subparagraph of Delegated Regulation (EU) 2022/1455, recognise the valuable and indispensable function of market making firms as liquidity providers and contain specific provisions for these firms in case of failure. The specific provisions/requirements were necessary because article 1 paragraph 6 (a) of Delegated Regulation (EU) 2022/1455 – in our view unnecessarily – limit the deductibility of “fees, brokerage and other charges” to cases “where they are directly passed on and charged to customers”.
Q6: Are expenses related to tied agents material for the calculation of the FOR to the extent to require a dedicated treatment for their calculation? If yes, are the considerations provided above sufficient to cover all the relevant aspects?
As bwf we have no definite opinion here.
Q7: Should the FOR be calculated distinguishing the costs related to non-MiFID activities, which criteria should be considered? What kind of advantages or disadvantages would this have in practice?
We understand that “mixed activities” firms might find themselves to be in a competitive disadvantage for the non-MiFID-regulated part of their business resulting from the FOR requirement. On the other hand, we share in principle the concerns expressed in paragraph 63 of the DP that assuming the isolated orderly wind-down of investment services only might be a somewhat unrealistic scenario.
However, as argued in our answer to Q5, we are of the opinion that the three months FOR – which originates from banking regulation – often results in inappropriately high fixed overhead requirements which probably could be reduced significantly without any sacrifice to regulatory scrutiny. If such a recalibration could be achieved, it would also ease the problem arising from “mixed activities” firms by bringing down the overall FOR even without differentiating between MiFID and non-MiFID activities.
Q8: Should expenses related to fluctuation of exchange rates be included in the list of deductions for the calculation of the FOR? If yes, which criteria should be considered in addition to the ones suggested above?
We think that for good reasons, there is – as mentioned in paragraph 69 DP – no provision in the current IFD/IFR framework which addresses the aspect of foreign exchange rates differences arising from foreign currency positions held by a firm’s clients. As a general rule, all risks arising from fluctuations in market prices, including FX risks, of assets belonging to clients should be borne by the clients to whom such assets belong.
Therefore, assuming that we have not misunderstood the question, we see no rational ground why fluctuations in exchange rates resulting from amounts in foreign currencies belonging to clients, should qualify as deductibles even in the case that the investment firm provides custody services.
However, the restriction “amount in foreign currencies, belonging to clients (…) for which the investment firm provides custody services” is only part of the explanatory text, not of the question.
Therefore, if amounts of foreign currency (or in foreign currency denominated securities) create an FX-risk for the investment firm itself, e.g. resulting from market making activities in securities denominated in foreign currencies, we think that such risks should be deductible in principle since they would not occur anymore, once a firm has ceased those activities. However, this is not the case described in the explanatory text.
Q9: Should the concept of ‘ongoing advice’ be further specified for the purpose of calculating the K-AUM? If yes, which elements should be taken into account in distinguishing a recurring provision of investment advice from a one-off or non-recurring one?
As bwf we have no definite opinion here.
Q10: Does the K-DTF provide a proper level of capital requirements for the provision of the services Trading on own account and execution of order on behalf of clients on account of the investment firm? If not, what elements of the calculation of the K-DTF present most challenges?
First of all, we would like to remember that the conceptual design as well as the calibration of K-factors were based on an intensive quantitative and qualitative analysis by EBA and the European Commission.
If “some market participants expressed concerns on the effectiveness of the K-DTF” (DP paragraph 98), it should be noted that this is a very general statement and it would be helpful to know which types of market participants have raised this question – in particular, whether the statement was made by investment firms which themselves are subject to K-DTF requirements or not. In this context it is worthwhile noticing that universal banks (which are CRR credit institutions) offering similar investment services and by doing so are directly competing with investment firms, are not subject to any regulatory capital charge which is based on their daily trading flow.
As mentioned correctly, the current design of K-DTF is based on the volume rather than on the number of trades. Accordingly, a certain volume can indeed represent a very different number of trades. However, this is not a new insight and inherent to the methodologic designed and proposed by EBA. To our understanding, it also reflects the general idea that regulatory provisions should be kept as simple as possible. Here we would like to recall one of the guiding principles of the Commissions original proposal: “The proposal is mindful of ensuring that the costs of the regime in terms of both capital requirements and associated compliance and administrative costs, which are generated by the need to manage the staff and systems in order to run the new requirements as well as report on compliance to supervisors, are kept to the minimum” (European Commission, Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on the prudential requirements of investment firms and amending Regulations (EU) No 575/2013, (EU) No 600/2014 and (EU) No 1093/2010 Brussels, 20.12.2017, COM(2017) 790 final, 2017/0359 (COD), p. 6 f.).
Furthermore, the construed and completely unrealistic example that 1 bn trades of EUR 0.01 (which equals EUR 10 mio of cumulated volume) could be deemed riskier than a single trade of EUR 1 bn is not convincing at all (in fact, we thought about whether this could have been an editorial error in the design of the – more than unrealistic – example). In the contrary, it would be a clear misconception in any way to assume that a frequent low volume trading flow (especially if it only cumulates to 1/100 of the overall volume of a second one to which it is compared) could be regarded “riskier” from a regulatory perspective. In addition, the following has to be taken into account: Even though there might be a probability that a certain percentage of the one bn EUR 0.01 transactions in the first sample might fail, such fails would be considered “high frequency, low impact events” from a risk management perspective (even though the actual risk of fails in today’s standard settlement environments is rather low), while a fail or even temporary delay in the execution and settlement of a EUR 1 bn ticket would certainly constitute a “low frequency, high impact risk” for the vast majority of Class 2 investment firms to whom the K-factor regime applies. – While “high frequency, low impact risks” can be relatively easy controlled by stochastics, this does hold true to “low frequency, high impact risks” (also known as “fat tail risks”), which – depending on the magnitude – might even threaten the existence of a firm! Taking such basic truths of risk management into consideration, we are, frankly speaking, more than surprised that EBA & ESMA are presenting such an – even though completely hypothetical – with all respect, ridiculous example as a basis for a supposedly serious regulatory discussion.
This said, we would conclude – and we have no indications which would suggest otherwise – that the calculation of K-DTF based on the volumes of transactions (a concept which btw is also applied for K-COH) is sufficiently precise for regulatory purpose while avoiding undue complexity which would have to be envisaged, if the number of transactions would have to be taken into account as an additional variable.
The second aspect which is discussed in paragraph 100 DP refers, refers to the question how K-DTP shall be calculated in situations where an investment firm concludes buy/sell transactions simultaneously and thereby interposing its balance sheet over the settlement period. While EBA & ESMA conclude that “it is implicit, in the current definition of the K-DTF, that both legs of this operation are to be taken into account”, we think that a competing view that both legs should be regarded as different parts of the same transaction and that the volume should be counted only once has considerable merit, since it would avoid the double counting of the transaction – whose economic value, following factual logic, can only be at risk once.
Q11: Would you have any examples where the calculation of the K-DTF based on comparable activities or portfolios results in very different or counterintuitive outcomes? If yes, how could the calculation of the K-DTF be improved?
Please refer to our answer to Q10.
Q12: What are the elements of the current methodology for the calculation of the K-ASA that raise most concerns? Taking into account the need to avoid complexifying excessively the methodology, how could the calculation of the K-ASA be improved to assess those elements?
Since bwf members which are subject to the IFD/IFR framework (some others are CRR credit institutions) usually are not engaged in the safekeeping and administration of assets of their clients, we would like to restrict our answer to some general considerations.
First, we expressly welcome that NCAs are monitoring the competition between investment firms and other peers, including banks, which are providing the same kind of services but do not have the same “direct” capital requirements as stipulated by the K-factor regime (in this case with respect to K-ASA) and we also agree that such differences potentially can result in a competitive disadvantage for investment firms (paragraph 116 DP).
The overall condition that Class 2 investment firms are required to hold regulatory capital based on various K-factor values which their peers, in particular (universal) banks, are usually not confronted with (with the exemption of K-NPR) inevitably results in questions of comparability and appropriateness which are indeed a very crucial aspects of the IFD/IFR regime which have been subject of intense discussions from the very beginning.
Without being able to elaborate this topic in detail here, we think that two points can provide some general orientation:
- The fact that investment firms have to hold regulatory capital based on different factors than credit institutions which are providing the same type of investment services and which they are offering to the same universe of clients appears only acceptable, if the IFD/IFR regime can be seen as a true alternative to the provisions laid down in the CRR. And factually, this was – as clearly documented – the original idea In the words of the Commission: “This proposal therefore creates a new regime for the majority of investment firms by carving them entirely out of the CRR/CRD IV framework and leaving only systemic investment firms within the scope of the latter” (European Commission, Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on the prudential requirements of investment firms and amending Regulations (EU) No 575/2013, (EU) No 600/2014 and (EU) No 1093/2010 Brussels, 20.12.2017, COM(2017) 790 final, 2017/0359 (COD), p. 5).
Unfortunately, this concept has already been violated from a methodological point of view with the subsequent introduction (at a relatively late stage in the legislative process) of K-NPR, with the intention to cover “risk to market”, whereby the calculation of net position risk was directly copied & pasted from the relevant CRR provisions. Very obviously, this was a significant deviation from the original idea of creating a comprehensively different regime (and just aside it was one of the biggest methodological flaws within the history of European capital market regulation up to date, since K-NPR, based on the CRR rules, undeniably measures “market risk” which is substantially different from “risk to market” – interestingly, the DP does not even mention this inconsistency, let alone to make a proposal to correct this open flaw). - While investment firms and banks may be competitors in providing investment services with regulatory capital requirements being calculated under different regimes, we think that the “litmus test” whether investment firms are set at an undue disadvantage to competing credit institution can be seen in the comparison of the overall capital requirements. For the same type of business, the capital requirements for investment firms should never exceed those of credit institutions. Conversely, a higher overall capital requirement for credit institutions might be justified in certain situations since banks provide investment services by imposing a balance sheet which is usually funded to a substantial degree by deposits. However, to conduct such a “litmus test” in a one-to-one comparison might be indeed challenging in practice as stated in paragraph 118 DP. Nevertheless, this does not alter the fundamental correctness of the heuristic when comparing capital requirements for investment firms and banks.
Q13: Clients’ asset protection may be implemented differently in different Member States. Should this aspect be considered in the calculation of the K-ASA? If so, how should that be taken into account in the calculation?
As a general remark, also within the IFD/IFR framework it should be avoided to compare “apples and pears”. In other words, if there is contestable evidence that the clients’ asset protection might be significantly different in different Member States then this – in principle – would justify indeed a differentiation in the calculation of K-ASA. However, from a political perspective it would probably be very difficult to conduct such a discussion in a sufficiently objective way. Therefore, we consider the realisation of such an approach to be rather unrealistic. Furthermore, any deviation from a harmonised approach would add to the complexity of the current regime.
Q14: Should crypto-assets be included into K-factor calculation, either as a new K-factor or as part of K-NPR?
First of all, as already mentioned in our answer to Q13 that K-NPR contains an embarrassing methodological error since it captures “market risk” (which means “risk to firm” arising from on- and off-balance-sheet positions which are prone to fluctuations in market prices) and not “risk to market” which is a fundamentally different concept. For sound reasons, a cornerstone of the current K-factor regime that it only addresses an investment firm’s trading book positions. One of the key reasons for this limitation is that investment firms do not conduct banking business (except Class 1 firms with “banking-like activities” which are subject to CRR rules) and most important, their on- and off-balance-sheet position do not put deposits at risk which investment firms are not authorised to hold.
Independently from the specific topic of crypto-assets, we are therefore highly concerned and alarmed when we read generalising justifications like “for a better alignment to credit institutions, investment firms could be asked to treat crypto assets in line with the treatment envisaged for credit institutions under the banking standards (Footnote 31: Prudential treatment of crypto-asset exposures (SCO60), 16 December 2022, BCBS).” – In fact, it should be remembered that it was the declared and explicit aim of the IFD/IFR framework to “disalign” or to decouple the regulatory frameworks for credit institutions and investment firms!
Here, it should be remembered that the EU was the only jurisdiction in the world which, from the days of “Basel I” decided to put, literally speaking, large, systemically important, international active banks (the original addressees of the standards developed by the Basel Committee of Banking Supervision), local banks and even investment firm more or less under the same regulatory “umbrella”. This resulted in a (ridiculous) situation, where even SME investment firms with ten or twenty employees were classified as “fully fledged” Basel trading book institutes and had to fulfil essentially the same capital adequacy and conduct of business requirements as globally active banks. The idea of a “new prudential framework for investment firms” was based on the (late) insight that this globally unique “one fits it all” approach was possibly not the best idea, not at least because it put European firms in a competitive disadvantage on a global level. Conversely, those European investment firms which had to comply with Basel-rules for decades, had literally “learned their lesson” and were able to “swim with the sharks” in the same European “CRR-pond”.
This was the initial situation in which the concept of a new regime, tailored exclusively for investment firms and following the core goal of “setting capital and other prudential requirements, including remuneration and governance, that are proportionate to investment firms (in order to) alleviate for the first time the significant costs that firms incur as a result of the bank-centric requirements of the current regime” (European Commission, Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on the prudential requirements of investment firms and amending Regulations (EU) No 575/2013, (EU) No 600/2014 and (EU) No 1093/2010 Brussels, 20.12.2017, COM(2017) 790 final, 2017/0359 (COD), p. 10).
All this seems to be somehow forgotten and it therefore sounds more than strange when the term “for a better alignment to credit institutions” is used by EBA & ESMA without any reflection as a justification for a possible rule change. In so far, the case of crypto assets but also several other considerations and proposals within the DP, seem “to breath the same spirit” and share a similar (dangerous) rationale. This is evident, for instance, in the chapters on a potential introduction of “fundamental review of the trading book” (FRTB) requirements and the potential adoption of the “credit value adjustment” (CVA) approach. We have to mention this expressly also, because the DP does not foresee any questions on these far-reaching considerations and therefore inhibits stakeholder to give any feedback within the call for advice consultation. As already mentioned in our answer to Q1 we find such a procedure in which EBA & ESMA, without giving any justification, effectively narrow the possibility of stakeholders to comment on certain important aspects of the DP is unacceptable.
As mentioned in our answer to Q1, we use the possibility to include an attachment to make at least a few comments on the “Implications of the Adoption of the Banking Package (CRR3/CRD6)”, which we consider to be of particular importance for our members.
Getting back to the topic of non-trading book positions in crypto-assets. In the event that EBA & ESMA potentially consider that Class 2 investment firms, over a predefined amount, could be required to hold own funds for crypto-assets based on the 1,250% risk weighting factor (which obviously equals a full coverage of crypto-asset positions based on the “standard” 8% Basel risk weight) as stipulated by the Basel Committee, illustrates how far the European Supervisors have already diverged from the original concept of a “new prudential regime for investment firms”. Infact it is just again a “1:1” copy & paste exercise from the banking regulation toolbox without even wasting a second on the thought how the Basel Committee arrived on the exceptionally high risk weighting factor of 1,250%. To our understanding the requirement that crypto-asset positions in the banking book shall be fully covered by own funds is clearly driven by the intent that those positions, under no circumstances, shall put deposits held by banks at risk!
For investment firms, which usually only employ their own capital or debt capital in the form of credits or loans where the creditors are well-aware of the credit risk they take, such a calibration seems to be completely inappropriate. Even more since any other company from the so-called “real economy” is allowed to take crypto-assets on their balance sheet without any capital requirement.
In our view, this also demonstrates the general dilemma of the new regime under IFD/IFR: In the far from perfect “old world” when (most) investment firms where subject to CRR rules the main problem was that these rules usually originated from negotiations within the Basel Committee on Banking Supervision (BCBS). The focus thereof always was on large internationally active banks (therefore also local and smaller European banks often “suffered” from a methodological European generalisation/misalignment). The problem was not only the (complex) “design” of the rules (and the frequently considerably high administrative burden they entailed) but equally important the calibration which regularly resulted from one (and often several quantitative impact studies “QISs”). It is not the BCBS to blame that these calibrations, not surprisingly, were not fit for purpose for investment firms whose balance sheet structures were not included in the QISs conducted by the BCBS.
Another very practical problem with the European transposition of Basel rules lied in the fact that new Basel rules always affected the (national) banking sectors as whole within the Member States and therefore, it was very difficult (if not de facto impossible) for investment firms to gain an appropriate level of attention for their specific needs. This is also a factor which should not be underestimated in analysing why the idea of a dedicated and alternative regime for investment firms initially gained generally positive industry feedback.
Although, despite all of the problems described above, there was one big advantage in those “old days” compared to today: At least at the level of adapting Basel rules to the European supervisory framework, even though investment firms sometimes may have found it difficult to get heard, but they were at least “sitting at the same table” during all stages of the consultation process since it was clear that new rules – if no express exemptions were stipulated – would also apply to investment firms. This is not the case anymore since in principle investment firms (except Class1(-) firms) are formally carved out from the CRR.
However, what we observe now and which appears highly problematic beyond the specific topic (in this case capital adequacy provisions for crypto-assets in the banking book) is an obvious tendency that EBA & ESMA consider to propose to apply instruments from the banking regulation toolbox, including “Basel” rules (in this case BCBS, SCO60, 16 December 2022 – similar examples within the DP are the topics “FRTB” and “CVA”) to investment firms simply “for a better alignment to credit institutions”. We are highly concerned about such developments, not only because of the missing appropriateness of banking rules in terms of design and calibration but also because such “spill over” or “knock on” implementations, if it becomes a rule to “copy & paste” newly introduced banking rules to the IFD/IFR framework at a later stage, would clearly violate the principles of democratic participation and equal treatment within the legislative process.
This said, we would not object in principle to discuss in an open and transparent way the general question, if exposures to crypto-assets under certain circumstances should play a future role within the K-factor regime. However, a prerequisite for such a debate would be a sufficient justification, based on evidence evaluated and presented by EBA & ESMA that the issue raises regulatory concern. The blunt justification of “a better alignment to credit institutions” certainly does not fulfil this requirement.
Q15: In the context of addressing operational risk for investment firm trading on own account, is there any further element to be considered to ensure that the requirements are proportionate to their trading activities?
The discussion of the appropriateness of K-DTF to cover operational risk in this question (as well as in the following question) seems to have some significant overlap with chapter 4.7. We therefore refer to our comments on Q10 which we do not want to repeat here.
Furthermore, in general, we think that K-DTF (together with K-COH) in its current form is a good proxy to reflect the level of operational risk that firms trading on own account or executing orders on behalf of clients in their own name are exposed to and it was EBA, based on long qualitative discussions and quantitative analysis which proposed the current calibration. If this should result in disproportionally low own funds requirements “in the opinion of some competent authorities” (paragraph 126 DP), we kindly ask EBA & ESMA to add some more substance to the discussion since any discussion which could result in changes to the current regime (and therefore may result in changing capital requirements and additional administrative/compliance costs) should be strictly evidence based – “opinions” which are not further specified, no matter who’s “opinion” it is, cannot be considered to lay sufficient ground for proposing legislative changes.
Q16: The discussion paper envisages the possibility to rely on alternative methodologies with respect to the K-DTF. If the respondents suggest an alternative approach, how would this refer to the two activities addressed under the K-DTF (trading on own account and execution on own account on behalf of the clients)?
In addition to our comments made on Q10 and Q15, we would like to add that we are once more very concerned and alarmed that EBA&ESMA – by discussing “reverting to the basic indicator approach, calculating own funds requirement as a percentage of the average over the three years of the relevant indicator (as set out for banks in Article 316 of Regulation (EU) No 575/2013)” (paragraph 127 DP) or alternatively “the standardised approach and refer only to the category ‘trading and sales’” (idid.) once again seriously consider to introduce existing prudential provisions for banks to the IFD/IFR framework, whereby it is not even clear whether the calculation of opRisk capital requirements based on CRR methodology would come on top of K-DTF or whether it is considered as an alternative.
In our view, K-DTF (as well as K-COH) are alternative, more business model specific concepts, compared to the CRR requirements. This clearly prohibits a cumulative requirement but also a replacement would be a clear turning away from the original intention to create an destinct, more specific and more appropriate prudential regime.
We also clearly and unequivocally reject the alternative proposal for a cumulative application of K-RTM and FOR as discussed in paragraph 128. As already mentioned above, capital requirement calculations based on the sum of K-factors (notwithstanding whether the methodology applied appears consistently persuasive) and FOR are complimentary and not cumulative calculations of demanded regulatory capital.
While the K-factor regime determines capital requirements under a “going concern” assumption, FOR takes a “gone concern” perspective. In other words, while (following and repeating EBA’s & ESMA’s own explanations and conclusions) the K-factor regime defines the regulatory capital required under normal conditions of operation and providing investment services throughout different phases of economic cycles, the fixed overhead requirement (FOR) is supposed to enable and ensure the orderly wind-down of an investment firm once the decision to cease activities (either by the firm itself or by the NCA) has been taken. Against such fundamental analysis, it is convincing to combine and apply the requirements und the K-factor regime and FOR in a “greater of approach”. The other way round, it would be downright absurd to combine them in a “cumulative” way since “going concern” and “gone concern” assumptions are mutually exclusive. – A fundamental methodological insight which is independent from the question whether one considers the calibration of the K-factor requirements and/or FOR appropriate for its specific purpose or not.
Q17: When addressing other activities an investment firm may perform, which elements, on top of the discussed ones, should be also taken in consideration?
We are generally sceptical to extend the application of the IFD/IFR regime beyond the provision of investment services according to MiFID. Although, this does not mean that we would not be aware that – in particular with digitalisation in its different factettes as a dominating driver – investment firms (as well as banks, near-banks, fin-tecs and other financial intermediaries) are very likely to extend their product and service offering substantially in the future.
However, as mentioned above, this is a general process which does not affect investment firms alone and any discussion on the potential need for regulatory intervention should be conducted from a holistic perspective in order to avoid inconsistent, imbalanced and duplicated regulation.
Q18: Investment firms performing MiFID activities 3 and 6 (trading on own account and underwriting on a firm commitment basis) are more exposed to unexpected liquidity needs because of market volatility. What would be the best way to measure and include liquidity needs arising from these activities as a liquidity requirement?
Here, we partly agree EBA’s & ESMA’s conclusion that “investment firms face different liquidity risks compared to credit institutions because their operations and business models are quite different” (paragraph 164 DP). Still, to the extent that credit institutions also provide investment services under MiFID, their liquidity needs are basically the same since they provide identical services to a similar universe of clients and are confronted with the same financial market infrastructure as trading venues, settlement cycles etc.
Nevertheless, we agree of course that “funding structures are different. For example, credit institutions may fund their operations using deposits which can be easily withdrawn, while investment firms commonly use equity as their main source of funding. Both can use debt, such as bonds, note, loans, etc., but for small investment firms it is often not a feasible option” (ibid.).
At the same time, we emphatically object EBA’s and ESMA’s unsubstantiated assertion that the liquidity provision under Article 43 of the IFR which requires investment firms to hold liquidity in form of liquid assets equal to one third of FOR (which equals fixed overhead requirements for one months) as “very soft” (paragraph 166 DP), which supposedly would suggest that “there may be merit in considering increasing it” (ibid.). Once again, a further tightening of existing, already high and principally “bank-like” requirements are proposed without presenting any convincing evidence.
It is simply wrong to assume or to imply that the current liquidity requirements can be considered a specifically “light touch” regulation. In the contrary, what is correct is that the current liquidity requirements for investment firms in key respects are strongly influenced by the “liquidity coverage ratio” (LCR) concept as it can be found in the CRR (Basel III) banking regulation toolbox. This holds true not only for the general one month (30 days) observation period (despite the fact that – as EBA & ESMA have correctly observed – investment firms are not confronted with the risk of an easy and immediate, unexpected withdrawal of deposits!) as well as with respect to the concept of (highly) liquid assets, which in part directly refers to Commission Delegated Regulation (EU) 2015/61 of 10 October 2014 to supplement Regulation (EU) No 575/2013 of the European Parliament and the Council with regard to liquidity coverage requirement for Credit Institutions!
While it is correct that the calculation of liquidity requirements based on FOR allows for some reduced complexity (compared to a more detailed calculation of anticipated net cash-outflows within the next 30 days), we are of the opinion that this simplification is definitely (over) compensated by the fact that the same one month/30 days liquidity buffer requirement applies to bank as well as to investment firms (while the ladder are not in danger of a liquidity squeeze resulting from an unexpectedly high withdrawal of deposits or a “bank run” in the worst case).
In fact, we rather think that EBA & ESMA, instead of making apodictic judgements that the current requirements are allegedly “very soft”, should rather start with an unbiased and open minded fact finding analysis which also includes the possible conclusion that the current rules might be already unnecessary tight and put European investment firms in an undue competitive disadvantage which in the long run will also negatively affect not only EU-capital markets but also the real economy within Member States.
We are also not aware of any significant case where liquidity requirements for investment firms based on FOR with a one month buffer period have given any reason for regulatory concern so far. In fact, for “buy-side” firms such as portfolio managers, FOR – except from extraordinary situations – is supposedly pretty close to actual cash-flow needs anyway. For “sell-side” firms active in securities trading one month cash-flows (containing in- and outflows) are, resulting from their trading activities within an infrastructural environment characterised by a standard “t+2” settlement cycle, usually significantly higher than FOR. However, it must not be forgotten that also the Basel III “LCR” requirement is based on a “net” outflow within 30 days. Accordingly, also for “sell side” firms FOR seems to be a quite good and regulatorily comfortable proxy on average (even more since substantial, not to say unrealistically high, “haircuts” on securities held in the high liquid assets portfolio are still to be anticipated).
One reason why we believe that the discussion should be conducted without prejudging the outcome and should include the possibility of concluding that the current liquidity requirements are already too high is in particular based on the observation that many investment firms (including many Class 2 firms) are in fact SME companies with SME typical cash-flow and funding structures. Therefore the current requirements which are, as mentioned before, at least oriented at provisions applicable to banks (with – as mentioned before – their specific issue of unexpected withdrawals of deposits) in practice often lead to overly prudent outcomes. E.g. it appears at least questionable that one day after pay day, an investment firm is required to hold already sufficient liquid assets for the following pay day (the same holds true – on a cumulative basis – for other comparably large monthly recuring cash outflow peaks, e.g. the periodic payment for office lease).
Finally, as a purely precautionary measure, the reminder that the one month/30-day liquidity buffer period which applies practically homogeneously to credit institutions should be regarded as absolute ceiling regarding the liquidity requirements for investment firms as long as it cannot be clearly demonstrated that liquidity requirements calculation based on FOR (a concept, just to be remembered, which was (re)introduced based on explicit preferences by EBA and the European Commission) leads to severe regulatory concerns. Accordingly, we encourage further qualitative and quantitative evaluation as proposed in paragraph 168 f. DP.
Q19: Investment firms performing the activities of providing loans and credit to clients as an ancillary service in a non-negligeable scale would be more exposed to liquidity risks. What would be the best way to measure such risk in order to take them into account for the purposes of the liquidity requirements?
As bwf we have no definite opinion here.
Q20: Investment firms, providing any of the MiFID services, but exposed to substantial exchange foreign exchange risk may be exposed to liquidity risks. What would be the best way to measure such risk in order to take them into account for the purposes of the liquidity requirements?
The question refers to the topic of “substantial foreign exchange risk”, which has no direct correspondence in the discussion text. Therefore, we find it practically impossible to reply in a meaningful/sufficiently precise way.
Frankly, we find such non-connected questions not helpful and rather confusing. Even more since, the other way round, it has repeatedly not been considered necessary elsewhere throughout the DP to give stakeholders the due opportunity to reply, even to very substantial and far-reaching considerations e.g. with respect to possible adaptions of provisions from the actual banking package.
Q21: Are there scenarios where the dependency on service providers, especially in third countries, if disrupted, may lead to unexpected liquidity needs? What type of services such providers perform?
In particular for “sell side” investment firms, third country activities may affect their liquidity needs in cross-border trading, when different jurisdictions involved have different standard-settlement cycles. E.g. the recent shift of the US to “t+1”, while the EU, for the time being, stays with “t+2” has required significant changes to liquidity management systems, e.g. for firms making markets in US-securities within the EU, whereby they might unwind or cover short- or long-positions resulting from this activity to some extent in the US home market under conditions where the liquidity in the securities affected is not sufficient within the EU. Aside from different settlement cycles, different time zones, which result often in different cut-off times within the settlement cycle need to be considered.
However, while such adjustments might have been challenging, they usually did not (or only to a limited degree) affect the liquidity requirements under IFR, which are based on a much longer observation period of one month. In this respect, the situation is not very different for credit institutions under CRR which have to comply with the 30 days LCR requirements, based on “net outflows” and not on “gross” liquidity needs.
Against this background, we do not see any need for recalibration of the current IFR liquidity framework caused by third country activities or service providers in such countries, given that the market infrastructure and the legal regulatory framework in such countries does not call for specific caution.
Q22: Are there scenarios where the dependency on liquidity providers, especially in third countries, would lead to unexpected liquidity needs? Could you provide some examples?
Here we have no further comments beyond those presented in our answer to Q 21.
Q23: What other elements should be considered in removing the possibility of the exemption in Article 43 of the IFR?
As those bwf members to whom the IFR applies are mostly Class 2 firms, we have no practical experience regarding the application of the exemption in Article 43 of the IFR and therefore no definite opinion on this topic.
Q24: Do you have any views on the possible ways forward discussed above concerning the provision of MiFID ancillary services by UCITS management companies and AIFMs?
Aside from the fact that we encourage a sufficiently detailed fact-finding exercise since any discussion of possible changes to the existing IFD/IFR framework should be clearly evidence based, as bwf we have currently no specific views on this issue.
Q25: Are differences in the regulatory regimes between MICAR and IFR/IFD a concern to market participants regarding a level playing field between CASPs and Investment firms providing crypto-asset related services? In particular, are there concerns on the capital and liquidity requirement regimes?
To our understanding, the underlying concept of MICAR was the creation of a self-contained set of regulations which is directly and equally applicable to a wide range of different norm addressees. In other words, MiCAR is deliberately designed as a “single rulebook” that defines the regulatory requirements, including capital and liquidity requirements, specifically for the business model and without referencing other, sector-specific frameworks, in this case IFR/IFD. This approach is expressly welcomed by the market, as it tends to reduce regulatory complexity, particularly for market participants that exclusively provide crypto services as CASPs.
For market participants that are both investment firms and CASPs, the regulatory capital and liquidity requirements must be observed separately for each business in accordance with IFR/IFD and MiCAR. This might be regarded as a disadvantage of the concept at first glance since it might lead to “competing” provisions within the same areas (most pronounced capital- and liquidity requirements). However, we currently do not see (yet) the need to standardise or eliminate this duplication, as the requirements under MiCAR for CASPs that are also investment firms are likely to be met in many cases anyway due to the often higher liquidity and capital requirements under IFR/IFD. The need for harmonisation should therefore at best be reassessed at a later date, after MiCAR has become fully applicable and the business activities have been tested in compliance with the various sector-specific regulatory regimes.
We therefore consider it neither necessary nor advisable at this stage to mingle MICAR with sector-specific IFR/IFD provisions. This also holds true for any crypto-asset related services. We also do not have any level playing field concerns here.
Q26: Sections 5.2, 5.4 as well as this Section 9.1 all touch upon how crypto-assets (exposures and services) may influence the IFD and the IFR. Is there any other related element that should be considered in the review of the investment firms’ prudential framework?
As mentioned already in our answer to Q14, we would not object in principle to discuss in an open and transparent way the general question, if and how exposures to crypto-assets could possibly influence the IFD and the IFR in the future. However, a prerequisite for such a discussion would be a sufficiently detailed empirical analysis presented by EBA & ESMA why and to which extent exposures of investment firms to crypto assets raise regulatory concern, whereby the regulatory perspective should be substantially different compared to banks with their funding structure based on deposits.
Q27: Is the different scope of application of remuneration requirements a concern for firms regarding the level playing field between different investment firms (class 1 minus and class 2), UCITS management companies and AIFMs, e.g., in terms of the application of the remuneration provisions, the ability to recruit and retain talent or with regard to the costs for the application of the requirements?
Obviously and as described correctly, remuneration rules differ among different sectors of the capital market and legislators were not only aware of such differences but intentionally decided to implement (or at least tolerated) different rules (e.g. there is no fixed ceiling of variable remuneration under IFD/IFR while a fixed ceiling exists within the CSD/CRR universe).
In other words, sector-specific variations reflect different assumptions about the kind and level of necessary and desirable “prescriptive” remuneration rules (whether from an individual perspective, legislators have always found the right balance in doing so, is a different question).
Accordingly, against this background or within this overall concept which allows for differentiations, the fact that remuneration rules among different types of entities active in capital markets might differ to some extent, does no per se raise “level playing field” concerns. As different firms have different principal-agent settings, the renumeration can adopt to that. An investment firm that is mainly equity funded does not need the same protection from adverse incentives compared to banks, funded by deposits. Consequently, the management can exercise a greater level of flexibility (e.g. by leveraging incentives) without raising regulatory concern.
Therefore, without further clarification, what shall – in the view of EBA & ESMA – constitute an “unlevel playing field” within the current discussion, we feel unable to comment on this in a more detailed way. And as illustrated in the previous paragraph, different regulatory treatment of different regulatory risks cannot constitute an “unlevel playing field” per se. In other words, the same economic activity (e.g. securities trading on own account) can have different regulatory implications when conducted by structurally different entities (banks vs. investment firms).
Furthermore, while “the ability to recruit and retain talent” should be given due attention in the process of designing (and reevaluating) a regulatory framework for financial markets, it is not e regulatory aim as such (like investor protection or attempts to keep systemic risks down). There are also strong variations within the same sector or even within the same company, in particular as a result of the “risk-taker” concept and “at the end of the day” the competition for talent is not restricted to the financial sector but banks, investment firms and UCIT companies are also competing with the rest of the economy which might be much less regulated (with a large part in practice being not regulated at all with respect to employee and management remuneration). And in accordance to what was said above, “the ability to recruit and retain talent” from a financial market regulator’s perspective is to ensure market stability with a framework that allows different market participates to attract and keep qualified personnel in sufficient numbers without incentivising undue risk-taking by remuneration practices.
Q28: Are the different provisions on remuneration policies, related to governance requirements and the different approach to identify the staff to whom they apply a concern for firms regarding the level playing field between different investment firms (class 1 minus under CRD or class 2 under IFD), UCITS management companies and AIFMs, e.g. in terms of the application of the remuneration provisions, the ability to recruit and retain talent or with regard to the costs for the application of the requirements?
Here, we would like to restrict ourself to a few, even though important, remarks:
- As mentioned in our answer to Q27 we are not of the opinion that certain differentiations in remuneration rules are problematic as such as long as they are based on a sound rationale, e.g. in the case of the removal of a fixed ceiling for variable remunerations for investment firms,
- The requirement to establish a “remuneration committee” as it is discussed in paragraph 233 DP, is a rather impractical concept, even for larger investment firms, which – once again – was copied & pasted directly from the banking regulatory toolbox. The reason is simply that not only the management but in particular the supervisory bodies (depending on board structures which also might be significantly different among Member States) tend to be relatively small in terms of headcount, compared to larger banks. This can result in a situation where the whole supervisory body would have to constitute the “committee” (even more since equal gender representation has to be strived for) if the relevant balance sheet threshold is continuously exceeded,
- We are of the opinion that the fact that the “remuneration bracket” of senior management and risk-takers was removed under CRD, while it persisted – respectively it became an element of the new prudential regime for investment firms – originates rather in a technical mishap on the timeline within the legislative process. The concept was removed from the CRD because it was widely regarded as inefficient and to a large extent practically useless by the industry and regulators alike. Therefore, it should be also deleted from the IFD (and wherever else it might still apply) as well.
Q29: Are the different provisions, criteria and thresholds regarding the application of derogations to the provisions on variable remuneration, and that they apply to all investment firms equally without consideration of their specific business model, a concern to firms regarding the level playing field between different investment firms (class 1 minus under CRD and class 2 under IFD), UCITS management companies and AIFMs, e.g., in terms of the application of the remuneration provisions, the ability to recruit and retain talent or with regard to the costs for applying the deferral and pay out in instruments requirements? Please provide a reasoning for your position and if possible, quantify the impact on costs and numbers of identified staff to whom remuneration provisions regarding deferral and pay out in instruments need to be applied.
The IFD/IFR remuneration framework (e.g. risk takers/identified staff concept, remuneration committees, focus on variable remuneration) and tools (“link between performance and variable remuneration, risk alignment, pay out in instruments and under deferral arrangements as well as the application of malus and claw back” – cf. paragraph 236 DP) were basically 1:1 adopted from the banking regulation toolbox without wasting much thought on the general insight that business models and risk profiles between credit institutions and investment firms are usually different (which led to the introduction of the IFD/IFR regime in contrast to CSD/CRR in the first place).
Like in the banking world, the application of several requirements is based on the exceeding of certain thresholds of on- and off-balance sheet assets whereby the IFD/IFR regime allows for further adjustments by Member States in form of increased thresholds (cf. paragraph 238 & 240 DP).
As far as EBA & ESMA suspect that such national discretions (we are talking about a potentially increased threshold from EUR 100 million to EUR 300 million and thereby about a maximal deviation of EUR 200 million, we consider such fears to be completely unfound. Even more since the DP itself concludes: “So far, the EBA is not aware of any distortions to the market that different thresholds may have caused” (paragraph 240 DP). – If there is any derogation which potentially could give rise to level playing field concerns, we see them in the different thresholds for credit institutions, which are calibrated in the EUR bns and investment firms which are calibrated with a standard of EUR 100 mn and a maximum of EUR 300 mn.
With respect to the different details in the CRD and IFD provisions regarding the EUR 50,000 de minimis threshold, which is discussed in paragraph 241 DP we do not object a harmonisation but we do not believe that the current differences give raise to serious concerns, let alone that “the difference in the criteria for the application of derogations could cause an unlevel playing field for recruiting and retaining staff and regarding the costs for applying the deferral and pay out in instruments requirements” (ibid.).
However, it would be a severe competitive disadvantage, if SME investment firms with a comparably small headcount would have to implement complex and expensive administrative arrangements in order to comply with deferral or malus and claw back arrangements. While the concepts might sound simple, they would be very time-consuming and technically complex in the implementation and administration. Such concepts might be feasible and appropriate for legal entities with several hundreds or thousands of identified staff but certainly not for the typical Class 2 investment firm.
Consequently, the insight that a comprehensive application of CRD/CRR remuneration and governance rules would be disproportional and accordingly “ongoing compliance and implementation costs related to certain remuneration and governance requirements are likely to exceed their prudential benefits, given their low risk to financial stability” (cf. COMMISSION STAFF WORKING DOCUMENT - Review of the prudential framework for investment firms, Brussels, 20.12.2017, COM(2017) 791 final, 2017/0358 (COD), p. 11) was a core principle underlying the conception of the IFD/IFR regime from the very beginning.
Furthermore, we would like to remember, that the current regulatory remuneration framework for credit institutions which still delivered the blueprint for the corresponding IFD provisions was strongly influenced in key aspects by the experiences from the financial crisis. The concept could be described as a multiperiod approach which shall discourage short term profits which might go along with taking long term risks which can materialise much later in the future. Whether this is a reasonable regulatory basic assumption, depends on the business models of the entities regulated. For institutions with large portfolios of OTC derivatives (e.g. interest rate swaps), the concept may be intuitive. It is much less convincing, if only (or primarily) cash-market operations are conducted. In our view, this lack of differentiation is a methodological shortcoming of the current approach which principally applies to credit institutions and investment firms alike.
Q30: Are the different provisions regarding the oversight on remuneration policies, disclosure and transparency a concern for firms regarding the level playing field between different investment firm, UCITS management companies and AIFMs, e.g., with regard to the costs for the application of the requirements or the need to align these underlying provisions? Please provide a reasoning for your position.
Our concerns regarding the disclosure requirements in a firm’s annual report relate more to data protection issues than to potential level playing field considerations with other financial market sectors. The level of granularity of disclosure requirements appears once again originated in the adoption of rules which were designed for much larger entities in the banking world, where the publication usually does not allow meaningful assumption on individual remunerations (e.g. members of the management board or other individual identified staff). For investment firms which very often have a comparably low headcount, the situation is different. Furthermore, the publication requirements are based on the concept of “market discipline”, which might be appropriate for a large international active bank with a broad shareholder base, including significant institutional investors. It is a much less convincing concept – if at all – for small to medium-sized investment firms, even if they might be publicly listed companies.
Q31: What would be costs or benefits of extending existing reporting requirement to financial information? Which other elements should be considered before introducing such requirement?
There are already existing and comprehensive financial reporting requirements for investment firms on a national level. These may vary between Member States and admittedly, we do not have oversight at the EU 27 level. If EBA & ESMA consider the existing national reporting requirements are not sufficient and give reasons for regulatory concern, they should explain why in more detail and possibly suggest harmonised minimum standards. However, at this point, we are not in favour of a centralised data collection approach since accounting standards in different Member States might differ and we think that the existing individual NCAs are best qualified as data collectors, not at least because the analysis of financial reporting data should not be a purely mechanical “number crunching” exercise but should be based on a detailed understanding of the particularities of the individual markets in different Member States. In our view, such expertise is still – at least to a large extent – concentrated within the various NCAs. Therefore, while we have no objection to the integration of such data, any harmonisation or mapping should be conducted in a close cooperation between EBA and the different NCAs.
Q32: Should there be the need to introduce prudential requirement for firms active in commodity markets and that are not currently subject to prudential requirements? How could the existing framework for investment firms be adapted for those cases? If a different prudential framework needs to be developed, what are the main elements that should be considered?
As mentioned before, we object the idea to use the IFD/IFR framework as a possible “collecting basin” or “catch all” approach for the regulation of all kinds of regulated or potentially regulated entities which are not credit institutions. We therefore are very sceptical with respect to the consideration to integrate currently still not regulated firms, active in the commodity markets, into the IFD/IFR regime.
Commodity markets, with respect to products, market structures and players involved, are very different from securities markets. While “buy-“ and “sell-side-”, “retail-“ and “wholesale-firms” which are currently captured by the IFD/IFR regime, also might show significant differences with respect to business models, client-structure and company size, they are – at least in most cases – still operating in a wider sense within the same market.
This does not hold true for commodity firms . Accordingly, not at least from the perspective of regulators, we think a clear distinction would be highly desirable. NCAs also would need differently trained staff with different knowledge backgrounds for the regulation of commodity markets (while the differentiations within these markets may be a challenge in itself) compared to securities markets. Furthermore, investment firms under the current IFD/IFR framework and commodity -firms are usually not competitors.
For all these reasons we do not see any convincing advantage but rather the danger of confusion and inappropriate regulation in a standardised/uniform regulation of those, structurally very different, markets.
Therefore, we very clearly would opt for an individually tailored regulatory framework which adequately takes into account the specific characteristics of commodity markets. In particular, it should aim for an adequate liquidity regime and avoid artificially limiting market resilience under the investment firm regulation as proposed by the comprehensive, recent analysis “PRINCIPLES OF ENERGY MARKET REGULATION – SECURING EFFICIENT & RESILIENT ENERGY TRADING, Report prepared for Energy Traders Europe”, Frontier Economics, Luther, 19 APRIL 2024, Url: https://cms.energytraderseurope.org/storage/uploads/media/frontier-luther---principles-of-energy-market-regulation-19042024.pdf