One of the building blocks of the EU’s Capital Markets Union project is entering a crucial few months as the proposed new Prudential Regime for Investment Firms enters parliamentary scrutiny.
FIA EPTA enthusiastically supports the objectives of the new Regime, also known as the Investment Firm Review (IFR), and we’ve taken a keen interest in its drafting. Now, as the process moves towards its endgame, we’re keen that the IFR is further aligned with the Capital Markets Union (CMU) goal and that it sits alongside MiFID II rather than conflicts with it.
There are two areas in particular we’d like the co-legislators to focus on: first, the risk classification of investment firms and, second, the measures suggested to calculate capital requirements.
Turning to classification. A primary objective of the CMU is to make it easier for European companies and individuals to access finance. Part of this means improving liquidity, choice, efficiency and quality in Europe’s financial markets.
Currently almost half of the liquidity on Europe’s exchanges is provided by principal trading firms such as FIA EPTA’s members. Under the proposed classification criteria in the IFR proposals, principal trading firms will instantly be categorised as ‘Class II firms’ without exception.
This means even the smallest and simplest principal trading firm will have to meet daunting capital requirements demands as well as face high compliance costs. Class I status is reserved for ‘large or systemic’ investment firms, like global systemically important investment banking groups, and Class III is for ‘small and non-interconnected’ firms.
There’s genuine concern among our members that the consequences of being ‘Class II’ will make some firms choose (or be forced) to leave the EU’s capital markets. It may also may deter new firms from being set up in Europe. This means the CMU objectives are weakened, not strengthened.
The classification of investment firms is meant to be based risk based – yet PTFs don’t have clients nor do they trade anyone’s money apart from their own. As a result, they have developed world-class risk management systems and are very disciplined in applying them.
In our view, Class III and II need to be distinguished by clear and quantifiable criteria that are actually risk-sensitive, for which we have some constructive suggestions. So, we will continue to make our case that the classification and categorisation criteria need further scrutiny if we really have our eyes on the CMU.
This leads into risk assessment to calculate capital requirements. The Commission has introduced new ‘K-factors’ which form the basis for calculating capital requirements under the new regime. It has identified two K-factors to assess for Risk to Market: KCMG and KNPR.
KNPR is a calculation of Net Position Risk and was developed for banks. And therefore, when applied to non-systemic investment firms, it produces disproportionate outcomes. Our analysis shows that if KNPR was applied to our members, their capital requirements would leap by 243% on average. It could even reach 1000% for some asset classes.
KCMG (which is derived from the margin collateral numbers calculated by clearing firms) better reflects PTFs’ business operations and results in more proportionate capital requirements. The Commission, however, has said firms must continuously monitor their risk exposure using both models and then adopt the higher of the two – which will almost always be the less efficient KNPR.
Another concern is the Risk to Firm calculation for capital requirements based on the Daily Trading Flows (KDTF). This links a firm’s daily trading volume to the capital it would be required to hold.
As it stands, the KDTF formula means that on days of high market volatility, PTFs can expect to reach their daily trading limits by lunchtime and thus be forced out of the market. Perversely, this would happen when markets and investors are most in need of the liquidity PTFs provide. By doing so KDTF would actually be conflicting with market makers’ MiFID II commitments to stay in the market in stressed circumstances.
The EU’s economy and its capital markets will benefit from a prudential regime which recognises and accounts for the distinct role of FIA EPTA’s members and other non-systemic investment firms. It should be proportionate and flexible and designed to help, not hinder, achieving the goals of the Capital Markets Union.
The goal of the CMU should provide the incentive to recalibrate these aspects of the IFR as it passes through the next stage of its development. We stand ready to work with all sides to reach this goal and adding the commitment of principal trading firms to the economic development of the European economy.