The new prudential regime for investment firms: key points from the first FCA Consultation Paper

United Kingdom

In December 2020, the Financial Conduct Authority (FCA) published the first of three planned Consultation Papers (CP20/24) (link) on the new UK Investment Firm Prudential Regime (“IFPR”), which is now due to be implemented on 1 January 2022 (link). This first consultation closes on 5 February 2021, with a Policy Statement and near final rules expected to follow in the first half of 2021.

In this article, we summarise some of the key points to note from the first Consultation Paper and comment on where the gaps remain, which may affect ongoing implementation projects. If you would like a high-level reminder of the background to the IFPR and the headline changes it will introduce, please review our earlier article on this topic (link).

Key points to note from the Consultation Paper

What is covered in the Consultation Paper and what is missing?

The Consultation Paper includes the first tranche of draft rules that will form part of a new single prudential sourcebook in the FCA Handbook for investment firms called “MIFIDPRU”. We expect that the process of simplifying and bringing the rules together in one place will be welcomed by many investment firms. The Consultation Paper covers some aspects of the application of the MIFIDPRU rules (i.e. which firms are subject to the rules and when), investment firm groups and prudential consolidation, aspects of the new rules for own funds (i.e. regulatory capital), concentration risk and aspects of regulatory reporting.

However, important topics have not yet been covered, with a second Consultation Paper expected to follow at the start of Q2 2021 and a third Consultation Paper at the start of Q3 2021. For example, the detailed liquidity, remuneration and risk management and governance rules are still outstanding, including the rules on the new Individual Capital and Risk Assessment (ICARA) process that will replace the ICAAP. Firms will possibly have only six months or less to prepare for implementation. Similarly, Collective Portfolio Management Investment (CPMI) firms will have to wait for confirmation as to how the IFPR will apply to them. It is also still unclear how the IFPR will interact with the FCA’s other prudential rules covering non-MiFID business. Finally, there has been uncertainty in the market as to the definition of assets under management (AUM) and assets safeguarded and administered (ASA). Unfortunately, firms will need to wait for the second Consultation Paper for more clarity in this respect. 

Use of same absolute amounts from EU IFR/D

The FCA has confirmed that it will retain the absolute amounts used in the EU Investment Firm Regulation and Directive (IFR/D) in relation to various requirements, but they will be in Sterling rather than Euro. Due to the current exchange rates, this may entail some advantages, for example the thresholds for remaining a small and non-interconnected firm will be relatively higher in the UK, but also slight competitive disadvantages, for example the permanent minimum capital requirements will also be relatively higher in the UK.

Firm categorisation – SNI and non-SNI firms

The FCA has confirmed that, under its proposals, the current definitions of FCA investment firms (e.g. BIPRU, IFPRU and exempt-CAD) will cease to exist. There will instead be two broad categories of solo-regulated investment firm: small and non-interconnected (SNI) or non-SNI. As a reminder, non-SNI firms will be subject to the “full” IFPR and includes firms that have permission to deal as principal and/or hold client money and assets. The FCA has also expressly confirmed that, with the exception of the on- and off-balance sheet total, the SNI thresholds only relate to the MiFID activities that a firm undertakes (we assume that the FCA is referring to MiFID business here).

Prudential consolidation – issues relevant for investment firm groups

  • Non-authorised parent undertakings. The Financial Services Bill 2019-2021, which is currently making its way through the UK Parliament, would if passed require the FCA to make rules applying to non-authorised parent undertakings that are either incorporated in the UK or have their principal place of business in the UK. The FCA has confirmed that, where applicable, the responsibility for complying with prudential consolidation (or the group capital test) will rest with the parent entity, whether or not it is an authorised firm. The FCA will have certain information gathering and enforcement powers in relation to such parent entities. As outlined in our previous updates, this is a significant departure from the approach of effectively enforcing consolidation group requirements only through the FCA regulated entities in the group rather than through the non-authorised group parent undertaking in the UK.

  • Group Capital Test (“GCT”). In order to use the GCT as an alternative to prudential consolidation, either the ultimate UK parent undertaking or an investment firm within its group must apply to the FCA for permission. The application must satisfy the FCA that the investment firm group has a “sufficiently simple” structure and that there is no significant risk of harm to others. The draft rules stipulate further formalities that must be met, including the calculations and necessary planning that must be undertaken (see draft MIFIDPRU 2.4.18 R). The FCA has stated that the presence of material “connected undertakings” within the group (e.g. entities that are linked by single management but not capital ties) means that it is unlikely that the structure will be sufficiently simple for this purpose. The FCA has also proposed a transitional arrangement for the temporary use of the GCT pending permission in certain circumstances.

Own funds – definition and composition of capital

The types and treatment of own funds under the IFPR will follow the same requirements as under the onshored Capital Requirements Regulation (“UK CRR”) although with some amendments to simplify the calculation of certain deductions and remove references to concepts that do not exist in the IFPR. This means that under the IFPR, all FCA investment firms will apply the same definition of own funds.

K-factor capital requirements – issues relevant for firms who deal as principal

The FCA has confirmed its intended approach to the K-factor capital requirements that are relevant to FCA investment firms that have permission to deal as principal (i.e. net position risk/K-NPR, clearing margin given/K-CMG, daily trading flow/K-DTF and trading counterparty default/K-TCD). The following were particular points to note:

  • Net position risk/K‑NPR. The FCA has confirmed that the MIFIDPRU rules will preserve the existing CRR market risk regime by carrying forward relevant rules and guidance from the current IFPRU and BIPRU sourcebooks, and by ensuring that the outstanding elements of CRR II which are due to be implemented by way of amendment to the UK CRR are not applied to FCA investment firms. Firms may already have permissions under the UK CRR in relation to their calculation of market risk and the FCA has confirmed that it will address permissions and applications, including its proposals for existing permissions for market risk, in a subsequent consultation.

  • Clearing margin given/K‑CMG. Investment firms may apply to the FCA for permission to use K‑CMG, instead of K-NPR, to calculate the market risk requirement for specified portfolios. The FCA has chosen to take a different approach to the EU by rejecting a uniform approach per trading desk, instead recognising the fact that trading desks may want to apply different methodologies to different positions. Significantly, the FCA has also proposed that investment firms that are not direct clients of clearing members should be able to apply for permission to use K-CMG in relation to portfolios that are subject to indirect clearing (which is also a different approach to the EU). The draft rules stipulate the further formalities involved in an application for permission (see draft MIFIDPRU 4.13.9 R and 4.13.12 R).

Own funds – transitional provisions

As expected, the FCA has proposed several transitional provisions (“TPs”) to help investment firms adjust to the proposed new minimum capital requirements for up to five years after IFPR implementation, including investment firms that have not yet been authorised to ensure that there is no competitive disadvantage. The FCA has also set out the detail of the application of the TPs to the consolidated own funds requirement.  

Client money and assets

In order to avoid arbitrage caused by the fact that client money held (CMH) is subject to a higher capital charge than assets safeguarded and administered (ASA), the FCA is proposing for client money invested in a money market fund to continue to be subject to the CMH charge, unless a firm is able to determine that in the event of its insolvency the relevant client(s) would have a direct proprietary interest in the units of the fund. It may be helpful for the FCA to clarify whether in its view simply complying with the relevant client assets rules here around registration and record-keeping would be sufficient to demonstrate that.

Regulatory reporting

In a move that will be welcomed by many investment firms, the FCA is proposing to adopt a bespoke UK approach to regulatory reporting, with a single suite of simplified IFPR reporting forms. The forms will need to be submitted on a quarterly basis and the reporting reference dates will be the last business day in each of March, June, September and December. This will mean that changing regulatory permissions will no longer often entail a transition to completely new regulatory returns. While the FCA is calling for fewer data items, the expectation is that firms will be able to produce additional information when asked to do so. The draft reporting templates (link) and instructions (link) have been published separately. The FSA029 balance sheet and FSA030 income statement will be retained and applied to all FCA investment firms. This is a marked contrast to the EU’s proposals to retain detailed reporting using COREP returns, which will be completely retired for FCA investment firms.

Impact of implementation – a cost/benefit analysis

The FCA expects the IFPR to be less burdensome for investment firms than the current requirements, highlighting the new optionality, simplifications to the regime and reduction in data reporting requirements as all being likely to impact firms in at least a “neutral-to-beneficial” way, and in many cases in an outright “beneficial” manner. The FCA suggests that implementation costs will be around £26,000 for non-SNIs and £5,000 for SNIs and small non-SNIs.