Our key takeaways from the FCA’s first consultation (CP20/24) on the new UK prudential regime ‘IFPR’

18th January 2021

The FCA issued its first consultation paper (CP20/24) on the new UK prudential regime ‘IFPR’ in December 2020. This follows a Discussion paper (DP20/2) issued in June 2020 that was based predominantly on the EU-wide IFD/IFR. Here we summarise our key takeaways for UK investment firms from CP20/24, that forms the first in a series of two subsequent consultations scheduled for 2Q2021 and 3Q2021, after which a final Policy Statement will be issued. The IFPR is set to go live on 1 January 2022 subject to progress and amendments to the Financial Services Bill (FS Bill). We have drafted this article with small and medium sized enterprises in mind. Firms that operate group structures will want to consider prudential consolidation factors that might be applicable to their business models. Several transitional provisions are available to firms up to a period of five years from implementation to build-up the required level of capital under the IFPRU. Speak to us for guidance, support, and implementation of the IFPR. We cover the entire process of regulatory change management including advice and full implementation of the new rules. 

 

General provisions, UK Investment Firm categorisation, and a shift to a single prudential rulebook known as ‘MIFIDPRU’

  • The UK Investment Firm Prudential regime (IFPR) is set to go live in 1 January 2022 which is a push-back from the EU-wide IFD/IFR implementation date of 26 June 2021. So UK Investment Firms will have more time to adjust to the new prudential regime

  • The FCA has reiterated the need for a new prudential regime under the IFPR from the current UK CRR regime (on-shored CRDIV/CRR regime) that was developed for banks and to protect depositors from banking failures. The IFPR focusses on harm FCA investment firms can cause to others and also considers capital, liquidity, and wind down factors specific to investment firms

  • The FCA has not covered Collective Portfolio management Investment (CPMI) firms that comprise of AIFM and UCITS investment firms in CP20/24

  • Current prudential definitions of FCA investment firms, such as BIPRU, IFPRU, exempt-CAD, will cease to exist and will be replaced with two broad prudential categories of FCA investment firms - Small and Non-Interconnected (SNI) and Non-SNI firms, based on activities undertaken. These are in line with the activities and scale of operations (thresholds) set out in IFD/IFR and DP20/2

  • Current prudential rules books applicable to investment firm such as BIPRU and IFPRU will be consolidated into one new single rulebook applicable to UK Investment Firms known as ‘MIFIDPRU’

 Own funds (capital resources) - a bit of gold-plating on deduction of software assets!

  • Treatment of own funds under the IFPR will follow the same requirements as under the UK CRR

  • The FCA is proposing that the own funds of FCA investment firms should be made up solely of:

    •  common equity tier 1 capital

    •  additional tier 1 capital

    •  and tier 2 capital

  • UK investment firms currently categorised under the IFPRU category will likely see a continuation of existing capital structure. However, BIPRU and Exempt-CAD firms are likely to require more specific adaptation to the new proposed capital structure

  • The Initial Capital requirement (ICR) also known as Permanent Minimum Capital Requirement (PMR) will increase to level suggested in the IFD and DP20/2 with a change in currency sign from the Euro ‘€’ to the British Pound Sterling ‘£’

  • Deductions from own funds (current year losses, deferred tax assets, etc) are largely in line with the EU rules. However, carve-out of certain eligible software from CET1 deduction under EU rules will be eliminated under the IFPRU and the FCA is proposing that all intangible assets must be deducted in full, with no carve-out for software assets

  • Proportions of total own fund requirement (TOFR) remains unchanged from EU laws in the following proportions:

    • CET1 ≥ 56% of TOFR

    • CET1 + AT1 ≥ 75% of TOFR, and

    • CET1 + AT1 + T2 ≥ 100% of TOFR

K-factors (variable capital requirements) for principal and matched principal traders

  • CP20/24 primarily focusses on K-factors applicable specifically to principal and matched principal traders that are likely to have the largest impact from these variable capital requirements. These are K-NPR (net position risk), K-CMG (clearing member guarantee), K-DTF (daily trading flow), K-TCD (counterparty default), and K-CON (concentration risk)

  • K-NPR (net position risk)- requirements similar to EU CRR II

    • Calculation of K-NPR is harmonised with UK CRR (EU CRR II)

      • K‑NPR requirement is to be calculated using the own funds requirements for market risk set out in Title VI of Part Three of the UK CRR

  • K-CMG (clearing member guarantee)- definition of ‘portfolio’ a variant to IFR

    • As previously iterated through DP20/2, investment firms may apply to the FCA for permission to use K-CMG instead of K-NPR

    • The formula to calculate K-CMG remains unchanged from the IFR article 23

    • FCA (UK) definition of a ‘portfolio’ for K-CMG purposes will be a variant to IFR article 23

      • FCA definition of a portfolio will be broader than the IFR including either all the positions attributable to a trading desk, or a subset of the positions of a trading desk where those positions share common characteristics and risks

      • The definition should not incentivise an investment firm to divide trading desks artificially, which could otherwise undermine the proper management of the risks arising from the activities of such desks

      • However, if an FCA investment firm has applied for permission to use flexibility, it must justify the choice of portfolio by referring to the common characteristics and risks of the positions it contains. Further, it must show it has not chosen the portfolio with a view to regulatory arbitrage

    • Firms that are clearing members of a central counterparty as well as those that are not direct clients of clearing members (i.e. firms subject to indirect clearing arrangements) can apply to use K-CMG subject to meeting eligibility criteria

    • Firms might find K-CMG to be a suitable alternative to K-NPR. However, note that firms making use of K-CMG will still need to calculate K-NPR for K-CON purposes as the calculation for K-CON is dependent on K-NPR and K-TCD

  • K-TCD (counterparty default)- largely unchanged from IFR

    • Provisions for the calculation of K-TCD are largely the same as the IFR in terms of scope and exemptions, the overarching formula to calculate K-TCD, formula for calculation of EV exposure value, replacement cost, PFE including supervisory factors for asset classes, collateral and volatility factors for different types of transactions, netting, and CVA

  • K-DTF (daily trading flow)- specificity on what constitutes ‘cash trades’

    • As a reminder, K-DTF captures daily trading flow for own name transactions including on behalf of client such as matched principal trading. It does not include the value of orders handled for clients in the name of clients that are captured within the scope of K COH – client orders handled

    • DTF will be measured in line with IFR as a rolling average (using the arithmetic mean) of an FCA investment firm's daily trading flow measured over the previous 9 months, but excluding the 3 most recent months. It will be the sum of the absolute values of each buy and sell order

    • Factors to be applied to cash trades and derivative trades remain same as under the IFR

      • the cash trade component of DTF should be multiplied by 0.1%

      • the derivatives trades component of DTF should be multiplied by 0.01%

    • However, the FCA has provided more specificity in CP20/24 as to what constitutes such trades, something the IFR failed to do. FCA proposes cash trades to be:  

      • transferable securities

      • money market instruments

      • units in collective investment undertakings

      • exchange-traded options

  • K-CON- concentration risk not just limited to the trading book

    • In CP20/24 FCA provides specificity around the scope of concertation risk not only limited to trading book exposures as laid out in the IFR on the basis that harm can arise from more than just a concentrated trading book exposure to a client

    •  To mitigate the potential for harm that can arise from different types of concentrated exposures or relationships, the FCA proposes that all FCA investment firms should monitor and control all their sources of concentration risk, including:

      • exposures in a trading book

      • assets (for example, trade debts) not recorded in a trading book

      • off-balance sheet items

      • the location of client money

      • the location of client assets

      • the location of its own cash deposits

      • the sources of its earnings

    • CP20/24 contains detailed guidance on the calculation of K-CON for firms that deal on own account including matched principal trading and OTFs trading MPB or on own account in illiquid sovereign debt

    • CP20/24 also lays down prescriptive criteria for exemptions from the calculation of K-CON

    • Soft limits and EVE (exposure value excess) calculations remain unchanged from IFR apart form change in currency sign from Euro ‘€’ to the British Pound Sterling ‘£

    • Non-SNI firms will have to calculate K-NPR and K-TCD for K-CON purposes

    • Reporting on concentration risk

      • Non-SNI firms are to report on information about the exposures or positions with their 5 largest counterparties

      • SNI investment firms will not be subject to the reporting requirement for concentration risk, although they must still monitor and control concentration risk

Reporting under the IFPR- possibly no more XBRL conversions and Corep returns!

  • The FCA will implement a single set of returns for all investment firms, simplified to 5-6 returns to capture own funds, PMR, and K-factors and group data if applicable

  • The FCA is set to retire FCA001, FSA002 and COREP returns for FCA investment firms

  • It has been proposed that all FCA investment firms should report information on a quarterly basis with the relevant reporting reference dates as the last business day in March, June, September and December

  • It has been proposed to continue to require FCA investment firms to submit balance-sheet and income statement returns. However, all FCA investment firms are to use FSA029 and FSA030 reports in the existing format for these purposes. These returns will also be required quarterly, but reporting reference dates will be determined by referring to the firm’s accounting reference date

Our feedback to DP 20/2 in action

Pillar 4 welcome our feedback to DP20/2 that has been addressed in CP20-24. We specifically raised the lack of mention in DP20/2 of the treatment of ICR/PMR for OTFs that make use of a matched principal limitation on non-equity instruments which have not been declared subject to the EMIR clearing obligation. We welcome the FCA’s inclusion of this category under the £750K PMR in CP20-24. OTF’s are able to operate with a standalone limitation to deal on own account on this matched principal basis, so this becomes relevant to OTFs looking to operate under this limitation.  We had raised the likely applicability and continued use of costly XBRL Corep returns that somewhat disadvantaged IFPRU firms over BIPRU firms due to XBRL conversion costs along with the hassle of completing somewhat overcomplicated reports that were developed for Banks under the CRDIV/CRR. The FCA has clarified the end of Corep returns under the IFPR and a shift to a single reporting structure for all investment firms. We welcome this change and anticipate investment firms will benefit form a more simplified capital adequacy reporting structure. We had raised several other issues with the FCA including about the likely article 43 (IFR) exemption from liquidity requirements for SNI firms and a request for more granular detail on the calculation of the FOR. We anticipate these to be addressed in subsequent FCA consultations.

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