Regulatory reporting requirements for Class 2 and Class 3 investment firms in the U.K. and Europe are about to change under the Investment Firm Directive and Investment Firm Regulation (IFD/IFR) - also known as IFPR in the U.K. All non-systemic (Class 2) firms and small and non-interconnected (Class 3) firms will notice a change to their capital and liquidity requirements and there will be new reporting obligations in these areas.
In the following sections we will examine 5-ways you can take control to prepare for the impending deadlines.
Step 1: Understanding the Timelines
The first of several deadlines set by the IFD/IFR is June 26, 2021. This deadline applies to all MiFID II firms and is when the regime goes live, meaning new obligations concerning own funds, capital requirements and liquidity. The U.K. will adopt the new IFPR from January 1, 2022, as announced on November 16, 2020. The two different go live dates are an immediate reflection of the post Brexit landscape that firms will need to operate in, and it will certainly add layers of cost and complications to firms with businesses in the E.U. and U.K.
E.U. based Class 2 firms will need to report new regulatory returns under the new regime starting September 30, 2021 and file their first submissions by November 11, 2022. They will have to report quarterly from then on. Class 3 firms will have to report first based on December 31, 2021 information and submit by February 11, 2022. Meanwhile U.K. based firms can expect to start reporting from March 31, 2022 and file their first submissions by May 11, 2022. (See “Knowing Your Reporting Obligations” below.)
Step 2: Determining your Class and Capital Requirements
Here is a summary of the capital requirements depending on the class of investment firm:
The newest element of these requirements is the calculation of K-Factors, which will apply only to Class 2 firms. If any of certain thresholds, described in Figure 2, is breached, then a firm is placed in Class 2. This means that a Class 3 firm will need to be able to, as soon as the regime goes into effect, scale its risk management practices to meet the Class 2 firm capital requirements should a threshold be breached.
This needs to be a watch item for firms particularly close to any threshold. Conversely, should a Class 2 firm fall below all the thresholds in Figure 2, it would need to maintain that state for six months before it could be reclassified as Class 3. A vital step to prepare for IFD/IFR and IFPR, therefore, is to determine which class your firm is likely to be in when the new regimes go live.
Step 3: Becoming OK with K-Factors
K-Factors are used to determine capital requirements. A firm’s capital requirement is the higher of its initial capital (either €730,000, €150,000, or €75,000), its Fixed Overhead Requirement (FOR) or K-Factors. The K-Factors are grouped into three risk categories:
- Risk-to-Client (IFR Articles 16-20)
- Risk-to-Market (IFR Articles 21-23)
- Risk-to-Firm (IFR Articles 24-33)
Risk-to-Client measures are proxies for the business areas of an investment firm from which harm to clients can create problems that will impact the firm’s own funds (capital). Within this class, four K-Factors have been defined: client assets under management and ongoing advice (K-AUM), client assets safeguarded and administered (K-ASA), client money held (K‐CMH), and client orders handled (K-COH).
This K‐Factor concerns firms that deal on their own account and is based on the market risk rules in the Capital Requirements Regulation (for Credit Institutions and Banks). In this risk class there are two K-Factors available to firms, Net Position Risk (K-NPR) as well as Collateral Margin Given (K-CMG) which a firm can apply to their regulator to use.
These K-Factors also apply to firms that deal on their own account. Within this risk class there are three new factors that firms will need to model: Trading Counterparty Default (K-TCD), Daily Trading Flow (K-DTF) and Concentration Risk (K-CON). Risk-to-Firm is the sum of these three factors. K-CON is determined using K-NPR and K-TCD as inputs and requires daily monitoring.
Step 4: Knowing Your Reporting Obligations
The K-Factors will be input into a new set of regulatory reporting obligations that Class 2 firms will need to comply with. To compile Risk-to-Client metrics, for example, firms will have to source data that has never been requested before for regulatory reporting, such as the average daily value of client orders handled over the last nine months, split between cash and derivative trades.
These obligations are a work in progress. The FCA has not disclosed precise requirements for U.K. firms, but the market is led to believe that they will be based on drafts published by the EBA. Beyond the regulatory reporting obligations, Class 2 firms must publish Pillar 3 Disclosure Reports. Class 3 firms that issue Alternative Tier 1 Capital Instruments also will have to do Pillar 3 Disclosure Reporting. . Both E.U. Class 2 and Class 3 firms must submit Pillar 3 Disclosure Reports from June 26, 2021, when they publish their next set of annual accounts, while the same applies to U.K. based firms, but from January 1, 2022.
The EBA has mandated many quarterly reports for Class 2 firms, perhaps more than under the CRR. Here they are, along with some guidance for Class 3 firms, for which the EBA (and FCA) propose a more proportional annual reporting obligation.
Step 5: Project Management
Firms cannot wait until the regulatory framework is finalized to begin their projects. A primary reason for the EBA and FCA publishing consultation and discussion papers is to fire a starting gun for the industry to start their preparations.
Meeting all the required deadlines requires strong, focused project management and strategic partners. The framework will be a top priority for every CEO, CFO and CRO at MiFID firms, and cooperation among IT, Compliance, Finance and Risk will be essential to manage the comprehensive changes being ushered in. In the run-up to June 2021/January 2022, firms first should determine if they are in Class 2 or 3. If the former, they must assess which K-Factors apply and whether their people, processes and systems are able to meet monitoring and reporting obligations. If not, they must start to build business cases to get funding for projects that will re-engineer their processes and systems to meet compliance deadlines that begin to arrive in less than a year.