ComplianceFinance11/01/2021 12:00:00 AM

All you need to know about K-factors

Nicos Kynicos

2021 promises to be an eventful year for MiFID investment firms as the new prudential regime comes into effect. Under the new prudential regime for MiFID investment firms, firms in the EU and the UK will have to put into practice new methods of measuring a variety of risks. As a result, many firms are likely to experience changes to their capital and liquidity requirements.

In an earlier commentary we went over the basics of the new framework, including the method by which firms will be classified based on size and activities, and suggested a five-step approach for implementing the new framework as the deadlines start to arrive in June 2021 for EU firms and January 2022 for UK firms. Now we are going to dig deeper and explain how K-factors – the new risk assessment measures for Class 2 firms, which comprise roughly two-thirds of the industry1 – will work.

K-factor Categories

K-factors will be used by Class 2 firms to determine their capital requirements. A firm’s capital requirement is the higher of its permanent minimum capital, its fixed overhead requirement, or its K-factor requirement. The K-factor requirement is the sum of: Risk-to-Client (RtC), Risk-to-Market (RtM), and Risk-to-Firm (RtF).

Risk-to-Client K-factors

Risk-to-Client (RtC) measures are proxies for the business areas of investment firms from which harm to clients can manifest as problems that will impact the firm’s own funds (capital). Within this risk class four K-factors have been defined:

  1. Client assets under management and ongoing advice (K-AUM). This captures the risk of harm to clients from the poor management or execution of client portfolios. By defining a need to hold capital against this risk, it provides support and client benefits in terms of the continuity of service.
  2. Client assets safeguarded and administered (K-ASA). This K-factor ensures that an investment firm holds capital in proportion to such assets, regardless of whether they are on its own balance sheet or in third-party accounts.
  3. Client money held (K-CMH). This captures the risk of harm where an investment firm holds its clients’ money, whether on its own balance sheet or in third-party accounts. This is broken down further into money held in segregated accounts (K-CMHS) and money held in non-segregated accounts (K-CMHNS).
  4. Client orders handled (K-COH). This captures the risk to clients of an investment firm that executes orders in the names of clients, and not in the firm’s name, say in providing execution-only services or when a firm is part of a chain of client orders. This is broken down further into client orders handled in cash trades (K-COHC) and client orders handled in derivative trades (K-COHD).

RtC is the sum of these factors, each adjusted by a coefficient, as set out in the figure below. The formula is: (a * K-AUM) + (b * K-CMHS) + (c * K-CMHNS) + (d * K-ASA) + (e * K-COHC) + (f * K-COHD).

In all cases the K-factor requirement is calculated on the first business day of each month, and, as you can see, data collection for all K-factors is daily, except for K-AUM which is monthly. Altogether, this means that firms will need systems and processes to collect, store and validate a large amount of data that they would not have previously had to do. Notably, we foresee the biggest impact to be in the areas of K-AUM, K-ASA and K-COH, as UK firms that hold client money already must do so on a segregated basis.

Risk-to-Market K-factors

Risk-to-Market (RtM) K-factors only apply to firms with a trading book that deals on their own account or on behalf of their clients, i.e. they deal on a matched principal basis or as a market maker. There are two K-factors for RtM:

  1. Net position risk (K-NPR) is a point-in-time measure that follows the standardized approach market risk rules set out under the Capital Requirements Regulation (CRR), which investment firms with trading books will be familiar with, including the revised approaches once they become available. Under the Investment Firm Regulation (IFR), firms should calculate their K-NPR as frequently as is proportionate, meaning that if their K-NPR is highly volatile, they should calculate more frequently than if their K-NPR is relatively stable. This is for the firm to judge, and a firm’s supervisor also will have a view on what is appropriate given the risks posed.
  2. Clearing margin given (K-CMG) relates to a MiFID investment firm’s derivatives positions that are subject to clearing. At a high level, it allows a firm to use the amount of margin required by its clearing member. This could then be used as a basis for calculating its risk position in its derivative positions as an alternative to K-NPR. To use K-CMG, the investment firm will require regulatory approval. IFR Article 23 describes five conditions that would need to be met for approval, and the firm also would need to prove to its supervisor that it is not using K-CMG simply to arbitrage capital requirement rules.

The calculation on the face of it is very simple, as it is basically the total margin required by the clearing member multiplied by 1.3, which market commentators have opined is excessive. On December 16, 2020, the EBA published its final draft Regulatory Technical Standard which included important definitions relating to “total margin” and “portfolio”. The FCA is still consulting on these definitions. It is likely that the EU and UK definitions will differ – which would complicate matters for firms with entities in both jurisdictions.

Finally, it’s important to note that K-CMG cannot be used as an input to the concentration risk K-factor requirement – only K-NPR can be.

Risk-to-Firm K-factors

Risk-to-Firm (RtF) is the final set of K-factors, and must be modeled by investment firms that deal on their own account. They are a simplified version of the banking rules for counterparty credit risk and large exposures. There are three RtF K-factors:

1. Trading Counterparty Default (K-TCD). This is a less risk-sensitive version of the counterparty credit risk rules that firms have been applying under the CRR and is essentially designed to ensure that investment firms have sufficient capital to cover replacement costs and, in some cases, takes into account changes in specific exposures. It applies to a finite set of transactions within a firm’s trading book.

2. Daily Trading Flow (K-DTF). This captures the operational risks of a firm executing many trades (on its own account or on behalf of clients) due to inadequate or failed processes, people, and systems, or from external events. As with K-COH, K-DTF will be measured separately for cash trades (K-DTFC) and derivative trades (K-DTFD), the former based on the amount paid or received per trade and the latter on the notional contract value.

3. Concentration risk (K-CON). This captures the risk from individual or highly connected counterparties where a firm has an exposure greater than 25% of its own funds or, for exposures to institutions and investment firms, the lower of 100% of own funds and €/£150m. It is a simplified version of the CRR’s large exposures framework and will require daily monitoring, as firms will have to notify their supervisor of any limit breaches immediately.

Calculating K-factors

When looking at calculating K-factors, there are a few formulas to consider to help better inform your capital and reporting requirements. For this section we will look at how to calculate RtF K-factors.

RtF is the sum of the three K-factors in this risk class: K-TCD, K-DTF and K-CON.

K-TCD is calculated according to the following formula:

K-DTF is calculated using this formula (g * K-DTFC) + (h * K-DTFD) where:
Concentration risk must be monitored daily by investment firms and, where exposure values exceed certain “soft” limits, a K-CON calculation is required that involves the following two-step process:

Importance of calculation requirements

Calculating K-CON is only one aspect of the concentration risk requirement. As already stated, firms must monitor concentration risk daily and notify their supervisor immediately of the amount of any excess and the name of the individual client or group of connected clients. That means firms will need a robust framework for measuring exposure value (EV) daily. Firms with trading books that measure RtM with K-CMG also must be able to measure K-NPR and K-TCD daily, as K-CMG cannot be used as an input to K-CON (see IFR Article 39). Firms also will need to report more than just K-CON, an issue that will be discussed in our third commentary, about reporting requirements.

End Notes

1 In analysis done by the EBA (ANNEX TO THE EBA OPINION EBA-OP-2017-11), one could infer from the sample used in their report that the Class 2 reporting population is about 68% of the total population, or 3,800 firms. This may seem high, and the EBA confirms in their study that the sample was skewed towards larger firms. Even with a 25% haircut, that is still about 2,800 firms which will be impacted by the K-factors.

2 The exposure value to any individual client or group of connected clients is calculated by adding together the positive excess a firm's long positions over its short positions in the trading book issued by the client calculated under the K-NPR rules with the exposure value of derivative contracts and SFTs to which K-TCD applies

3 See Article 36 of the IFR: https://eur-lex.europa.eu/legal-content/EN/TXT/ HTML/?uri=CELEX:32019R2033&from=EN#d1e3592-1-1

4 See paragraph 1 of Article 37 of the IFR: https://eur-lex.europa.eu/legal-content/ EN/TXT/HTML/?uri=CELEX:32019R2033&from=EN#d1e3592-1-1

Nicos Kynicos
Manager - Regulatory Reporting, UK, Ireland and The Nordics
Nicos has been advising and delivering solutions to financial institutions in the areas of risk management and compliance since the inception of Basel II. He has a deep understanding of capital and liquidity management including regulatory reporting as well as the underlying data and technology needed to satisfy these complex requirements.
OneSumX Regulatory Reporting for Investment Firms
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