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-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 (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:
- 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.
- 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.
- 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).
- 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).