IFD/IFR – The new prudential framework for Investment Firms
Following the publication on the 5th of December, 2019 in the EU Official Journal regarding the Investment Firms Directive (IFD) and Investment Firms Regulation (IFR), the new IFD/IFR regime came into force on the 26th of June, 2021 as originally planned.
The idea behind the new IFD/IFR framework is to separate (via classification) past regulatory standards set to regulate large banking groups with regulatory standards proportionate to the size/activities/risk of Investment Firms, at EU level.
Although designed for reasons more sophisticated than a simple description, IFD/IFR aims to regulate in such way that depending on the business practices, size and interconnectedness with other players, a potential failure of the investment firm can be “wound down in an orderly manner with minimal disruption to the stability of the financial markets”.
The larger scale firms will be classified as Credit Institutions and be regulated according to those standards, whereas for the rest of the Investment Firms, capital requirements will be calculated according to a Permanent Minimum Requirement, a Fixed Overhead Requirement and a new set of standards called K-Factors.
K-Factors take into consideration all those characteristics that pose a threat – external/internal (Risk to Customer, Risk to Market and Risk to Firm) – and calculate the requirements accordingly.
A practical guide to the IFD/IFR was published by CySEC with all the relevant information. The guide’s link can be found in Circular 355, point 6. A summary of the guide is provided below.
Under the IFD/IFR framework, there are four (4) classes of Investment Firms:
Class 1A – Characteristics:
- Investment Firm with current initial capital requirements of Euro 730,000 [that carry out any of the activities referred to in points (3) and (6) of Section A of Annex I to Directive 2014/65/EU (points (3) and (6) of Part I, Annex I of the Law)]
- systemically important firm due to the Risk to Market threat its size and activities pose
- will seek authorization as a Credit Institution
- is not a commodity and emission allowance dealer
- bet you didn’t know that emission allowance dealer was a thing, did ya? Google, also a thing, states the following “to incentivise firms to reduce their emissions, a government sets a cap on the maximum level of emissions and creates permits, or allowances, for each unit of emissions allowed under the cap. For a given permit price, some firms will find it easier, or cheaper, to reduce emissions than others and will sell their permits via a dealer.”
- is not a collective investment undertaking “not investing funds in various securities, real estate and other assets, with the sole aim of spreading investment risks”
- is not an insurance undertaking “authorised under the law of a territory within the EEA to carry on insurance business”
- the total value of the consolidated assets of the undertaking is equal to or exceeds EUR 30 billion
- the total value of the assets of the undertaking is less than EUR 30 billion, and the undertaking is part of a group in which the total value of the consolidated assets of all undertakings in that group that individually have total assets of less than EUR 30 billion and that carry out any of the activities referred to in points (3) and (6) of Section A of Annex I to Directive 2014/65/EU is equal to or exceeds EUR 30 billion
- the total value of the assets of the undertaking is less than EUR 30 billion, and the undertaking is part of a group in which the total value of the consolidated assets of all undertakings in the group that carry out any of the activities referred to in points (3) and (6) of Section A of Annex I to Directive 2014/65/EU is equal to or exceeds EUR 30 billion.
Class 1B – Characteristics:
- Investment Firm with current initial capital requirements of Euro 730,000 [that carry out any of the activities referred to in points (3) and (6) of Section A of Annex I to Directive 2014/65/EU (points (3) and (6) of Part I, Annex I of the Law)]
- will remain under CySEC supervision under CRR2/CRDV for prudential requirements(article 1(2) of IFR).
- is not a commodity and emission allowance dealer
- is not a collective investment undertaking
- is not an insurance undertaking
- total value of the consolidated assets of the investment firm is equal to or exceeds EUR 15 billion
- the total value of the consolidated assets of the investment firm is less than EUR 15 billion, and the investment firm is part of a group in which the total value of the consolidated assets of all undertakings in the group that individually have total assets of less than EUR 15 billion and that carry out any of the activities referred to in points (3) and (6) of Section A of Annex I to Directive 2014/65/EU is equal to or exceeds EUR 15 billion
- the investment firm is subject to a decision by the competent authority in accordance with Article 5 of IFD.
Class 2 – Characteristics:
- default categorization for Investment Firms
- large Investment Firms not classified as Systemically Important, they pose little to no threat to financial markets stability
- will be subject to new Remuneration rules
- an investment firm is categorized as Class 2 if it no longer meets any of the conditions mentioned in point Class 3 below
- will be subject to all IFR rules.
Class 3 – Characteristics:
- subject to IFR but with limited scope
- non-Systemic SNI (defined as small and non-interconnected investment firms)
- They don’t undertake higher risk activities
- They don’t hold client money or client securities
- AUM (Assets Under Management) measured in accordance with Article 17 is less than EUR 1,2 billion;
- COH (Client Orders Handled) measured in accordance with Article 20 is less than either: – EUR 100 million/day for cash trades; or – EUR 1 billion/day for derivatives;
- ASA (Assets safeguarded and administered) measured in accordance with Article 19 is zero;
- CMH (Client Money Held) measured in accordance with Article 18 is zero;
- DTF (Daily Trading Flow) measured in accordance with Article 33 is zero;
- NPR (Net Position Risk) or CMG (Clearing Margin Given) measured in accordance with Articles 22 and 23 is zero;
- TCD (Trading Counterparty Default) measured in accordance with Article 26 is zero;
- The on‐ and off‐balance‐sheet total of the investment firm is less than EUR 100 million; 5
- The total annual gross revenue from investment services and activities of the investment firm is less than EUR 30 million, calculated as an average on the basis of the annual figures from the two‐year period immediately preceding the given financial year. Investment firms under class 3 will be subject to the new IFR/IFD regime but with certain exceptions.
IFD/IFR Capital Requirements for Class 2 and 3:
PMR – Permanent Minimum Capital Requirement depending on activities
€75,000 – Not permitted to hold client money or securities belonging to its clients
- Reception and transmission of orders in relation to one or more financial instruments
- Execution of orders on behalf of clients
- Portfolio management
- Investment advice
- Placing of financial instruments without a firm commitment basis
€750,000
- Dealing on own account
- Underwriting and/or placing of financial instruments on a firm commitment basis
- Operation of an Organised Trading Facility (where the investment firm engages in dealing on own account or is permitted to do so
€150,000
All other Investment Firms
FOR – Fixed Overhead Requirement
- Set to at least ¼ of preceding year’s fixed overheads
- Excludes variable overheads such as profit shares, fees to tied agents, non-recurring expenses, variable remuneration, losses from trading on own account, tax expenditures
KFR – K-Factor Capital Requirement (for Class 2 firms)
- K-factors are quantitative indicators targeting the measurement of the risk posed by the investment firm to its customers (RtC) and to the market (RtM) but also the risk posed to the firm itself (RtF).
- A coefficient is used to multiply the K-Factor, with the result being the capital requirement.
Risk to Client (RtC)
K-AUM: Assets under management – under both discretionary portfolio management and non-discretionary advisory arrangements of an ongoing basis (Art. 17 – IFR).
Coefficient – 0,02%
K-CMH: Client money held – captures the risk of potential for harm where an investment firm holds money for its customers taking into account the legal arrangements in relation to asset segregation and irrespective of the national accounting regime applicable to client money. Excludes client money that is deposited on a (custodian) bank account in the name of the client itself, where the investment firm has access to these client funds via a third-party mandate. (on segregated or non-segregated basis) (Art. 18 – IFR).
Coefficient – 0,4% (on segregated accounts) 0,5% (on non-segregated accounts)
K-ASA: Assets safeguarded and administered – ensures that investment firms hold capital in proportion to such balances, regardless of whether they are on its own balance sheet or in third-party accounts (Art. 19 – IFR).
Coefficient – 0,04%
K-COH: Client orders handled – captures the potential risk to clients of an investment firm which executes its orders (in the name of the client, not in the name of the investment firm itself). (Art. 20 – IFR).
Coefficient – 0,1%
Risk to Market (RtM)
K-NPR: Net position risk – based on the market risk framework (standardised approach, or if applicable, internal models) of the CRR (Art. 22 – IFR)
Or K-CMG: Clearing member guarantee – Investment firm’s clearing member – where permitted by a Member State competent authority for specific types of investment firms which deal on own account through clearing members, based on the total margins required by an investment firm’s clearing member (Art. 23 – IFR)
Risk to Firm (RtF)
K-DTF: Daily trading flow – based on transactions recorded in the trading book of the investment firm dealing on own account, whether for itself or on behalf of a client, and the transactions that an investment firm enters through the execution of orders on behalf of clients in its own name. (Art. 33 – IFR)
Coefficient – 0,1% for cash trades, 0,01% on derivatives
K-TCD: Trading counterparty default – investment firm’s exposure to the default of their trading counterparties in accordance with simplified provisions for counterparty credit risk based on the CRR (Art. 26 – IFR)
K-CON: Concentration – concentration risk in an investment firm’s large exposures to specific counterparties based on the provisions of the CRR that apply to large exposures in the trading book. (Art. 39 – IFR).
IFD/IFR – Own funds requirements
Investment firms shall have own funds consisting of the sum of their Common Equity Tier 1 capital, Additional Tier 1 capital and Tier 2 capital, and shall meet all the following conditions at all times (Art. 9 of IFR):
- Common Equity Tier 1 capital /D >= 56% D
- [Common Equity Tier 1 capital + Additional Tier 1 capital] /D >= 75% D
- [Common Equity Tier 1 capital + Additional Tier 1 capital + Tier 2 capital] /D >= 100% D
Where D is the highest of own funds requirements as defined in Art. 11 of IFR and described above as:
- Fixed overheads requirement (FOR)
- Permanent Minimum capital requirement (PMR)
- K-Factor Requirement (KFR)
Concentration Risk Requirements
Concentrated Risk to an individual client or group of clients is limited to 25% of the Investment Firm’s own funds
Liquidity requirements
Investment firms under class 2 and class 3 (subject to exemptions) shall hold an amount of liquid assets equivalent to at least one third (1/3) of the Fixed overhead requirement, calculated in accordance with Art. 13(1) of IFR.
Disclosure requirements
- risk management objectives and policies (Art. 47 – IFR)
- internal governance arrangements (Art. 48 – IFR)
- own funds requirements (Art. 49, 50 – IFR)
- remuneration policy and practices (Art. 51 – IFR)
- investment policy (Art. 52 – IFR)
- environmental, social and governance risk (Art. 53 – IFR)
Reporting requirements
For deadlines on submission dates please refer to Circular 442 – published on April 21, 2021
- Level and composition of own funds
- Own funds requirements
- Own funds requirement calculations
- Where the firm is a Class 3 firm – the level of activity, including the balance sheet and revenue breakdown by investment service and applicable K-factor
- Concentration risk
- Liquidity requirements
Its very important for all new and existing Cyprus Investment Firms (CIFs) to familiarize themselves with the IFD/IFR framework, its obligations and templates. The IFR became fully applicable to all EU member states on the 26th of June, 2021. The IFD was transposed into national legislation and entered into force the same day.
Useful links
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