How the EU capital adequacy regime will apply to those with DIM permissions

  • Describe the importance of new EU capital adequacy requirements
  • Identify how it will apply
  • Explain how it will work going forwards, post-Brexit

Another good reason for implementing the EU proposals is, if the UK does implement IFR and IFD, it could help facilitate a finding by the European Commission that the UK regime governing investment firms is equivalent to EU regime for the purposes of the cross-border access requirements in MiFIR (although this could be challenging).

IFR/IFD creates three categories of firms. A business must apply a range of factors in order to determine which category applies.

In  this article, we will be looking at class two and class three firms. These firms will fall within the non-systemic distinction, which is likely to apply to firms providing DIM services. It would be helpful to define these two categories.

A Class 2 firm will satisfy a number of tests, the most pertinent being: 

  • AUM under management ≥ €1.2bn
  • Daily Client Orders handled ≥ €100m (cash trades) or €1bn (derivatives)
  • Assets safeguarded and administered ≥ zero
  • Client Money held ≥ zero
  • On- and off-balance sheet total ≥ €100 million
  • Total revenues from investment services and activities (average of the last 2 years) ≥ €30m

A Class 3 firm is simply described as “Other authorised investment firms”.

The main regulatory change will be an increase in the initial capital requirement and, for some companies, the introduction of a new methodology for calculating the ongoing risk-based capital requirement that applies to the business.

Class 2 investment firms will be subject to the higher of the sum of their “K factor” requirements, one quarter of their annual fixed overheads and their initial capital requirement. It is the K-factor which is the new dimension in deciding the initial capital requirement, and it is designed to provide a quantitative indicator for specifically identified risks.

There will be three K-factor groups: risks to customers, risk to markets, and risk to companies. The formula for calculating a company’s fixed overhead requirement is expected to stay the same.

 It is important to bear in mind that Initial Capital Requirements will be set according to their authorised activities, and therefore a Class 3 firm could have capital requirement as a Class 1 firm. The IFD sets the capital requirements out on this basis as follows:

  • €750,000: dealing on own account or underwriting or placing on a firm commitment basis (including for operators of organised trading facilities authorised to deal on their own account);
  • €75,000: reception and transmission of orders, execution of orders on behalf of clients, portfolio management, investment advice, placing on not a firm commitment basis;
  • €150,000: operation of a multilateral or organised trading facility.

From this, it can be gleaned that it is important to look at the scope of a firm’s permissions and conduct a strategic review to ensure that these permissions are absolutely necessary for the conduct of its business. Unnecessary permissions could trigger a higher level of capital adequacy with all that entails.

It can be seen from these categories that most DIMs will fall within the second category.

This means that a firm that is currently a BIPRU €50,000 (£46,200) limited licence firm will see their initial capital requirement increase to €75,000 from 26 June 2021 onwards, subject to a potential transition period.

This initial capital requirement will continue to represent the absolute minimum a company must hold to meet its capital requirements.