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The FCA's second policy statement on the implementation of the Investment Firms Prudential Regime

The FCA's second policy statement on the implementation of the Investment Firms Prudential Regime

Overview

On 26 July 2021 the Financial Conduct Authority (FCA) published PS21/9: Implementation of Investment Firms Prudential Regime.

This is the FCA's response to the second of its three consultations on the new prudential regime, which was published in April 2021 (CP21/7)(we summarised this in our briefing here). It contains feedback on the issues raised by respondents and a further set of "near-final" rules, to complement and consolidate those published alongside the first Policy Statement in June 2021 (PS21/6)(see our briefing here).

Barring some unforeseen development, the new IFPR regime will come into force in the UK on 1 January 2022. While a third, and final, consultation paper – which is expected shortly - will cover some residual matters (disclosure requirements, some consequential amendments and some overarching application provisions) the vast majority of the rules are now finalised.

Now that the policy consultation stage is finished regarding most aspects of the new regime in substance, the focus is on the granular application of the detailed near-final rules.

The topics covered in PS21/9 (see here) are set out at a very high level below.

Remuneration

In outline, all firms (including SNIs) will have to comply with a small number of basic remuneration requirements relating to remuneration policies and practices (i.e. relating governance and oversight, fixed and variable remuneration, restrictions on variable remuneration)("basic requirements"); beyond that, non-SNI firms will be subject to more detailed requirements (such as identifying material risk takers, the ban on guaranteed variable pay, malus and clawback)("standard requirements").

Only the largest non-SNI firms (i.e., for firms without a trading book, those with a rolling average of on- and off- balance sheet assets above £300m over the preceding four year period) would be required to meet the full remuneration requirements by complying with "extended remuneration requirements" (i.e. remuneration committee and pay-out process rules)("extended requirements").

The FCA has amended the application provision in the rules to refer to "performance periods" rather than "performance years" to allow for the fact that some firms have, e.g., quarterly performance periods rather than performance years. The new remuneration rules would enter into force on 1 January 2022. Firms will therefore have to apply the new rules from the start of their next performance period/year beginning on or after that date. Firms currently subject to IFPFRU or BIPRU Remuneration Codes should continue to apply those rules to performance periods preceding 1 January 2022.

In the final rules, the FCA has clarified that the MIFIDPRU Remuneration Code applies to carried interest arrangements and that carried interest must be valued at the time of its award. There is a new rule that provides that the requirements on pay-out, deferral, retention and ex-post risk adjustment only do not apply where: (a) the value of the carried interest is determined by the performance of the fund in which the carried interest is held; (b) the period between award and payment of the carried interest is at least 4 years; and (c) there are provisions for the forfeiture or cancellation of carried interest in certain situations (i.e., broadly, the material risk taker was responsible for significant losses or failed to meet fitness and propriety standards). The second and third criteria may be difficult to meet. The result is that the MIFIDPRU carried interest rules will be tougher than those applied to full-scope AIFMs under the UK AIFMD regime. The FCA has not accepted amendments proposed by industry groups which would have had the effect that carried interest arrangements would be deemed to meet the clawback rules without further adjustment. Firms will now need to review, and in some cases amend, their carried interest arrangements for UK staff.

The FCA has included guidance indicating a 3-year clawback period will be the appropriate starting period for all FCA investment firms.

The final rules confirm that CPMIs will have to apply the remuneration codes applicable to the types of business they conduct. Where a firm is subject to the MIFIDPRU Remuneration Code and, for instance, the AIFM Remuneration Code, it must comply with the most stringent of the relevant provisions. For instance, if a member of staff has responsibilities for both MiFID and non-MiFID business they will be a material risk taker for the purposes of the IFPR regime but also AIFM Remuneration Code Staff and will therefore be subject to both the MIFIDPRU Remuneration Code and the AIFM Remuneration Code. The firm will have to consider which requirement in each of the Codes is the most stringent on a provision by provision basis.

The EBA guidelines on sound remuneration policies under the EU IFD will not apply to FCA MiFID investment firms.

Own funds requirements

A fixed overheads requirement (FOR) will apply to all firms. There has been an amendment to clarify that LLP members' shares in profits are deductible provided they are fully discretionary and have been included in total expenditure (previously the draft rules had referred generally to "partners'" shares in profits, which covered general and limited partnerships, but not LLPs).

The first consultation and its policy statement had addressed the K-factors that at the time the FCA considered are applicable only to firms with permission to deal on own account (see below with regards to K-DTF). The second consultation and this latest policy statement looks at the remaining K-factors, i.e.:

  • Assets safeguarded and administered (K-ASA) – no changes to the rules consulted on;
  • Client money held (K-CMH) – broadly as consulted on, but with some clarification on the measurement of CMH and some discussion on the use of qualifying money market funds;
  • Assets under management (K-AUM) – broadly as consulted on, but with some clarificatory amendments with regards to the transitional provisions that apply to firms with missing data points together with detailed guidance on what may or may not be included when measuring AUM. The FCA has added guidance on the meaning of "investment advice of an ongoing nature" which will be of relevance to many alternative investment advisory firms;
  • Client orders handled (K-COH) – clarification of the intention that generally a transaction that the firm has executed should fall under either COH or DTF and there should not be a gap between them. This does not necessitate any changes to the COH rules but does require clarification on the application of K-DTF (see below).

Significantly, the FCA has acknowledged that there was a "gap" in the way that its draft rules for K-COH and K-DTF had previously applied. K-DTF had been expressed, in the general application provision, as only applying to firms that deal on own account. This meant that firms that execute orders on behalf of clients in their own name, but without dealing on own account, would not have been caught by either K-COH or K-DTF. The FCA has addressed this lacuna by clarifying that K-DTF is not limited to firms that deal on own account and will extend to firms that execute orders on behalf of clients in their own name. So, for instance, portfolio managers that execute client trades in their own name, pending a subsequent allocation amongst client portfolios, will be subject to K-DTF in respect of such activity, irrespective of whether the activity amounts to dealing on own account. The definition of "SNI firm" is amended to reflect this change: i.e. any firm that trades in its own name on an agency basis cannot be an SNI.

Where relevant, the above K-factors will also apply to an FCA investment firm group subject to prudential consolidation. Some amendments have been made to clarify the consolidated application of AUM, COH or DTF to intra-group transactions or arrangements.

The second consultation included a transitional provision (TP4) enabling firms that are already authorised on 1 January 2021 to calculate an average metric for as long as they lack the necessary historical data to perform the required "standard" calculation for certain K-factors (K-AUM, K-COH, K-CMH, K-ASA and K-DTF). This is not available for firms which undertake a new MiFID activity after the beginning of the IFPR regime; instead, the draft rules had contained "missing data" provisions essentially copied out from the EU Investment Firms Regulation. In the near-final rules the FCA has now amended those provisions so that the methodology used for the modified calculation of the average metric where historical data is missing is similar to the one provided for in TP4.

The second consultation had set out the FCA's proposals regarding an option to adjust the calculation of the coefficients for the daily trading flow K-factor (K-DTF) in periods of extreme market stress. The policy statement confirms the rules will proceed as proposed, although the FCA will keep the operation of the adjustment under review.

Basic liquid assets requirement

All firms will have to maintain a basic liquid asset requirement, based on holding an amount of core liquid assets equivalent to at least one third of the amount of its FOR (plus, if relevant, 1.6% of the total amount of any guarantees provided to clients). This can apply on an individual and consolidated basis (where applicable). The near-final rules confirm that where firm benefit from transitional relief allowing them to use an alternative requirement for their FOR, the basic liquid assets requirement should be calculated on the basis of the FOR as reduced. This means that exempt-CAD firms may be able to take advantage of transitional relief for their basic liquid assets requirement where they can apply the alternative requirement for their FOR.

Risk management, ICARA and SREP

In terms of risk management and governance, the policy statement confirms the introduction of an Internal Capital Adequacy and Risk Assessment (ICARA) process for all firms, through which firms will have to meet an Overall Financial Adequacy Rule (OFAR). Through the ICARA process, firms will determine what level of own funds and liquid assets they need over and above the own funds and basic liquid assets requirements outlined above.

Guidance in the rules under consultation had suggested that larger firms would have to review their ICARA process twice-yearly: the final rules provide that firms will only be required to review their ICARA processes once a year unless there are material changes to their business model.

The FCA has rejected the request from some respondents for transitional relief from the ICARA requirements for those firms that are not currently subject to an ICAAP. The lengthy commentary points to the fact that the FCA considers the lack of a transitional provision for the ICARA is consistent with the fact that there are transitional provisions for the own funds requirements; it refers to the fact that, as part of the ICARA process, firms will consider whether the risk of material potential harms can be reduced through proportionate measures other than holding additional financial resources. The final rules will, however, introduce new transitional provisions for firms with individual capital guidance or individual liquidity guidance.

The final rules will introduce an ICARA Questionnaire reporting template in support of the FCA's overall move towards "proportionate" prudential supervision based on sectors and risk of potential harm to consumers and markets.

The rules will clarify the risk management responsibilities under the Senior Manager and Certification Regime (SMCR).

Governance

The rules include high level requirements relating to internal governance and controls, clarification as to which firms are required to establish risk, remuneration and nomination committees and, where relevant, the composition and role of those committees.

Regulatory reporting

The FCA will introduce new remuneration reporting requirements (on new form MIF008). In addition, own funds will be reported on MIF001, liquid assets on MIF002, monitoring metrics on MIF003, non-K-CON concentration risk on MIF004, K-CON on MIF005 and group capital test reporting on MIF006 (which, in the final rules, has been reformatted).

Some of these reports are a simplified version of existing reporting templates. This simplification extends to the additional reporting form for collective portfolio management investment (CPMI) firms (such as AIFMs and UCITS managers which also undertake "top up" MiFID activities) - FIN067 will be updated.

An ICARA questionnaire (MIF007) will replace the existing FSA019 (Pillar 2) form.

All firms will be required to submit their IFPR returns via RegData in an xml file format.

Application of the rules to collective portfolio management investment firms

CPMIs will use the MIFIDPRU 4.5 methodology for calculating the FOR for the firm as a whole. Other MIFIDPRU rules will only apply to the MiFID (i.e. "top up") business of the firm. Broadly, the rules that are currently set out in Chapter 11 of IPRU-INV will be carried forward and will therefore be substantially the same (subject to the specific FOR methodology referred to above and some necessary consequential amendments).

The rules have been amended to clarify that the transitional relating to the fixed overheads requirement (FOR) and K-factors requirement can apply to CPMIs.

Next steps

The third and final consultation is expected shortly; the policy statement for that will be published in Q4 2021. The new regime will come into force on 1 January 2022.


If you would like further information or assistance in understanding the potential impact of the policy statement and the near-final rules, please speak to your usual Travers Smith contact or any of the individuals below.

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