Prudential regulation of investment firms in the European Union

List of abbreviations 9

1. Introduction to investment firms and the applicable prudential frameworks 11
1.1 Research topic & questions 12
1.2 Research methodology 13
1.3 Scope and reservations 15

2. Investment firms: What are they and which risks are they exposed to? 19
2.1 Investment firms in European legislation 19
2.1.1 How to assess the risks of investment firms? 21
2.1.2 Investment services and activities 24
2.1.2.1 Transmission of orders 26
2.1.2.2 Execution of orders 28
2.1.2.3 Matched principal trading 31
2.1.2.4 Dealing on own account 32
2.1.2.5 Portfolio management 37
2.1.2.6 Investment advice 39
2.1.2.7 Underwriting & placing without a firm commitment basis 40
2.1.2.8 Operating a Multilateral Trading Facility or an Organized Trading Facility 44
2.1.2.9 Systematic Internalisers 46
2.1.3 Ancillary services in MiFID 47
2.1.4 Framework for assessing prudential risks of investment services and activities 50
2.1.4.1 Critique on the framework used by Moloney 51
2.1.4.2 Framework for assessing the risk profile of investment firms 53
2.1.5 Exemption to the scope of MiFID 53
2.1.6 Commodity derivative dealers 56
2.1.7 AIFMD and UCITS authorised firms performing investment services 58

3. Fundamental differences in the risk profile of investment firms and banks 61
3.1 Differences between banks and investment firms 61
3.2 Types of exposures and balance sheet items of investment firms 65
3.2.1 Banks 65
3.2.2 Investment firms 67
3.2.2.1 Larger broker-dealer investment firms 68
3.2.2.2 Prototypical European investment firms 69
3.2.3 Comparison of banks and investment firms 71

4. Safeguarding client money and asset segregation 73
4.1 What is asset segregation and the impact on the risk profile of an investment firm? 76
4.1.1 Structural or off-balance sheet asset segregation 77
4.1.2 Statutory or on-balance sheet asset segregation 79
4.1.3 Concluding remarks on the methods of asset segregation and their implications for the risk profile of an investment firm 80
4.2 Ambiguity in European prudential requirements for investment firms with regard to “holding client money or securities” 81
4.3 The effects of asset segregation on the differences between banks and investment firms 84

5. International standards for the prudential regulation of investment firms and banks 87
5.1 IOSCO objectives and principles of securities regulation 88
5.2 Different prudential standards in the securities sector 91
5.3 Net Capital Rule 93
5.4 Basel Capital Requirements 94
5.4.1 The Basel approach to credit risk 95
5.4.2 The Basel approach to market risk 95
5.4.3 The Basel approach to operational risk 96
5.4.4 Usability of Basel approach for the risk profile of investment firms? 99

6. Prudential investment firm regulation in the European Union 101
6.1 The regulation of investment firms in European law 101
6.1.1 Particulars of the regulatory regime for investment firms 103
6.1.2 Reasons for prudential supervision 103
6.2 Financial systems in the European Union and their impact on the design of prudential securities regulation 107

7. How should the CRD 2013 and the CRR be applied to investment firms? 111
7.1 “Firm” and “investment firm” under CRD 2013 and CRR 111
7.2 Applicability of the various requirements in CRD 2013 and CRR 115
7.2.1 Initial capital 115
7.2.2 Own funds requirements 119
7.2.2.1 Article 92 of the CRR 121
7.2.2.2 Article 96 of the CRR 121
7.2.2.3 Article 95 of the CRR 122
7.2.2.4 Fixed overhead requirement 126
7.2.2.5 Article 93 of the CRR 127
7.2.3 Definition of capital for initial capital requirement 128
7.2.4 Consolidation and other requirements 131
7.2.4.1 Consolidation 132
7.2.4.2 Leverage and large exposures 133
7.2.4.3 Liquidity 134
7.3 Conclusions 135

8. Other topics and applicable requirements 137
8.1 Going-concern versus gone-concern regulation 137
8.2 Volcker rule for investment firms? 140
8.3 Banking Recovery and Resolution Directive 144
8.3.1 Introduction 144
8.3.2 The BRRD requirements: recovery and resolution plans 145
8.3.3 The BRRD requirements and investment firms 146
8.4 Assessing systemic relevance of investment firms 149
8.5 Conclusions 154

9. A new prudential framework for investment firms 157
9.1 A new proposal for a prudential regime for investment firms 157
9.1.1 Why a new prudential regime? 158
9.1.2 The Investment Firm Regulation and Directive 161
9.2 Investment Firm Regulation 164
9.2.1 Categorization 164
9.2.1.1 Class 1 investment firms 165
9.2.1.2 Critique on Class 1 investment firms 167
9.2.1.3 Class 1a and 1b investment firms 170
9.2.1.4 Critique on Class 1a and 1b investment firms 172
9.2.1.5 Class 2 and 3 investment firms 176
9.2.2 Capital requirements 176
9.2.2.1 Initial capital and permanent minimum requirement 177
9.2.2.2 Fixed overhead requirement 178
9.2.3 K-Factors 179
9.2.3.1 Risk to Client 182
9.2.3.2 Risk to Market 189
9.2.3.3 Risk to Firm 193
9.2.4 Consolidation 199
9.2.4.1 Group capital test 200
9.2.5 Liquidity 203
9.2.6 Own funds requirements 206
9.2.7 Other requirements 208
9.3 Investment firm Directive 208
9.3.1 Changes to the BRRD 210
9.4 Fund managers with MiFID top-up under IFR and IFD 211
9.5 Conclusions 212

10. Conclusions 215
10.1 Framework for assessing prudential risks of investment firms 216
10.1.1 Operational risk 217
10.1.2 Financial risk 218
10.1.3 Systemic risk 218
10.2 What are the prudential risks of investment firms? 219
10.3 Prudential regulatory regime for investment firms in the EU 220
10.4 Recommendations to better align the prudential regulatory response with the actual risk profile of investment firms 223
10.4.1 Prudential requirements to mitigate operational risks 223
10.4.2 Prudential requirements to mitigate financial risks 225
10.4.3 Orderly wind down requirements 226
10.4.4 Methods for assessing systemic risks of investment firms 228

Summary 231
Samenvatting 237
Sources and literature 243

Legislation 243
European treaties 243
EU Regulations and Directives 243
EU Delegated Regulations and Delegated Directives 245
EU ESA Guidelines 246
EU legislative proposals 247
Other legislation 248
Case law 248
Reports of international organisations or supervisory authorities 248
Books 252
Articles 255