It is about to happen!  The Investment Firm Directive/Regulation (IFD/IFR) and the German implementation in the Wertpapierinstutsgesetz (WpIG)

IFD and  IFR  have already entered into force in late December 2019. As a directive, the IFD provisions had to be transposed into member state law. In Germany, this has been implemented with the new Securities Institutions Act (Wertpapierinstitutsgesetz, WpIG), which will enter into force on 26 June 2021 and will be the counterpart to the German Banking Act (Kreditwesengesetz, KWG) for investment firms. The main provisions are to be applied as early as the end of June 2021.

In preparation for the prudential regime transition, the German Central Bank (Deutsche Bundesbank) has recently been contacting all covered investment firms, i.e. mainly asset managers, advisors and brokers, to make them aware of the new provisions and to already gather initial data (the so-called K-factors, to be entered in an Excel spreadsheet) in order to be able to classify the firms concerned. Practice already shows that there are some ambiguities in the definitions that need to be taken into account, e.g. how many single investment advisory contracts with a client constitute an "ongoing" or "recurring" advisory relationship.

IFD (in the form of the WpIG) and IFR will rearrange the previous regulatory 'patchwork' for investment firms with regard to own funds requirements and some other topics (e.g. remuneration). It remains to be seen whether the new provisions will reduce this perceived patchwork of henceforth IFD/IFR, CRD/CRR and MiFID/MiFIR or whether they will contribute to it – especially because MiFID/MiFIR provisions – in particular the conduct of business rules – remain applicable in principle. In any case, the initial data request by the Bundesbank already posed some challenges for many of the firms surveyed.

While small firms will benefit from less regulation, the legislation for (systemically) relevant investment firms means no less than equal treatment with (credit) institutions in the sense of a level playing field. As a result, all other (small and medium-sized) investment firms are in principle no longer subject to the CRD/KWG/CRR framework and will have to find their way into the WpIG and IFR. Those firms will be brought under a separate, secluded supervisory regime.

Regulatory background

As early as 2015, the European Banking Authority (EBA) pointed to some weaknesses in the existing supervisory framework.

The current regime, which primarily addresses (large) banks, makes the regulation of investment firms extremely complex and does not adequately reflect the nature, scale and complexity of their (non-bank) activities and underlying business model. The European Commission therefore presented a new supervisory framework at the end of 2017 based on the EBA proposals that led to the IFD/IFR.

The revised prudential regime for investment firms

Overview of the key provisions

Firms with a consolidated balance sheet total of EUR 15 billion or more remain within the scope of CRD/CRR (i.e. large investment firms). Firms with a consolidated balance sheet total of EUR 30 billion or more are even classified as systemically important and are henceforth subject to direct ECB supervision (i.e. CRR credit institutions).

All other investment firms (as defined in MiFID II, class 2 and 3, i.e. mainly asset managers, advisors and brokers) will be subject to the new supervisory framework by June 2021 replacing the application of the CRD/CRR regime to those firms; small and non-interconnected investment firms (class 3) will be subject to even more limited requirements.

So-called "K-factors" (new risk parameters) are used in the classification of investment firms and the new calculation methodology for capital requirements. K-factors are quantitative indicators that are intended to identify risks that an investment firm may pose to clients, market access or liquidity, and to the firm itself. On the basis of these K-factors, the Bundesbank recently requested initial data from the investment firms concerned in order to obtain a first overview of the classifications (and concrete numbers of firms in classes 1 to 3 in Germany). Ashurst has already been able to accompany and support some of these firms in the assessment, data compilation and communication with the respective Bundesbank regional office.

In combination with the IFR, the WpIG will in future provide an independent prudential regime for investment firms. Comparable in design and structure to the KWG, the WpIG basically governs the entire range of prudential requirements of financial market intermediaries. In all other respects, MiFID II/MiFIR provisions remain applicable.

The WpIG structure – an overview

New risk metrics: K-factors as central control component

Investment firms will have to calculate their capital requirements on the basis of so called K-factors (cf. Articles 15 et seq. IFR). In addition, the K-factors are used to determine how an investment firm is to be classified in the new regime and which provisions apply to the firm. In Germany, this classification is currently handled by the Bundesbank regional offices.

The European Commission divides the K-factors into three groups (which in turn consist of subgroups related to the respective risk):

a) Risk-to-Client ("RtC", Article 16 IFR):

(i) K-AUM - Assets under management (Article 17 IRF)

For many small to medium-sized asset managers and advisors, the threshold of client assets under management (AUM) of EUR 1.2 billion will be the decisive landmark in terms of their regulation. It is important to understand that AUM includes not only both discretionary and non-discretionary portfolio management, but also "ongoing investment advice" (cf. Article 4(1) no. 27 IFR).

Excursus:

Ongoing investment advice?  Both supervisory law and (at least German) civil law actually assume that investment advice is typically provided on a one-off basis to a client.

This raises the question of how often investment advice must be provided to the same client for it to qualify as "ongoing"? Or, in other words, how many single dots add up to one line? Due to its significance for the capital adequacy of smaller investment advisors in particular, this question must be carefully examined. In a worst case scenario, a "wrong" conclusion would lead to a misclassification and insufficient own funds (or even an excessive amount of own funds).

In German civil law, investment advice, unlike portfolio management, which is also (and primarily) covered by "K-AUM", is precisely not a continuing obligation, unless, according to the Federal Court of Justice, the parties expressly agree upon this.

Could an investment adviser then consider to contractually exclude any "continuing obligation" with the client in order to avoid its regulatory qualification under the IFR as ongoing investment advice (provided that civil law prevails upon regulatory law)?

Thinking even further: Does the activity of a 'robo advisor' that offers and provides investment advice digitally qualify as "ongoing" simply because the client has installed the corresponding app and can obtain investment advice at virtually any time?

The IFR itself does not provide much guidance in this regard. In recital (24) it only speaks of "continuity of service of ongoing portfolio management and investment advice", whereas the IFR understands investment advice as the MiFID service (cf. Article 4(1) no. 20 IFR). Article 4(1) no. 21 IFR refers to "investment advice of an ongoing nature" as "the recurring provision of investment advice as well as the continuous or periodic assessment and monitoring or review of a client portfolio of financial instruments, including of the investments undertaken by the client on the basis of a contractual arrangement." The systematic approach at least shows that not every MiFID investment advice shall be covered by the IFR.

At this point, a legal explanation or definition of what is actually meant by "ongoing" or "recurring" would have been appreciated. This will probably remain to be clarified in the course of prudential practice.

End of excursus.

ii.  K-CMH – Client money held (Article 18 IFR)
iii. K-ASA – Assets safeguarded and administered (Article 19 IFR)
iv. K-COH – Client orders handled (Article 20 IFR)

b) Risk-to-Market ("RtM", Article 21 IFR):
i. K-NPR – Net position risk (Article 22 IFR)
ii. K-CMG – Clearing member guarantee (Article 23 IFR)

c) Risk-to-Firm ("RtF", Article 24 IFR):
i. K-TCD – Counterparty default (Article 26 IFR)
ii. K-DTF – Daily trading flow (Article 33 IFR)
iii. K-CON – Concentration risk (Article 39 IFR)

For the purpose of aggregation and calculation of K-factors, the coefficients provided for in Article 15 IFR shall be taken into account.

Note: The calculation itself is not overly complex, but collecting relevant data and its evaluation is causing some headaches right now – so is the use of vague terms such as "ongoing" advice, see our excursus above. However, these form the basis for the appropriate categorisation, and therefore the calculation is essential for all other aspects and should be regarded as extremely important. Close cooperation between the implementation project and your accounting/reporting department (or your external auditor) is essential.

Investment firms must monitor the value of their K-factors for any trends that could result in them having a materially different capital requirement for the following reporting period and must inform their competent authority of that materially different capital requirement.

Revised classification

Investment firms will be divided into three (with two subcategories in class 1) categories, referred to by EBA as a) "class 1a/b firms", b) "class 2 firms" and c) "class 3 firms":

a)  Systemically relevant firms (within the meaning of class 1a firms) are 'bank-like' firms (although they do not regularly engage in deposit or lending business) which are (re) classified as "credit institutions" and are therefore fully subject to the prudential requirements of CRD/CRR. These are companies with total assets equal to or exceeding EUR 30 billion that carry out risky, bank-like activities (e.g. dealing on own account or underwriting). Systemically relevant investment firms will then be supervised by the ECB in the same way as systemically significant institutions and will have to undergo a separate authorisation procedure and subsequently apply ECB rules (in addition to the investment services provisions).

Article 8a(3) CRD IV (and sentence 1 of recital 33 of IFD; cf. Section 2(15) WpIG) requires large investment firms authorised under MiFID II that met the conditions for treatment as a class 1 investment firm on 24 December 2019 to submit an application for re-authorisation as a credit institution under the relevant implementing provisions of national law by 27 December 2020 (i.e. re-authorisation is not automatic).

Note: Investment firms seeking re-authorisation may continue their activities until a decision has been taken on their application. However, they may require additional authorisations to take deposits and lend money which will be a matter of national law in the home country of the firm to determine the scope of the other activities which the firm is permitted to pursue. The question of the competent supervisory authority as well as the nature and scope of the licensing procedure depends on the existing and intended licenses. This also determines which existing processes can still be maintained (which would ensure a smooth transition), and for which activities new organisations and processes need to be established. Firms affected should consult with their supervisory authority at an early stage. Such licensing procedures can take well over a year, depending on the licenses in question.

Most systemically important investment firms are currently based in UK and those relocating to the EU or increasing its presence in EU 27 (e.g. as a result of Brexit) would need to consider whether they are affected by this new classification. This means that those firms would also be required to seek authorisation as credit institutions under the CRD/CRR framework.

b)  In addition, there are class 1b investment firms, with a consolidated balance sheet total of EUR 15 billion or more, which are at least not systemically relevant and therefore not subject to ECB supervision, but will nevertheless remain subject to the CRD/CRR. The re-authorisation discussed above also applies to them.

c)  Class 2 investment firms are non-systemically relevant investment firms which do not qualify as small and non-interconnected investment firms either and to which the WpIG/IFR applies without limitation.

d)  Small and non-interconnected (class 3) investment firms are very small firms with non-interconnected services. Pursuant to Article 12(1) IFR, an investment firm is deemed to be a small and non-interconnected investment firm if it complies with all the K-factor-based thresholds specified therein, such as (excerpt only):

• K-factor AUM is less than EUR 1,2 billion (probably the most critical point for most of the companies concerned);
• most other K-factors must even be zero;
• the on‐ and off‐balance‐sheet total of the investment firm is less than EUR 100 million;
• 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.

Note: Particular attention must be directed to the various K-factors, which must be zero (e.g. the counterparty default (K-TCD) or the daily trading flow (K-CON)), but deviate from that, the entity will already fall into class 2. We assume that not all investment firms that consider themselves "small" will fall into class 3.

The German legislator currently lists 720 investment firms in Germany that fall under the WpIG, of which around 70 (and thus at most about 10% of all firms) are class 2 medium-sized investment firms and around 650 are class 3 small investment firms. Concrete numbers will result from the ongoing assessment of the Bundesbank.

The individual classifications each have different effects:

a) Class 1a firms:
Firms of systemic importance will in future be classified as credit institutions. This means that these quasi-banks will be subject to the prudential requirements laid down in the CRD/CRR regime. With regard to the initial capital, Article 9(1) IFD (Section 17 WpIG) applies in this respect, i.e. EUR 750,000; instead of EUR 730,000 as previously (Article 28(2) CRD IV, cf. Article 10 lit. (a) IFD); but in case of a re-authorisation as CRR credit institution as much as EUR 5 million in accordance with Article 12(1) CRD IV; they will fall within the scope of the Single Supervisory Mechanism (SSM) and the direct supervision of the ECB. It may also be necessary to amend organisational and risk management procedures. In Germany, these firms would need a licence according to Section 32 KWG.

b) Class 1b firms:
Such firms are to be treated as institutions subject to the CRD/CRR regime. The changes for class 1b firms are not expected to be significant as such firms will continue to be authorised as investment firms and will continue to be subject to prudential regulation under CRR and monitored for compliance with the prudential requirements under CRD IV. However, they will need to consider carefully how the exemptions for investment firms will be incorporated into the revised texts of CRD V/CRR II. In Germany, these firms would need a licence according to Section 15 WpIG. The WpIG applies only to a limited extent via its Section 4. In all other respects, the KWG applies.

c) Class 2 firms:
For this class of investment firms (with a balance sheet total of less than EUR 15 billion), the WpIG/IFR requirements set out below apply without any limitations.

d) Class 3 firms:
An investment firm that fulfils the requirements set out in Article 12(1) IFR must meet only limited capital and liquidity requirements, cf. Article 6, Article 9(4), Article 11(2), Article 43(1) 2, (3), (4) IFR, and is exempt from reporting and disclosure obligations under Articles 46, 54 IFR, and from calculating exposure values under Article 36(1) IFR. These investment firms (i.e. smaller asset managers, investment advisors and investment brokers – the latter depends on which activity is used to effect orders) will be subject to a highly simplified set of provisions.

The conduct of business rules for investment firms must in principle be complied with in full (also reflecting typical civil law issues). This administrative burden will therefore change little for the time being.

Application level

In principle, all investment firms must apply the provisions of the IFR on an individual basis (Articles 5 to 8 IFR). Exceptions are provided for small and non-interconnected companies in banking groups that are subject to consolidated application and supervision in accordance with the CRR (Article 6 IFR).

Own funds and capital requirements

The provisions on own funds are contained in Articles 9 and 10 IFR. Class 2 investment firms shall have own funds consisting of the sum of their Tier 1, Additional Tier 1 and Tier 2 capital, of which at least 56 % must be CET 1, 75 % cumulated from CET 1 and Additional Tier 1, and 100 % in total from all three capital tiers.

The initial capital requirements for investment firms are set out in Articles 9 – 11 IFD (Section 17 WpIG):
a)  EUR 750,000 for investment firms authorised to provide one or more of the following MiFID II (Annex I) services and activities: A3 (dealing on own account), A6 (underwriting of financial instruments and/or placing of financial instruments on a firm commitment basis); also EUR 750,000 for investment firms authorised to provide the investment service in A9 (operation of an OTF) if these firms are dealing on their own account or are authorised to do so;

b)  EUR 75,000 for investment firms which are not permitted to hold/control client money or securities but which are authorised to provide one or more of the following MiFID II (Annex I) services and activities: A1 (reception and transmission of orders in relation to one or more financial instruments), A2 (execution of orders on behalf of clients), A4 (portfolio management), A5 (investment advice), A7 (placing of financial instruments without a firm commitment basis); and

c)  EUR 150,000 for all other investment firms.

The general capital requirements are laid down in Articles 11 to 14 IFR. Investment firms, with the exception of small and non-interconnected companies (Article 11(2) IFR), must at all times have equity capital corresponding to the highest of the following values (Article 11(1) IFR):

a) their fixed overheads requirement which should be set at (at least) 25 % of the fixed costs of the preceding year (Article 13 IFR);

b) their permanent minimum capital requirement, which must be at least equal to the amount of initial capital specified in Article 14 IFR; or

c) the K-factor requirement specified in Articles 15 et seq. IFR; and

d) a small and non-interconnected (class 3) investment firm must have only such capital as is equal to the highest of the amounts set out in a) and b).

Disclosure and reporting

The provisions on disclosure are contained in Articles 46 to 53 IFR. Investment firms are required to disclose their risk management objectives and policies, capital resources, capital requirements, remuneration policies and practices and corporate governance standards.

Article 54 IFR requires investment firms to report all the following information to the competent authorities on a quarterly basis: the amount and composition of own funds; capital requirements; calculation of capital requirements; the scope of activity in relation to the conditions referred to in Article 12(1) IFR; concentration risk; and liquidity requirements. By way of derogation, small class 3 investment firms shall only submit an annual report.

Article 53 IFR explicitly deals with environmental, social and governance risks. According to this provision (almost all) investment firms disclose information on environmental, social and governance (ESG) risks, including physical risks and transition risks (i.e. changes in politics, technology and the market environment). The information is disclosed once in the first year and thereafter every six months.

Third countries provisions

According to the European Commission, the requirements for equivalence decisions in relation to third countries and the supervision of companies with parent companies in third countries will be strengthened:

a) Article 47 MiFIR will be amended (applying to non-EU (third country) investment firms seeking to provide investment services to EU clients), which refers to Commission decisions on the equivalence of third-country jurisdictions. This requires the third country to have legally binding requirements in the area of prudential, organisational and conduct of business rules relating to investment firms that meet all the requirements of MiFIR/MiFID II, CRD IV/CRR and finally IFD/IFR.

This applies especially to the post Brexit UK: If the UK's domestic supervisory framework were to differ from that of the IFD/IFR, the EU could decide that the UK would not be granted such equivalent status.

b) According to Article 55 IFD, if the parent company of an investment firm is located in a third country, the EU Member State in which the firm is domiciled is obliged to verify whether the investment firm is subject to supervision by the authorities of the third country comparable to that of the IFD/IFR on a group level. The competent authority, which would act as group supervisor if the parent company were established in the EU, may require the establishment of a European investment holding company or a mixed financial holding company in the EU (which is equivalent to the provision on the intermediate EU parent undertaking (IPU) pursuant to Article 21b CRD V).

In Germany, these provisions have been implemented as a single measure in Section 2g KWG. If two or more CRR credit institutions or investment firms domiciled in an EU/EEA state have the same parent company domiciled in a third country and the total value of the assets of the third country group within the EU/EEA exceeds EUR 40 billion, these companies must set up a joint intermediate EU parent company.

MiFID business conduct, organisational and governance requirements

The IFD/WpIG sets up its own internal governance system (including remuneration) for class 2 and 3 firms (Articles 25 et seq. IFD; Sections 38 to 69 WpIG). For the large class 1 firms, the current Articles 73, 88, 91 CRD IV remain applicable.

Apart from that, there are basically no further changes with regard to rules of business conduct and organisational requirements. It is therefore to be feared, particularly with regard to business conduct rules and organisational requirements, that the patchwork of provisions will rather increase than shrink.

Miscellaneous

Pillar 2

The IFD contains provisions on Pillar 2 requirements based on the existing CRD IV requirements (cf. ICAAP, Article 24 IFD (Section 39 WpIG); SREP, Articles 36 and 37 IFD (Sections 47, 48 WpIG); supervisory powers of competent authorities, Article 38 to 45 IFD (Sections 49 et seq. WpIG)).

Remuneration and governance

The provisions on remuneration and governance are contained in Articles 25 to 35 IFD (Articles 30, 32 to 34 IFD; Section 38, Sections 41 to 46 WpIG). The provisions are a revised version of the governance and remuneration requirements, which are currently set out in Articles 74 to 96 CRD IV.

According to the CRD/CRR regime, there are bonus cap provisions requiring a firm to limit variable compensation to 100 % of fixed compensation (or 200 % with special shareholder approval, cf. Article 94 CRD IV). However, unlike the CRD/CRR framework (which applies to class 1 firms), the IFD/IFR do not include a requirement for a "bonus cap", the keyword is "appropriate". However, class 2 firms must issue at least 50% of the variable remuneration in non-cash instruments, with a deferral of part of the variable remuneration for 3 to 5 years and subject to malus and clawback clauses.

The governance and remuneration provisions do not apply to small and non-interconnected firms. However, class 3 firms (and all other investment firms) remain subject to the remuneration requirements of MiFID II. These requirements stipulate that firms may not reward or evaluate the performance of their own employees in a way that is contrary to their duty to act in the best interests of the client or that provides an incentive to recommend or sell a particular financial instrument when another product could better meet the needs of the client.

Overall Assessment

In essence, WpIG/IFR primarily bring about changes for small and medium-sized investment firms by exempting them from the supervisory framework of CRD/CRR and putting them under a separate set of rules in addition to the existing MiFID II/MiFIR provisions. This is intended to relieve these types of firms of the prudential burden – but it remains to be seen whether this will actually be the case, as MiFID II client-related and most organisational rules will remain unaffected and the new regime will impose substantially new calculations and reporting requirements.

Therefore, it is questionable whether this intended relief through the 'reduction of regulation' will actually be experienced by small and medium-sized investment firms. Ultimately, the complexity is not to be underestimated due to the common combination of directive and regulation, as well as the additional level 2 legal acts and level 3 guidelines of the supervisory authorities.