Investment Firms Regulation and Directive (‘IFR/IFD’) – A new prudential framework

MFSA updates its Rulebook on Investment Firms

On 26 June 2021, a new prudential framework targeting investment firms authorised and supervised under the Markets in Financial Instruments Directive (‘MiFID II’), known as the ‘IFRD Package’ was brought into effect. It is composed of two main legislative instruments – the Investment Firms Regulation (EU) 2019/2033 (the ‘IFR’) and the Investment Firms Directive (EU) 2019/2034 (the ‘IFD’), currently supplemented by the European Banking Authority (‘EBA’) reporting framework 3.1, which generally consists of implementing technical standards on reporting and disclosure obligations for investment firms.

Prior to the IFRD Package, investments firms were subject to the ‘one-size-fits-all’ banking framework, established by the Capital Requirements Regulation (‘CRR II’) and the Capital Requirements Directive (‘CRD IV’). However, due to regulatory weaknesses identified in the CRR/CRD framework capturing small and medium-sized investment firms, European legislators opted for the adoption of the IFRD Package as an appropriate and proportional regime to better address the particularities of those firms, particularly in terms of risk-sensitivity factors.

Nonetheless, investment firms of significant size (otherwise referred to as systemic firms) will continue to fall within the scope of the CRR/CRD framework, effectively resulting in a ‘two-geared’ prudential system. The assessment of the framework to be applied (either the CRR/CRD or IFR/IFD) will be based on a classification exercise prescribed under the IFRD Package. Notwithstanding the applicability of either regime, MiFID II and the Markets in Financial Instruments Regulation (‘MiFIR’) provisions will remain applicable in their entirety to all investment firms.

Malta is currently in the process of implementing the IFR and transposing the IFD into local legislation, primarily by way of amendments to the Investment Services Act (‘ISA’) (Chapter 370 of the Laws of Malta) and to various Subsidiary Legislation (‘S.L.’) under ISA, in particular to S.L. 370.15, 370.25 and 371.15 of the Laws of Malta, and also through the introduction of new S.L. specific to the implementation of the IFRD Package.

Furthermore, the Malta Financial Services Authority (‘MFSA’), as the national competent authority, has also enacted changes to the ‘Part BI: Rules Applicable to Investment Services License Holders which Qualify as MiFID Firms’ (the ‘Rulebook’), to reflect the revisions introduced by the IFRD Package. The new MFSA Rulebook has become applicable as of 6 August 2021.

The key provisions of the IFRD Package and the principle changes which have been enacted through the Rulebook are as follows:

1. Applicability

The IFRD Package applies to Investment Firms authorized and supervised under MiFID II. To that end, the new prudential framework does not apply to credit institutions, even when these offer MiFID II services, and neither to UCITS Management Companies or Alternative Investment Fund Managers. However, de minimis Fund Managers providing MiFID II services should, in principle fall within scope.

2. Firm Classification

The IFRD Package introduces the classification of investment firms into three classes and one sub-class, namely, (i) Class 1 and the sub-class, Class 1 Minus; (ii) Class 2; and (iii) Class 3. Following this change, the Rulebook is further divided into three parts:

A. Part 1 General: All classes

This part applies to all investment firms, irrespective of their classification, and contains provisions which are homegrown and partially transpose MiFID II and the IFD.

B. Part 2: Class 1 and Class 1 Minus

This part applies to investment firms of considerable size (systematic) being subject to the CRR/CRD framework, which for the purposes of the IFRD framework, are treated as if they were credit institutions. This part effectively implements the CRR Regulation and partially transposes the CRD Directive.

As a first step in assessing whether investment firms should be classified as Class 1 or Class 1 Minus, firms must provide or perform the following activities or activities: (i) dealing on own account; and/or (ii) underwriting in financial instruments; and /or (iii) placing of financial instruments on a firm commitment basis.

As a second step of the classification process, investment firms must have total consolidated assets under management equal to or in excess of EUR 15 billion in order to automatically be classified into Class 1, while firms having total value of consolidated assets under management equal to or exceeding EUR 5 billion but less than EUR 15 billion may, at the MFSA’s discretion, be classified into Class 1 Minus. This is a reflection of the provisions of the IFRD Package which allows competent authorities to determine under which framework (either the CRR/CRD or IFR/IFD) Class 1 Minus firms should fall.

C. Part 3: Class 1 Minus, Class 2 and Class 3

This part implements the IFR and partially transposes the IFD – it governs and regulates Class 2 and Class 3 investment firms. This part also applies to all Class 1 Minus firms on a case-by-case basis and as the MFSA deems fit.

Investment firms falling within either Class 2 or Class 3 are those which are not considered systematic, ‘bank like’, nor of significant size. Class 3 investments firms are generally small and non-interconnected firms, must have total consolidated assets under management of less than EUR 1.2 billion and must, at all times, satisfy certain cumulative conditions. Unlike the other firm classes, there is no specific list within the IFRD Package which Class 2 investment firms must adhere to. Class 2 firms, being small but interconnected firms (unlike those in Class 3), are the residual class, since they satisfy neither the requirements for Class 1, nor Class 1 Minus, nor Class 3.

3. Risk metrics: K-Factors

The IFRD Package also introduces quantitative indicators, known as ‘K-factors’, to accurately reflect the risks investment firms face. K-factors are divided into three risk groups, namely the (i) risk-to-client; (ii) risk-to-market; and (iii) risk-to-firm group. As a primary step, all firms regardless of their classification should calculate their own capital requirements using the K-factors for categorisation purposes. When performing such calculations, the K-factor requirement reflect the sum of the three K-factor groups.

However, only Class 2 investment firms are required to calculate their K-factors when assessing their own funds requirements. Class 1 firms must calculate their own funds requirements as per the CRR Regulation, whereas Class 3 investment firms are required to apply either the Fixed Overheads Requirement or the Permanent Minimum Capital Requirement.

4. Own funds & Capital requirements

The amount of initial capital which investment firms are required to have upon authorisation is determined on the basis of the investment services provided and/or the investment activities performed and in this respect, depending on such services provided or activities performed, there are three categories of minimum initial capital, these being of EUR 750,000; of EUR 150,000; or of EUR 75,000.

In particular, Investment Services License holders, which hold a Category 3 Local Firms License and were authorized by the MFSA before 26 December 2019, have five years within which to increase their own funds to a minimum of EUR 750,000, with a minimum increase of EUR 100,000 each year. Hence, by 2026, all domestic investment firms being in possession of Category 3 license should have an initial capital of EUR 750,000.

In addition, all investment firms must have internal processes in place to monitor and control their liquidity needs and must maintain a minimum of 1/3 of their fixed overheads in liquid assets. By way of derogation however, Class 3 firms are exempted from such obligation given their lack of systemic importance and operational efficiency.

5. Prudential reporting requirements

All investment firms subject to the IFR/IFD framework must comply with the prudential reporting requirements set out therein. By way of derogation however, investment firms forming part of a group are exempted (without being required to apply for exemption) from reporting on an individual basis.

For firms having accounting year-ends as at 31 December, the reporting framework will be applicable as of Q3 of 2021, whereas for investment firms with a different accounting year-end, reporting requirements apply once the reporting period covers at least three months under the IFRD applicability.

A new standardised set of templates (Annexes) to be used by firms in fulfillment of their reporting obligations is included in the revised Rulebook. Class 2 firms are required to submit Annex I on a quarterly basis to cover their reporting requirements in terms of own funds, concentration risk, liquidity requirements and thresholds monitoring, whereas Class 3 investment firms are instead required to submit Annex III on an annual basis to meet their reporting obligations.

Firms are encouraged to perform an impact assessment to determine any revisions or improvements necessary in line with the IFRD Package. License Holders being authorised prior to the IFRD Package coming into effect, are requested to submit their original license certificate to the MFSA, in order for the MFSA to proceed with re-issuing the License Certificates to reflect the license classification system revised in terms of the IFRD Package. The specific timeframes for such procedures may be found here.

Deloitte Malta will be monitoring developments in the furtherance and implementation of the IFRD package.