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Market Regulation

Investment firms review

November 16, 2020

Level 2 measures

Executive Summary

  • The recognition by EU institutions that applying the CRD/CRR framework is disproportionate for most EU investment firms, and the subsequent introduction of the new IFD/IFR regime, is crucial for the development of deep and liquid capital markets in Europe;
  • When designing technical standards under the newly created IFD/IFR regime, it will be key to keep in mind that too rigid a framework would raise barriers to entry for smaller firms, impact liquidity provision on EU markets, and hurt the global competitiveness of EU capital markets;
  • Market making in listed instruments by non-bank principal trading firms in a cleared environment is a low-risk activity that does not justify the application of significant bank-type capital requirements.
  • Notably, recognising the specific characteristics and risk management strategies associated with market making by these principal trading firms – such as resorting to external clearing members or systematic transaction hedging – will be pivotal to preserving their ability to efficiently provide liquidity on EU markets.
  • Regarding the classification of firms, balance sheet totals or trading volumes are not the best indicators of risk for such market makers and should not solely be used to justify the application of bank capital rules to them;
  • EU legislators have rightfully decided to allow firms the use of the margin requirements of the General Clearing Member as a proxy for market risk requirements. Technical standards under the IFR should recognise the efficiency of these models to manage risk and preserve the benefit of this appropriate market risk framework.
  • With regards to the prudential consolidation of investment firm groups, applying all the IFD/IFR requirements to non-EU subsidiaries of EU investment firms could put them at a competitive disadvantage. This could indirectly impact the competitiveness of the EU investment firm groups and potentially incentivise EU holding companies to relocate their headquarters outside the EU.
  • In order to protect Europe’s diverse market ecosystem, investment firms should have enough flexibility in the way they structure (and capitalise) themselves. When it comes to payment in instruments of variable remuneration, flexibility in the type of eligible instruments or possible alternative arrangements will be needed to allow firms to reward employees in a way that is compatible with their legal and capital structure.

Introduction

Optiver commends the recognition by EU institutions that application of the CRD/CRR framework is disproportionate for most investment firms in the EU and strongly supports the introduction of the new IFD/IFR regime. 

As the focus has now turned to drafting Level 2 measures for a range of different aspects of the new IFD/R, it will be very important that independent market making firms can fully benefit from the more proportional regime that IFD/R offers, so that capital requirements are no longer constraining market makers in their role as providers of liquidity to the benefit of all investors. 

In this paper, we first briefly describe what it means to be a market maker and how market makers differ from most investment firms. We subsequently focus on how these characteristics should be taken into consideration when drafting the individual Level 2 measures. 

Market making by principal trading firms

Optiver started business in 1986 with one trader on the floor of the Amsterdam Options Exchange. By quoting bid and ask prices in options, he provided liquidity to the brokers who needed to execute orders for their clients. By immediately hedging all his trades with the underlying security he kept his risk limited. 

To this day, all our positions are generally hedged immediately, meaning that our gross positions can be very large, but the net position (and thus the risk) is extremely low. The balance sheet total of firms like Optiver is therefore an inappropriate indicator of the risk of its activities. 

Although some large banks also conduct market making activities, market making in itself is not a bank-like activity. 

The characteristics of a bank’s market making activities are substantially different from that of a principal trading firm. Banks generally make markets by providing buying and selling prices as a service to their (institutional) clients. Generally, these quotes are for large sizes, trades often take place over the counter (OTC) and very often the instruments are OTC derivatives or bonds. The risks associated with these kinds of trades are high – especially market risk (as hedging very large trades is difficult) and counterparty risk (as trades are not centrally cleared). Most importantly, although these banks trade on their own account – if things go wrong the savings and funds of clients are always at risk, as the proprietary trading activities are typically not ring-fenced.

Market making by principal trading firms, on the other hand, generally takes place on-exchange (and thus in centrally cleared instruments using an external general clearing member) and for small trade sizes, directly with other exchange members. Compared to banks, there is virtually no counterparty risk as the general clearing member guarantees the trades towards the market maker’s counterparty, and since every trade is hedged virtually instantaneously, the market risk is negligible. Another important characteristic of an independent market maker is that it does not hold any client money or deposits. In the event of a failure, only the (private) shareholders of the company will lose their capital.

Considering the special characteristics and unique risks of market making by independent principal trading firms, it is crucial to determine the appropriate level of capital that will enable them to successfully continue to provide liquidity on EU markets

2. Class 1 minus (art. 5 IFD)

According to art. 5 of IFD, national competent authorities (NCAs) may apply the CRR requirements to investment firms who (in short): 

  1. are not commodity traders;
  2. trade on own account or do underwriting;
  3. carry out activities similar to those commonly associated with undertakings that take deposits or other repayable funds from the public and grant credit on their own accounts;
  4. the activities referred to in (b) and (c) take place on such a scale that they could pose a systemic risk.

As mentioned in the introductory remarks, although both banks and independent market makers trade on their own account, their activities (and more importantly the associated risks) are substantially different. Furthermore, as trades are generally both centrally cleared and monitored, margined and guaranteed by a clearing member, failures of independent market making firms are extremely rare and have never had a systemic impact. 

RTS under art. 5(6) IFD, which will determine the conditions under which NCAs will be empowered to subject certain firms to the CRR/CRD framework, should not solely focus on trading volumes or balance sheet total when assessing independent market making firms. Instead, aspects like the level of exchange trading (v. OTC), resort to external central clearing, margining and potential risk to end-investors or savers should be considered.

Optiver believes that it would make sense to use the existing EBA guidelines on Other Systemically Important institutions (OSII) as the basis for this RTS. After all, if investment firms are potentially brought in scope of the banking framework, they should be assessed for their systemic relevance using the same criteria. 

Furthermore, we suggest expanding Annex II of the OSII guidelines to include additional, ancillary indicators, particularly relevant for trading activities (which can be used for the trading activities of both investment firms and banks), to determine their systemic relevance.

We believe that ancillary indicators that demonstrate systemic risk of trading activities are:

  1. Trading activities where clearing takes place within the same group (i.e. self-clearing – as opposed to using an external clearing member)
  2. Large positions in non-listed, complex, illiquid instruments (as opposed to trading in listed, liquid and standardised instruments);
  3. Taking directional positions on the markets (as opposed to trading done under a MiFID market making agreement);
  4. Trading activities as part of a larger investment firm group or credit institution (as opposed to being a ‘pure’ principal trading firm without clients).

3. Own funds / instruments (art. 9 IFR)

European investment firms are generally much smaller firms than banks and can have a variety of different legal structures (depending on national company law particularities). The legal set-up of a firm generally also determines how the firm is capitalised. 

Under art. 9(4) IFR, EBA and ESMA are asked to establish a list of all the forms of instruments in each member state that qualify as ‘own funds’. Recital 12 IFR states that: “To ensure that the requirements are proportionate to the nature, scope and complexity of the activities of investment firms and are readily accessible to them within this Regulation, a review should subsequently take place as to the appropriateness of continuing to align the definition and composition of own funds with Regulation (EU) No 575/2013”. 

In the Netherlands the ‘Vennootschap onder Firma’ (VoF) is a common legal partnership structure for trading firms, in which the capital of the partners is truly at risk. As this model creates strong alignment of incentives for the prudent management of risks by firms, partners’ capital in this type of firm should be considered as an eligible own fund instrument under the IFR/IFD framework. 

Deferred variable pay

At principal trading firms fixed pay is generally very low and employees receive a share of the profit of the firm as variable pay. Under IFD, investment firms are required to defer at least 40% of the variable remuneration for 3-5 years. The total amount of deferred variable pay can therefore be as high as 15-25% of the total capital requirement. 

To allow for sufficient flexibility and to adapt to the variety of EU investment firms’ structures, deferred payments to employees should also qualify as capital under the own funds requirements, as long as firms are fully able to reduce or cancel these deferred payments in case of a decrease in the firm’s economic performance.

4. Calculating K-CMG (art. 23 IFR)

Principal trading firms generally use a General Clearing Member (GCM) to access the market and to guarantee the firms’ trades to the market through a CCP. To manage that risk, the GCM monitors the firm’s trading activities in real-time and requires the firm to post collateral and margin. This margin provides for market stress scenarios and ensures that firms always have sufficient capital to leave a positive balance after a complete liquidation of all the firm’s positions. The amount of margin or collateral required depends on the characteristics of the positions in the instruments the firm has, the correlation between those instruments and positions, and things like the liquidity and volatility in the market. 

This margining model by GCMs has proven to be successful and adequate over the last decades. These GCMs are moreover already supervised by clearing members’ regulators under CRD/CRR. 

Art. 23(3) IFR mandates EBA to specify the calculation of the amount of the total margin required and the associated K-CMG. In line with the recognition of the efficiency of these margin models as a proxy for market risk at level 1, it will be important to make sure that technical standards on K-CMG recognise the historically-proven robustness of these models, and allow their ongoing adaptation based on experiences and market developments, as is the case today. 

Since the Level 1 text specifically references that the model “shall always be designed to achieve a similar level of prudence than the one required in the provisions on margin requirements in Article 41 of Regulation (EU) No 648/2012”, it makes sense to use a simplified version of the RTS covering Article 41 and only take the market risk requirements of this RTS.

The technical standards should not restrict the availability of K-CMG for market making firms, as the CRD/CRR alternative (K-NPR) is not suitable for their activities. For example, it should be possible for firms to identify portfolios for K-CMG themselves, as long as these portfolios have a consistent documented trading strategy.

5. Prudential consolidation (art. 7 IFR)

IFR requires firms to apply the majority of the requirements on a consolidated basis. Art. 7(5) mandates EBA to draft RTS to specify the details of the scope and methods of this consolidation. 

The EU is currently the only jurisdiction in the world that applies such a stringent capital and remuneration framework on investment firms. Applying all these requirements to non-EU subsidiaries of EU investment firms may put these non-EU subsidiaries at a serious competitive disadvantage to local competitors and will ultimately impact the profitability and competitiveness of EU headquartered firms. It would make the EU a very unattractive location for holding companies of international groups of investment firms, even more so as (according to art. 25(4) IFD) the remuneration requirements would also have to be applied on a consolidated basis. 

The IFR capital framework is strongly based on the characteristics of the EU markets and EU investment firms. As non-EU markets have their own characteristics and non-EU firms are subject to local (capital) requirements based on local rules and regulations, it is not always opportune to apply the EU IFR framework one-on-one on the activities of non-EU firms. A good example is K-DTF, which is calibrated based on historical volumes traded by EU investment firms on EU markets. Due to different market structures (e.g. instruments being traded on multiple markets in the US) trading volume related requirements for EU firms may not be proportionate to the activities of US subsidiaries. 

Derogation: book value or local requirements

Under CRR, regulators can allow investment firms to either use the book value or the local capital requirements for their non-EU subsidiaries. A similar possibility under the IFR is provided for in art. 8 IFR. 

If or when providing guidance to NCAs, who need to approve and notify the EBA of the use of this derogation, the EBA should consider the importance of the local capital requirement derogation for the investment firm group. Contrary to the situation of banks (for which the book value is generally lower than the local capital requirements), the book value is somewhat less relevant to most investment firms given it is generally much higher than the local capital requirement.

6. Additional capital requirements (art. 40 IFD)

In the context of CRD, the discretion left to NCAs to impose additional capital requirements has not been helpful in achieving a harmonised capital regime in the EU. 

When it comes to IFR, it will be important for EBA when drafting the RTS under art. 40(6) to draft objective and harmonised criteria for the imposition of any additional capital requirements as too much discretion could lead to an un-level playing field and regulatory arbitrage by investment firms within the EU. 

7. Additional capital requirements (art. 40 IFD)

Under the IFD, firms will have to pay a part of their employees’ variable remuneration in shares or equivalent non-cash instruments. However, as explained above, investment firms often have different legal and capital structures compared to that of banks, which impacts the extent to which they can issue and/or use shares for remuneration purposes.

Allowing sufficient flexibility in the type of instruments and alternative arrangement that can be used, will be key to protect the ability of firms to reward their employees in a way that is compatible with their legal and capital structure when developing the RTS under art. 32(8) IFD.

For example, deferred variable pay that would be linked to the value (e.g. share price) or the longer term financial performance (profitability) of the firms could be used as an alternative. 

Adopting such an “outcome-based” approach would preserve the diversity of EU investment firms’ ecosystem.

ArtTopicLegal referenceSuggested way forward
5 IFDClass 1 minus: NCA discretion1. Competent authorities may decide to apply the requirements of Regulation (EU) 575/2013 pursuant to point (c) of Article 1(2) of [Regulation (EU) —/—-[IFR] to an investment firm that carries out any of the activities referred to in points (3) and (6) of Section A of Annex I to Directive 2014/65/EU where the total value of the consolidated assets of the investment firm exceeds EUR 5 billion, calculated as an average of the last 12 consecutive months, and any of the following applies:

(a)the investment firm carries out these activities on such a scale that the failure or the distress of the investment firm could lead to systemic risk as defined in point (10) of Article 3(1) of Directive 2013/36/EU; (…)

6. EBA, in consultation with ESMA, shall develop draft regulatory technical standards to specify further the criteria set out in points (a) and (b) of paragraph 1, and ensure their consistent application. EBA shall submit those draft regulatory technical standards to the Commission by [twelve months from the date of entry into force of this Directive]. Power is delegated to the Commission to adopt the regulatory technical standards referred to in the second subparagraph in accordance with Articles 10 to 14 of Regulation (EU) No 1093/2010.
> Using the EBA guidelines (EBA/GL/2014/10) on assessing “other systemically important institutions” for assessment on EU level of activities.

> Adding some extra ancillary indicators specifically for trading activities
Recital 13(IFR) 9(4) IFRInstruments qualifying as “own funds”To ensure that the requirements are proportionate to the nature, scope and complexity of the activities of investment firms and are readily accessible to them within this Regulation, a review should subsequently take place as to the appropriateness of continuing to align the definition and composition of own funds with Regulation (EU) No 575/2013.

On the basis of information received from each competent authority, EBA together with ESMA shall establish, maintain and publish a list of all the forms of funds or instruments in each Member State that qualify as such own funds. The list shall be published for the first time within 12 months after the date of entry into force of this Regulation.
> Allowing the capital of partners in a “VoF” (Dutch General Partnership) and other partnership structures to qualify as own funds.

> Variable pay at principal trading firms is a (deferred) profit share that can be significant. If this profit share is deferred and can be reduced or cancelled at the discretion of the firm it should qualify as “own funds”.
23 IFRCalculating K-CMG margin requirementsThe margin models used by that clearing member to call the margin referred to in point (c) above shall always be designed to achieve a similar level of prudence than the one required in the provisions on margin requirements in Article 41 of Regulation (EU) No 648/2012.

K-CMG shall be the third highest amount of total margin required on a daily basis by the clearing member or QCCP from the investment firm over the preceding 3 months multiplied by a factor of 1.3.

EBA, in consultation with ESMA, shall develop draft regulatory technical standards to specify the calculation of the amount of the total margin required and the method of calculation of K-CMG as referred to in paragraph 2, in particular when K-CMG is applied on a portfolio basis, and the conditions for the fulfilment of the provisions in paragraph 1 point (e).

The EBA shall submit those draft regulatory technical standards to the Commission by [twelve months from the date of entry into force of this Regulation].

Power is delegated to the Commission to adopt the regulatory technical standards referred to in the first subparagraph in accordance with Articles 10 to 14 of Regulation (EU) No 1093/2010.
> Using a simplified (i.e. only covering market risk) version of the RTS covering Art. 41 of EMIR.

> Allowing firms to identify portfolios for K-CMG themselves, as long as these portfolios have a consistent documented trading strategy. To prevent arbitrage switching of portfolios should be limited

> Tampering with or putting additional requirements on margin models that have already proven to be safe, even in crisis situations, and that are already supervised by clearing members’ regulators.
7(5) IFRPrudential consolidationEBA shall draft regulatory technical standards to specify the details of the scope and methods for prudential consolidation of an investment firm group, in particular for the purpose of calculating the fixed overheads requirement, the permanent minimum requirement, the K-factor requirement on the basis of the consolidated situation of the investment firm group, and the method and necessary details to properly implement paragraph 2.

EBA shall submit those draft regulatory technical standards to the Commission by [twelve months from the entry into force of this Regulation].

Power is delegated to the Commission to adopt the regulatory technical standards referred to in the first subparagraph in accordance with Articles 10 to 14 of Regulation (EU) No 1093/2010.
> Limiting the application of the capital and remuneration requirements in IFD/IFR on a consolidated level to the necessary prudent management of risks within the group.

40(6) IFDAdditional capital requirementsEBA, in consultation with ESMA, shall develop draft regulatory technical standards to specify how the risks and elements of risks referred to in paragraph 2 shall be measured, including risks or elements of risks that are explicitly excluded from the capital requirement set out in Parts Three or Four of [Regulation (EU) —/—[IFR].

EBA shall ensure that the draft regulatory technical standards include indicative qualitative metrics for the amounts of additional capital referred to in Article 39(2)(a), taking into account the range of different business models and legal forms that investment firms may take, and are proportionate in light of:

(a) the implementation burden on investment firms and competent authorities;

(b) the possibility that the higher level of capital requirements that apply where investment firms do not use internal models may justify the imposition of lower capital requirements when assessing risks and elements of risks in accordance with paragraph 2.

EBA shall submit those draft regulatory technical standards to the Commission by [18 months from the date of entry into force of this Directive]. Power is conferred on the Commission to adopt the regulatory technical standards in accordance with Articles 10 to 14 of Regulation (EU) No 1093/2010.
Defining harmonised and objective criteria for the imposition of additional requirements to ensure a level-playing field for investment firms within the EU.
32(8) IFDPayments in instruments> Defining harmonised and objective criteria for the imposition of additional requirements to ensure a level-playing field for investment firms within the EU.> Allowing maximum flexibility in the range of eligible instrument in order to adapt to the variety of EU investment firms’ structures.

> Adopting an ‘outcomes based’ approach for alternative arrangements (e.g. deferred variable pay that is linked to the value of the company or linked to the long term financial performance of the firm).