EFET notes the five main criteria set out in Article 131(2) CRD IV used to assess systemic importance of an institution (size, interconnectedness, substitutability, complexity and cross-border activities.) We believe that these criteria remain appropriate for distinguishing systemically important investment firms, which ought to remain subject to the provisions of CRD IV and CRR as well as other relevant regimes.
EFET is of the opinion that any future prudential regime for investment firms should be risk-sensitive. To this end, it has to allow clear differentiation between different categories of firms depending on their risk profiles in order to ensure that systemic and non-systemic firms are treated appropriately. We therefore propose a fourfold categorisation of firms:
Class 1 – systemic and bank-like investment firms (G-SIIs and O-SIIs subject to CRD IV / CRR regime)
Class 2 – systemic and not bank-like investment firms
Class 3 – non-systemic investment firms (including Commodities Dealers)
Class 4 – small and not-interconnected investment firms
We offer no further comments on the technical elements of the proposed criteria.
Please note that the following comments are made without prejudice to EFET’s overarching opinion on the inappropriateness of prudential requirements for Commodities Dealers as discussed in the cover letter attached to this response.
We concur with the recommendations included in the EBA’s December 2015 report that a proportionate solution needs to be adopted for small firms with low or no interconnectivity within the financial system. As a general comment, we are of the opinion that the principles for a new prudential regime for investment firms should distinguish between different types of activities and the differing risk profiles of investment firms. However, we are of the view that the proposed three-fold categorisation does not provide sufficient granularity in order to distinguish between various types of investment firms depending on their risk profile. As a general rule, we believe that systemic and non-systemic firms cannot be part of the same category, as subjecting the latter to the same requirements as the former would be entirely inappropriate. As noted under our response to Question 1, we propose a four-fold categorisation of firms as we believe it would be more representative to investment firms’ risk profiles.
We note the set of overarching principles proposed by the EBA and we generally consider them as a helpful foundation. However, all principles are not equal and we believe that ensuring that an investment firm has the resources to fund an orderly winding down of its business should it fail should be the main objective of prudential requirements for non-systemically important investment firms.
We believe it to be critical that any new prudential regime for non-systemically important investment firms considers the activities of Commodities Dealers and the specificities of physical commodities markets. To this end, we offer the following comments on the proposed principles:
While we do not support the inclusion of Commodities Dealers within the scope of prudential regulation, we agree with the EBA’s assessment that in relation to investment firms that are not ‘systemic and bank-like’, the purpose of the prudential regime cannot be to provide the same level of assurance as it is for firms that are large and systematically important.
That said, it is difficult to reconcile Principle (a) with the EBA Opinion on the first part of the Call for Evidence on investment firms [EBA/Op/2016/16]. Any new prudential regime ought to apply to non-systemic investment firms only. Equivocation as to the scope of any new regime should be avoided. The new regime must also ensure that systemic and non-systemic firms are not included in the same category. To this end we believe that Class 2 should be reserved to systemic, non-bank like investment firms only. We provide more detailed comments on this point in our response to Question 4.
We do not support Principle (b)(i). We respectfully disagree with the EBA’s general assumption that the failure of an investment firm would necessarily impact its customers and the markets in which the investment firm is active. We strongly oppose any requirement that a failed investment firm should be obliged to recover and continue to provide investment services beyond what is necessary to effect an orderly wind-down. The EBA’s general assumption does not hold for Commodities Dealers who, to a large extent, deal exclusively on own account in commodity derivatives, generally have no external customers and do not generally hold client money or securities. We also disagree with ‘riskiness’ categorisation of dealing on own account generally, and in particular with respect to Commodities Dealers. Please refer to our response to Question 4 for additional comments on this point.
We do not support Principle (b)(ii). We do not believe that additional liquidity requirements for Commodities Dealers are warranted.
We support Principle (b)(iii). We consider that the principal and overriding objective of any new prudential regime should be harmonised minimum own funds requirements that are sufficient to fund the orderly winding down of a failed investment firm. This does not mean that such firm needs to be kept in the markets for long. Under EU law such applicable time horizons for liquidation periods typically amount to two days for exchange traded derivatives (ETDs) and five days for cleared OTC derivatives.
While Commodities Dealers do not generally hold client money or securities, we support this principle and we agree that it should address the specific risks associated with such activities. However, we are of the opinion that prudential regulation should complement conduct and market regulation, and not seek to replace or override it. Organisational rules introduced by MiFID I and MiFID II are not the only types of such regulation that are applicable to Commodities Dealers. This should be clearly reflected in the principles.
We agree with the principle that any future prudential regime for investment firms should be harmonised across the EU. However, any such regime must be considered and calibrated carefully in order not to put EU investment firms at a competitive disadvantage to their non-EU competitors. Any such regime must include some restriction on the recourse to and use of national competent authority (NCA) discretion so as not to hamper a harmonised regime across the EU.
We do not oppose Principle (e) to the extent that it does not imply that an investment firm subject to any new regime should be forced to recover and continue trading, regardless of their classification. This would run counter to the principal objective of facilitating orderly winding down of investment firms. We agree with the basic principle that the higher the risk posed by an institution, the higher capital requirements applicable to such an institution. Systemic Class 2 firms should therefore be treated as going concern, but this should not apply to a (new) Class 3 that should only be treated on a gone concern basis.
While we agree with the general principle that firms that pose or are exposed to more risk should be subject to proportionately higher capital requirements, we do not agree with an assumption that the balance sheet or leverage should be the principal basis for measuring the risk profile of an investment firm.
We are concerned that the risk to customer (RtC), risk to market (RtM) and risk to firm (RtF) measures proposed by the EBA double-count some key risks. We are also sceptical of the argument that RtC or RtM increases proportionately with any increase in the RtF as described by the EBA.
We agree generally with the EBA’s proposed classification of non-systemically important investment firms.
However, we consider that the classification of investment firms needs considerable work. We are concerned that, as proposed, almost all Commodities Dealers would be excluded from Class 3. On the contrary, we believe that investment firms defined as Commodities Dealers under any new regime should be considered Class 3 investment firms (subject to changes to the classification as proposed) unless there are compelling reasons to classify these firms otherwise. As noted in our response to Question 1, we believe that expanding the current three-fold categorisation by one additional class would provide for more accurate classification of investment firms. As currently proposed, Class 2 would cover both systemic and non-systemic firms, which is not appropriate. We therefore propose to retain Class 2 for systemic and non- bank like firms and to create a new Class 3 category for non-systemic firms. Current Class 3 (small and non-interconnected firms) should become a new Class 4.
We disagree with certain proposed exclusion criteria. We provide more detailed comments on select criteria under Question 4 below, but we would like to highlight that the “dealing on own account” exclusion is entirely inappropriate and does not take into consideration the activities of Commodities Dealers, their negligible exposures to external customers and the clearing arrangements to negate risks to markets in the event that such firms fail. Equally, we see no basis for excluding investment firms from that class that make use of the MiFID passport or that are part of a wider group.
It has been brought to our attention that the “dealing on own account” permission creates some confusion. We would like to take this opportunity to clarify some of those issues as we believe it is important in the context of our response to Question 4. Not all trading done on own account is proprietary trading as understood by the EBA. Dealing on own account could encompass both hedging activities (as in the case of Commodities Dealers) and non-hedging activities – such as liquidity provision or market making (which can, but do not have to be, proprietary). Unfortunately MiFID permissions do not differentiate between the firms’ underlying business, which is particularly punitive for Commodities Dealers. We would therefore suggest considering an additional factor – such as the underlying business of the firm on a group basis – in order to further differentiate between hedging-like dealing on own account and other activities that may amount to proprietary trading as understood by the EBA.
We do not support the idea of merging (new) Class 3 with other investment firms under one single prudential regime with ‘built-in’ proportionality. We consider such a proposal contrary to the objective of a simple, proportionate regulatory capital regime for non-systemic investment firms.
i) using a MiFID passport - We oppose this exclusion and we agree with the EBA’s analysis at paragraph 19. The ‘passporting’ of an investment activity or service to another Member State does not imply any additional conduct or prudential risk. On the contrary, the passporting mechanism was introduced to overcome challenges stemming from the obligation to comply with the regulatory requirements of each EU Member State where an investment firm may seek to conduct business and it is broadly considered by the industry as one of the biggest advantages of the Single Market in financial services. Such an exclusion would penalise the use of a MiFID passport and we consider this contradictory to the key policy objective of the MiFID regime.
As a general comment, we are of the opinion that any new prudential regime should not ignore or seek to replace existing conduct and market regulation, in particular the MiFID regime. The exclusions proposed by the EBA do not properly consider, or account for, MiFID requirements. These proposed exclusions should be re-assessed.
Following on from our comments made in response to Question 3, we oppose in particular excluding investment firms from (new) Class 3 that may deal on own account in financial instruments. This activity poses no material risk to customers as assessed by the EBA. Dealing on own account by Commodities Dealers poses no material risk to commodity derivatives or emissions markets as assessed by the EBA given established clearing and margin arrangements. The proposed exclusion would have the effect of excluding 709 investment firms, including all 103 Commodities Dealers from the proposed class. We believe this would be contrary to the recommendations of EBA/Op./2015/15.
We suggest that the EBA consider any additional quantitative measure for distinguishing Class 2 and (new) Class 3 investment firms. We consider that an appropriate (new) Class 3 “ceiling” could be applied based on either:
(a) Maximum FOR value; or
(b) Maximum net liquidation value of the investment firm’s positions in financial instruments
We consider it appropriate for the EBA to propose only ranges for such a quantitative measure, which should then be tested in the course of a quantitative impact study preceding any Commission legislative proposal.
We offer the following comments on the particular criteria:
a) holding client money or securities - We support this exclusion
b) ancillary service of safekeeping and administration (B1) - We support this exclusion.
c) dealing on own account (A3) - We oppose this exclusion. Such exclusion would debar Commodities Dealers from (new) Class 3. We see no possible justification for excluding a type of investment firm en masse.
d) underwriting or placing with a firm commitment (A6) - We support this exclusion.
e) the granting of credits or loans to an investor (B2) - We oppose this exclusion. Commodities Dealers may make loans to a counterparty in the course of providing an investment service in commodity derivatives, emission allowances or derivatives thereof. We do not consider such actions unduly risky or the preserve of credit institutions or systemically-important investment firms. As such, we see no basis for such actions excluding an investment firm from the class.
h) being member of a wider group - We oppose this exclusion. We do not consider the hypothetical example posed by the EBA to be credible and we are concerned that such an exclusion could be applied beyond banking and investment firm groups. Indeed, we consider that intragroup guarantees of Commodities Dealers support the application of lesser prudential requirements.
j) using tied agents - We support this exclusion.
We are concerned that, based upon the phrasing of the question, the EBA appears to have already decided upon proposing the K-factors approach to the Commission as the basis of a new prudential regime. We are of the view that this should not be pre-determined and that the EBA should work from a blank sheet and thus remain open to alternative approaches.
However, should the EBA ultimately advise the European Commission to adopt the K-factors approach in new legislation, we believe that the approach needs adjustments in order to make it applicable to Commodities Dealers. We present our detailed comments in response to Question 6 below but we would like to highlight that the underlying objective of any potential prudential regime for Commodities Dealers should be focused on orderly wind down.
We note that as proposed, the K-factors approach is focused on a firm’s activities and their potential risk implications. It does not, however, address qualitative aspects of external factors such as creditworthiness of Commodities Dealers’ counterparties or adverse changes in the market place (price fluctuations, etc). Therefore, from the risk management perspective of Commodities Dealers, we are of the opinion that this approach fails to determine potential external risk factors stemming from markets and counterparties. As Commodities Dealers apply a broad range of risk management tools and procedures in line with conduct and markets regulation, we are of the opinion that any potential K-factor approach should duly take into account such activities and apply downward scalars for identified risk-reducing behaviours.
In addition, we are of the opinion that the K-factor approach undermines the recent efforts to introduce convergence between the accounting and risk frameworks as implemented by an updated IFRS 9 standard. This standard incorporates the expected credit loss (ECL) approach therefore allowing greater consistency between credit risk practices of an institution and their accounting requirements.
While we acknowledge that this approach has some usefulness for analytical purposes, we question its general applicability to Commodities Dealers and the applicability of the risk to firm factor in particular.
As we discuss in more detail under Question 6, the applicability of the risk to customer (RtC) factor to (new) Class 3 is minimal. While some Commodities Dealers provide limited risk management services to professional clients and eligible counterparties, those are always large corporates who are looking to hedge their risks. Those include, for example, commercial airlines that need to hedge risk stemming from the fluctuating fuel prices. Commodities Dealers do not transact with retail clients.
Given the characteristics of trading arrangements and exposure types of Commodities Dealers we are of the opinion that the risk analysis for this sector of firms should be focused mainly on the risk to market factor. Consistent with our proposed fourfold classification of investment firms for the purpose of the new prudential regime we are of the opinion that all non-systemic firms - Class 3 (including Commodities Dealers) and Class 4 - pose no or minimal risk to market (RtM) and as such should be regulated purely on a gone concern basis, i.e. the principal objective of the regime should be to facilitate orderly winding down of a failing firm.
We equally believe that the risk to firm factor should be removed from the analysis as it does not address any additional potential risks that would not have already been tackled by the risk to customer and risk to market factors.
Finally, any consideration of potential K-factors should include relevant timeframes / observation windows during which an institution will gather data relevant for the analysis. No such application should be retroactive, i.e. in respect of time periods preceding entry into application of relevant provisions. In addition, the scope of the K-factors is not clear and will require further clarification, in particular with regards to exclusions of intragroup trades.
We are of the opinion that Commodities Dealers should be included within (new) Class 3 and subject to capital requirements based on FOR. Therefore, no K-factor calculation should be applicable to such firms.
In the event that Commodities Dealers would nevertheless be subject to K-factor analysis, EFET is of the opinion that the proposed K-factors approach needs to be expanded to cover additional qualitative and quantitative criteria This is necessary to properly account for various types of business models that are presented by investment firms. We are mindful, however, that such input will require additional analytical work and significant input from the business. We will be happy to provide our additional input on an alternative K-factors approach after we have had a chance to discuss the matter in more detail within the industry and to review the results of the data collection exercise.
Risk to Customers (RtC)
EFET is of the opinion that, by and large, the Risk to Customers (RtC) factor should have very limited or no application in the consideration of a potential new prudential regime for Commodities Dealers. In practice, for the majority of Commodities Dealers, none of the proposed K-factors (asset under management, assets under advice, assets safeguarded and administered, client money held, liabilities to customers and customer orders handled) will be applicable.
The majority of the transactions entered into by Commodities Dealers are for hedging purposes which means that for every such transaction there are tangible physical assets that can be used in the event of default as an additional loss-mitigating factor.
A small minority of Commodities Dealers may undertake the investment service of executing orders on behalf of clients as prescribed in Section A(2) of Annex I of MIFID II. However, the material risk is negligible when client orders are transmitted therefore the k-factor should be calculated on the basis of client orders executed, as opposed to handled, plus an appropriate scalar.
Risk to Markets (RtM)
EFET is of the opinion that only a carefully calibrated RtM factor can form the basis of a potential prudential regime for Commodities Dealers. As proposed, the RtM factor is focused on balance sheet exposures and in practice Commodities Dealers’ balance sheets do not reflect typical risk management procedures undertaken by such investment firms. Balance sheet and off-balance sheet exposures do not consider hedged positions, whether of the investment firm or of the investment firm’s group.
A significant amount of exposure to financial markets for Commodities Dealers in commodity derivatives is through centrally cleared, exchange-traded derivatives (ETDs), which means that all such transactions are subject to initial and variation margin payments. The great majority of EFET members are not self-clearing but are entering into clearing arrangements via General Clearing Members (GCMs). GCMs are usually large and sophisticated financial institutions, which maintain a strict pre and post-trade risk management framework. Counterparty credit risk exposures of Commodities Dealers are therefore significantly reduced. In respect of OTC commodities derivatives transactions Commodities Dealers are subject to EMIR risk mitigation requirements and some of them are subject to voluntary clearing arrangements. The RtM factor should therefore account for cleared and margined derivatives positions held by Commodity Dealers in a proportionate manner with a downward scaling factor.
In general, the risk of a situation equivalent to the contentious “runs on banks” in the commodity sector is very low. As historical defaults in the sector demonstrate, the bankruptcy of even a large utility company did not result in physical market disruption and energy supplies continued to reach end-customers. Similarly, financial market disruption from one or a number of concurrent failures of Commodity Dealers would be minimal. As discussed in respect of the RtC factor above, all external transactions that Commodities Dealers undertake are with a limited number of professional counterparties. Both Commodities Dealers and the counterparties employ risk management procedures that are focused on mitigating potential stress events.
As a prevailing market practice Commodities Dealers have exposures to a very limited number of external counterparties. Those counterparties are professional financial or non-financial entities which are aware of the scale and character of potential risks stemming from derivatives transactions and also have their own risk management systems and procedures in place. Commodities Dealers do not deal with retail counterparties. Transactions with external professional counterparties do not happen randomly but are subject to stringent checks and evaluation procedures, such as credit checks, limits and guarantees. The predecessors to the EBA and ESMA noted in their 2008 report that as “The majority of participants in commodity derivatives markets are sophisticated and have the knowledge and experience to make their own investment decisions [...] the potential for significant market failure due to information asymmetries is limited” [CESR/08-755, CEBS 2008 154]. We believe that this analysis remains valid. The RtM K-factor should therefore exclude all transactions with eligible counterparties.
As Commodities Dealers’ exposures are usually limited to a small number of counterparties, the level of general interconnectedness, which is the primary factor behind any potential contagion effect, is equally low and risks are largely contained.
The low level of interconnectedness between Commodities Dealers and the financial markets became evident during the 2008 financial crisis. The collapse of Lehman Brothers and the subsequent credit squeeze heavily impacted financial markets worldwide, but it had no material impact on the energy trading industry. The opposite is also true and examples of commodities market participants failing have not impacted broader financial markets.
In addition, no Commodities Dealer maintains a position of dominance in their sector. Therefore the potential failure of one of the firms in the sector would not de-stabilise the market. This is very different from certain interest-rate, fixed income or similar dealer-dominated markets.
EFET believes that FOR should be the basis for the calculation of own fund requirements for (new) Class 3 as we are of the opinion that this prudential capital calculation method appropriately addresses non-systemic nature of such firms. As a potential alternative to this method EFET would like to raise for the EBA’s consideration prudential capital calculation measure that would treat RtM as a small additional capital requirement in addition to margin that might extend the orderly wind down of an investment firm. Should the requirement for Commodity Dealers to calculate own funds be introduced, we suggest that it could be based on a net liquidation value (NLV) of a firm’s portfolio rather than on the size of its balance sheet or the value of its off-balance sheet transactions.
NLV would be calculated as the total cash value of all of a Commodities Dealer’s long and short positions when liquidated. NLV should be calculated by taking into account both variation margin (VM) and initial margin (IM) posted by a firm. However, NLV needs to be calibrated carefully and any IM included in NLV calculation should be discounted for the purpose of the liquidity requirements
Risk to Firm
EFET respectfully disagrees with the EBA’s argumentation included in paragraph 49 of the Discussion Paper. We do not agree with the assumption that RtF drives additional RtC or RtM.
Commodities Dealers’ positions are generally not leveraged. When they are, they are significantly less leveraged than the positions of financial institutions. More fixed assets that firms hold results in less leverage.
As it is currently drafted by the EBA, the inclusion of the RtF factor for firms dealing on own account in financial instruments results in double-counting as all potential risk exposures to external parties are already captured under RtC and RtM factors.
Inclusion of the RtF factor ignores the fact that Commodities Dealers – and all other investment firms – are already subject to stringent business conduct and markets regulation. It also ignores the role of GCMs and central counterparties (CCPs) that would step in to restrict the trading activity in financial instruments of a Commodities Dealer that is in financial distress.
As such, we are of the opinion that RtF should be disapplied for all (new) Class 3 firms, including Commodities Dealers. If appropriate, the EBA could consider adopting a modified RtF factor as a capital add-on applicable only to a sub-section of bigger firms that would fall within Class 2 and only as a discretionary measure for NCAs. Calibrated as such, RtF would perform a similar role to a discretionary systemic risk buffer and other capital buffers under Chapter IV of CRD IV.
In any event, it should be the role of national competent authorities, subject to an appropriately calibrated observation period, to assess the potential RtF in a given time as part of their ongoing supervision of investment firms.
EFET does not agree with the EBA’s RFUM proposal. We believe that all relevant risks of Commodities Dealers may be identified and quantified according to the RtC and RtM factors with some adjustment. We do not accept the EBA’s argument that RtC and RtM measures necessarily increase proportionately to any RtF and believe these risks can potentially be addressed by own funds, which, are already addressed by K-factors or risk management arrangements of credit institutions or systemic investment firm counterparties. There is therefore no justification for the inclusion of the additional up-lift measures.
We do not think that the purpose of prudential regulation is to regulate the conduct of firms. If there are legitimate measures indicating that an investment firm has become more risky, there may be reasons to apply additional own fund requirements. We do not believe, however, that primary legislation cannot foresee all circumstances in which this may occur. Rather, we consider this a decision of the investment firm’s NCA under its Pillar II discretions.
EFET does not believe that the ‘built-in’ approach is appropriate for (new) Class 3 investment firms. We are of the opinion that (new) Class 3 investment firms, including the vast majority of Commodities Dealers, should be subject to simple minimum own fund requirements based on FOR.
Additionally, EFET is of the opinion that any attempt to apply a ‘built-in’ approach would add unnecessary complexity to the new regime for small and non-interconnected firms, contrary to Recommendation 1 of EBA/Op/2015/20.
We agree that FOR should remain part of any new regulatory capital regime. We believe that the requirement is appropriately set out in Delegated Regulation (EU) No 241/2014 as regards own funds requirements for firms based on fixed overheads
We propose that any new prudential regime would distinguish Class 2 and (new) Class 3 investment firms on the basis of FOR or the net liquidation value of the investment firm’s positions in financial instruments. Own funds requirements for Class 2 and (new) Class 3 investment firms under any such regime would differ. Consequently, while any prudential requirements for systemic (Class 2) firms should be based on going concern basis, prudential treatment of non-systemic firms (new Class 3) should be based on gone concern basis. The objective for non-systemic firms therefore should be to ensure that investment firms hold sufficient resources to fund the orderly winding-down of that firm should it fail.
We see no basis for distinguishing investment firms within either Class 2 or (new) Class 3 on the basis of the financial instruments they buy or sell. Indeed, we believe that the clearing and margin arrangements prevalent in European derivative markets make for more stable, less risky markets where contagion from the failure of one or more market participants is adequately contained.
As a general comment, we are of the opinion that firms within (new) Class 3 should be expressly subject to capital requirements based on FOR and only on a gone concern basis. This should be equal with exempting such firms from making any calculations based on K-factors.
EFET members are of the opinion that no specific simplification of relevant capital definitions for the purpose of the potential prudential requirement for investment firms would be helpful. Commodities Dealers usually have very simple capital structure, mainly composed of Tier 1 instruments.
In this context we would suggest expanding the definition of regulatory capital for Commodities Dealers. The nature of Commodities Dealers’ businesses means that they hold a substantial amount of physical assets, thus we are of the opinion that the definition of regulatory capital should take certain physical assets into account. Certain physical assets are easily re-deployable (such as stock, certain machinery), which can be sold or transferred relatively quickly to fund orderly wind down. We recognise that the eligible capital for Commodities Dealers cannot be fully satisfied by permissible physical stocks but we suggest that at least a large proportion should be able to be composed of permissible physical stocks, subject to appropriate haircuts.
The value of physical commodities assets has already been recognised by EU law makers in the Regulation (EU) 2015/2365 on the transparency of securities financing transactions (SFTR).
Additionally, we would argue that EU emission allowances (EUAs) as financial instruments should qualify as regulatory capital. EUAs are considered quality capital for the purposes of the settlement mechanisms under the EU Emissions Trading System and therefore we believe that their value should be recognised under the regulatory capital regime.
We are of the opinion that the current CRR approach dealing with deductions and prudential filters should be simplified for the purpose of the development of a new prudential regime for investment firms.
In particular, we note that the current CRR approach to Additional Value Adjustments (AVA) is complex and burdensome. Therefore we would advocate the removal of the AVA approach, as it currently stands, from the future prudential regime for investment firms and Commodities Dealers. Alternatively, we propose that Commodities Dealers should be able to use the simplified approach as included in Commission Delegated Regulation (EU) 2016/10 at all times and without threshold restrictions.
Additionally, we would caution against unlimited national discretions as experience shows that these are vulnerable to misuse by NCAs. The objective should be to prevent the layering on of own fund requirements by NCAs which would undermine Pillar 1.
EFET agrees that simplification of the definition and quality of capital for the purpose of the introduction of a new standard of regulatory capital would benefit Commodities Dealers. Please refer to our comments under questions 14 and 15.
The approach set out in Part II CRR with some adjustments is the most appropriate approach.
EFET is of the opinion that if the EBA and the Commission were to proceed with the revision of initial capital requirements, it should be done on a proportionate and risk-based basis. There should be no automatic increase in the initial capital base. We agree that the existing requirement for investment firms to hold minimum initial capital in order to meet its MiFID authorisation conditions should be preserved.
We equally agree with the EBA’s suggestion that the definition of capital used for the purposes of meeting the minimum levels required for MiFID authorisation should be aligned with the revised definition of capital for the purpose of meeting own-fund requirements under the new prudential regime for investment firms.
We also agree that the levels of initial capital for investment firms can be revisited in line with the development of a new and more granular classification of firms and taking into account inflation rates.
We agree with the EBA’s suggestion that the levels of initial capital should be harmonised across the EU and national discretion removed. In general, firms authorised to conduct the same activities should be subject to the same initial capital requirements in order to ensure a level-playing field.
While EFET agrees in general with the EBA’s suggestion that the levels of initial capital need to be adjusted, at a minimum, in order to take due account of a changed inflation rate over the period of implementation of current rates, we do not agree that any automatic increase between currently existing brackets would be appropriate. As the EBA rightly notes in paragraph 108, any material increase in the amount of initial capital could prove a problem for firms to meet – but a transitional regime would not be enough to mitigate that and due consideration needs to be given to the actual amount of a potential increase.
We believe that any increase needs to be proportionate and for firms that are currently subject to the lower initial capital requirements.
A number of other factors could be also taken into the account, such as size and business development plan.
In addition, we are of the opinion that the (current) EUR 730,000 initial capital category should be disapplied to (new) Class 3 and 4 firms. The proposed EUR 1.5 million as the potential target for the increase would be completely disproportionate for such non-systemic firms. We believe that for such firms the higher of initial capital or FOR should be the basis.
EFET supports the proposal of aligning the concept of eligible capital with the definition of regulatory capital.
EFET is of the opinion that it would be difficult to develop a common stress test scenario that would be applicable to all types of investment firms and Commodities Dealers. Any potential stress test scenarios would need to take into account particular characteristics of a firm’s business model. In addition, we see no particular benefit of having a regulatory obligation to conduct stress tests. Regular monitoring of positions, exposures and liquidity is a part of firm’s risk management process.
EFET members agree with the EBA’s conclusions included in its December 2015 report and in the current Discussion Paper that both Liquidity Coverage Requirement (LCR) and Net Stable Funding Ratio (NSFR) are not appropriate for investment firms in general, and for Commodities Dealers in particular.
In general, commodities market participants do not fund their activities through short-term deposit-like instruments. They are unlikely to have large unfunded exposures that would be sensitive to short-term liquidity crunches. To date, there have been no liquidity crisis events in EU commodities market.
Liquidity requirements for Commodities Dealers are specific to the sector and are very much different from liquidity requirements of other institutions. Commodities Dealers do not provide loans and do not accept deposits and therefore are not subject to increased demand for cash in a stress scenario. In addition, such firms have access to stable and diversified sources of funding through a number of diversified financial institutions and via capital markets.
We therefore are of the opinion that liquidity requirements are not relevant to Commodities Dealers and should not be imposed. Given that Commodities Dealers are non-systemic and are unlikely to face sudden and escalated pressure on cash outflows, such requirements are not needed. We can, however, consider very limited reporting obligations appropriate to demonstrate that no liquidity risks arise, but we do not support the introduction of additional tools to address those risks other than what Commodities Dealers already have in place.
As noted above in Question 14 in respect of regulatory capital, EFET is of the opinion that certain physical assets are liquid (such as stocks) and can be easily liquidated in order to fund an orderly wind down. Thus certain physical assets should be considered liquid assets for the purposes of meeting liquidity requirements. In addition the following should be equally accepted as liquid assets for Commodities Dealers, with no haircuts – (i) cash held at regular bank accounts by the firm and (ii) cash pooled at group level upon which the investment firm can call upon unconditionally.
EFET does not support a minimum liquidity standard for non-systemic investment firms. The liquidity risk of investment firms’ business is sufficiently mitigated by the minimum own fund requirements and other standard risk management tools employed by firms. As a result, we are not supportive of supplementary requirements.
EFET members are of the opinion that liquidity management for non-systemic firms should be covered by firms’ standard risk management functions that monitor cash flow and balance sheet exposures on a daily basis, therefore no additional liquidity requirement is necessary. In any event, qualitative requirements should be applied in a proportional way, commensurate with the level of size and complexity of the investment firm.
EFET questions the utility of the ‘large exposures’ provisions in the new regime given the Article 493 CRR derogation and negative scope of Article 388 CRR. We are of the opinion that any large exposure regime would be appropriate only for systemic (Class 2) investment firms.
Non-systemic investment firms – including all Commodities Dealers - should be fully exempted from any large exposure regime. Any concentration limits should recognise that a fully consolidated corporate group represents one single credit unit. Consequently, any intragroup exposures should be exempt from the large exposures calculation. This would be consistent with the treatment of intragroup transactions under EMIR.
Additionally, as mentioned in the December 2015 EBA report on investment firms, Article 400 (j) CRR exempts exposures to CCPs from the large exposure regime. In a context where more and more instruments must be cleared centrally (amongst others under EMIR or the as a result of the Article 28 MiFIR Trading Obligation) it is important that this exception be kept in order to avoid that abiding by regulatory obligations generate an increase in capital requirements.
Similar to the requirements regarding liquidity, we consider only very limited reporting obligations appropriate to demonstrate that no concentration risks arise, but not additional requirements on top of those which Commodities Dealers already have in place. We agree that the monitoring of the concentration risk should be part of the ICAAP process for each non-systemic investment firm, including Commodities Dealers, as sound risk management practice. The frequency of such reporting may however differ between classes of investment firms. Non-systemic investment firms should not be subject to regular reporting to NCAs but at their request only (and with a maximum of number of demands/reports per year).
We support a general derogation from consolidated supervision for Commodities Dealers owned or controlled by an unregulated entity. In this respect we would like to refer to the EBA’s conclusion in paragraph 149 of the Discussion Paper, recognising that “each prudentially regulated entity in the group should already have its own on-going regulatory capital requirements at an individual level, appropriate to the particular nature of its own business, and it would not seem proportionate to try to extend ‘proxy’ capital requirements to cover every type of unregulated entity that could exist within a group, particularly if there are no customers of a regulated service or activity. “ We are fully supportive of this statement.
We are of the opinion that no other aspects need to be addressed. Commodities Dealers comply with MiFID risk management requirements and are subject to ongoing supervision by NCAs. There is therefore no need to develop another layer of prudential regulation as it will create duplicative competences.
EFET supports the need for transparency in the market. However, Commodities Dealers active in power and gas markets are already subject to burdensome regulatory reporting regimes under REMIT, EMIR, SFTR and the upcoming MIFID II. Some of Commodities Dealers also fall within the scope of CRR reporting requirements. We note that prudential reporting requirements are particularly burdensome.
Due to the single rulebook principles, the granularity of information to be reported is the same for all regulated entities (credit institution or investment firm), regardless of their size, portfolio of activities or business model, or of their status as ‘systemic or non-systemic’. Moreover, the granularity of some reports, especially on liquidity, is increasing over time. For many investment firms, only a small number of cells of the LCR reports are relevant. The same situation arises regarding e.g. ALMM reports.
Hence we welcome the EBA’s conclusion recognizing that (amongst others) the COREP/FINREP requirements are “a vast amount of reporting, making it extremely complex, onerous and costly to comply with by investment firms” due to the granularity of detail required, the numerous templates, and reporting obligations that are unrelated to the riskiness of an investment firm and the high frequency.
Some examples of this excessive regulatory burden that investment firms currently face are the following:
(i) Weekly solvency report
(ii) Yearly recovery plan
(iii) Burdensome quarterly COREP reporting on large exposure (“LE report”), liquidity ratio (LR report), credit risk (CR GB report), market risk (“MR MKK” report), CA report
(iv) Additional yearly national reports
Also the Commission has already acknowledged that the current regulatory reporting regime is excessive for smaller and less complex credit institutions and proposes in the CRR 2 package measures to reduce and simplify the reporting burden applying to these firms by reducing the frequency, simplifying the templates, etc. The same is true for investment firms.
So at least the same simplification of templates and reduction of the frequency should be sought under any new prudential regime for investment firms. This should be the case for e.g. the concentration risk reporting. It would be more efficient if firms do not have to report systematically every quarter their largest exposures but perform ad-hoc reports at the request of their national regulator. Today the reporting framework on large exposures consists of six templates which include much information that could be simplified, especially to avoid the double reporting per group and per individual client within groups of connected clients.
On the other hand, one should also challenge the need for the continued reporting of other non-relevant data considering the different risk profiles of investment firms. In this respect, the K-factors approach supposes that templates which are currently based on credit-risk exposure, such as the template to identify the geographical location of credit exposures (CR-GB) or volatility for CVA, shall be removed or adjusted to use the same metric for both capital adequacy and reporting purposes.
Regarding other regulatory reporting examples, under EMIR reporting requirements Commodities Dealers face compliance challenges created by the dual-side reporting requirements. Moreover, these various reporting regimes operate in parallel resulting in complex, duplicative and expensive requirements. For example, MIFID II will require reporting of trading venues’ positions and economically equivalent OTC contracts on behalf of clients. This requirement is itself laborious and challenging but much of the information is already made available to trade repositories in line with EMIR thus duplicating the work load.
Over burdensome reporting requirements imposed by EU financial services legislation and the resulting compliance costs are widely recognised issues. The European Commission acknowledged the problem in its recent Communication on the Call for Evidence and, more specifically, committed to addressing challenges posed by the reporting requirements under EMIR in the EMIR Review Report published in November 2016.
Consequently, EFET is of the view that including further reporting requirements in the new prudential regime for investment firms would exacerbate this problem and would be disproportionately burdensome on small and non-complex investment firms. EFET believes that the approach adopted by the European Commission in its Report on the Call for Evidence should be maintained and applied to the development of the new prudential regime for investment firms. This approach is based upon sound evidence gathered for the Call for Evidence consultation process.
We believe that the exemption of non-systemic and not-bank like firms from the scope of Directive 2014/59/EU on Bank Recovery and Resolution Directive (BRRD) is necessary. As highlighted throughout our response, and in line with the EBA’s recommendations included in the December 2015 report on investment firms, the objective of the regime for (new) Class 3 should be to facilitate orderly wind-down. Therefore, non-systemic and non-‘bank like’ firms would not require central bank liquidity or state support and should not be subject to BRRD.
EFET supports the EBA’s position that non-systemic and non-bank like investment firms should not be subject to the corporate governance requirements in CRD IV. These requirements are neither proportionate nor appropriate for small non-complex investment firms, particularly Commodities Dealers. As stated in paragraph 170 of the Discussion Paper, the objectives of governance rules are to ensure sound management and robust internal control frameworks are in place.
The internal structure and management of Commodities Dealers is very different to that of a credit institution due to the different business activities and objectives. Therefore the CRD IV governance and remuneration framework is not suited for non-systemic investment firms in general, and to Commodities Dealers specifically.
Any remuneration and governance requirements need to be applied in accordance with the proportionality principle and as the EBA notes, investment firms – including Commodities Dealers – already comply with governance requirements of MiFID. We believe therefore that no additional regime is required as this would simply serve to duplicate and overcomplicate the robust regime which investment firms are already subject to under MIFID and which will be expanded and strengthened under MIFID II.
The controversial remuneration provisions in CRD IV were developed in order to “tackle excessive risk taking” by certain categories of staff in credit institutions. We are of the opinion that those provisions are overly burdensome to implement – for instance the process of gaining regulatory exemption for persons that do not qualify as “material risk takers” discourages certain institutions from using the exemption. Similar considerations apply to governance processes linked with risk-taking regulation, such as the need to establish an independent risk administrator for all firms with a total balance sheet in excess of EUR 10 billion.
Overall, we believe that CRD IV remuneration provisions do not necessarily contribute to implementation of sound remuneration policies but rather distort competition between institutions and put smaller firms at a competitive disadvantage (firms that cannot afford to substantially increase fixed components of remuneration lose out in the competition for talent).
EFET notes that the objective of rules on remuneration is to curb incentives which amplify excessive risk taking. This is an objective identified by the Financial Stability Board (FSB) and echoed by the co-legislators in CRD IV (Recitals 62 and 63) and by the EBA itself in paragraph 172 of the Discussion Paper. It must be understood that the business models of Commodities Dealers are distinct from those of credit institutions to which the rules were initially addressed. The structure of Commodities Dealers’ businesses and their remuneration policies do not intensify risky behaviour and there are comprehensive governance procedures in place to prevent misconduct. Therefore, a unique regime should be established to reflect these differences. This would also be in line with the EBA’s recommendations included in its December 2015 opinion that administrative burden stemming from remuneration requirements should be reduced for smaller institutions [EBA/Op/2015/25]. We note that the EBA opinion was reflected in the recently published European Commission’s proposal to amend Article 92 CRD IV.
We wish to reiterate that any regime which results from the Article 508 CRR review should purely address prudential matters and should not duplicate or complicate the conduct rules to which investment firms are already subject.
The principle of proportionality in the application of remuneration rules was recognised when the rules were devised at a global level and when implemented at a European level. Recital 66 CRD IV states that the remuneration requirements should reflect the differences in institutions and be applied in a proportionate manner taking into account factors such as size, internal organisation and the nature, scope and complexity of activities.
EFET supports this strong emphasis on proportionality but would add that the strict governance and conduct requirements to which investment firms are already subject should also be considered.
EFET supports the EBA’s stance on maintaining the distinction between systemic and bank-like firms and other investment firms for the purposes of remuneration provisions and agrees that the former should continue to subject to be to the CRD IV rules on remuneration.
EFET advocates a principles-based approach with proportionality at its core. Such a regime should not include definitive caps on remuneration, similar to those imposed by Article 94(1) CRD.
Some EFET members already qualify as Commodities Dealers within the meaning of Articles 493(1) and 498(1) CRR. Amongst those, a limited number of firms that obtained MiFID authorisation before 31 December 2006 currently do not benefit from of Articles 493(1) and 498(1) CRR exemptions and remain within Pillar 1 capital requirements.
The CRD IV/CRR regime poses significant challenges for Commodities Dealers as it does not take into account specific characteristics of the commodities sector. The risk profile, risk management and hedging strategies of commodity firms reflect the specific features of commodities markets in which they operate.
The risk posed by commodities firms to financial markets is in no way comparable to the systemic risk posed by credit institutions and large financial investment firms. As such, we are of the opinion that the CRD IV / CRR regime should not apply to Commodities Dealers.
From the experience of EFET firms that are currently within the scope of CRD IV / CRR regime, we can offer the following comments on some of the specific requirements:
- Own funds requirement – the current requirements do not take into account the risk profile of commodities firms and the characteristics of commodities markets, such as price volatility and liquidity. Commodities firms employ significantly less leverage than other market participants and they are also subject to lower credit risk. On the other hand, under the current regime such firms’ exposures to corporates result in substantially higher risk weighting. Additionally, other sustainable capital instruments held by Commodities Dealers should be recognised for the solvability ratio calculation, allowing the Commodities Dealer to exclude physical assets (e.g. power plants, transportation and storage infrastructure, etc.) and commodities assets (e.g. gas and/or coal stored, Co2 certificates, etc.) from the calculation.
- Risk capital requirements – the development of an internal risk model is complex and very time-consuming, which leaves Commodities Dealers dependant on the standardised (STD) approach. STD approach is punitive to firms whose main business consists of dealing in commodities and commodity derivatives.
- The SDT approach for determining risk weight - does not take into account the specific features of commodities markets and fails to reflect the economic reality of commodity trading activities. The approach is based on external ratings issued by ECAIs. Where there is no ECAI credit exposure to determine the credit quality of a counterparty is weighted at 100%. This approach is punitive to commodities firms in two aspects – (1) most commodities end-users are corporates that are usually unrated and (2) many commodity trading firms are themselves not rated, therefore subject to 100% weighting. Asset-backed commodities firms are additionally penalised in this approach, as tangible assets (e.g. generation, storage, and transportation facilities) are 100% risk-weighted.
- Counterparty risk requirements – As the standardised approach is too conservative (e.g. not differentiating between margined and un-margined transactions), Commodities Dealers use the CEM calculation method which is not adequate for commodities firms to estimate the credit risk exposure to counterparties as it will often lead to an overestimation of the risk which, considering the nature of commodities markets, may disadvantage commodities firms. The CEM approach is not sufficiently risk sensitive and over simplifies the net-to-gross ratio (long and short positions cannot be offset, within a netting agreement the offsetting positions are limited to 60%, the add-on factors do not properly reflect the different correlations and volatilities across the different commodity sub-asset classes). CRR 2 proposes changing the calculation methodology to SA-CCR, but this method is still too complex.
- Settlement risk - settlement of transactions in physical commodities markets is fundamentally different to the delivery of dematerialised securities. Payment terms under invoices or transaction structures may not necessarily be aligned with delivery and off-take. Settlement terms vary widely across commodities and mostly exceed 5 working days above which CRR requires institutions to hold capital against exposures to price differences arising from financial and physical transactions. The CRR regime does not therefore recognise the bespoke payment arrangements existing in commodity transactions.
- Market risk - The standardised methods (both the simplified approach and the maturity ladder approach) are not appropriate for commodities firms who have very large positions in physical commodities.
- Minimum liquidity requirements – both NSFR and LCR are not appropriate to Commodities Dealers as such firms do not normally fund their activities through short-term deposit-like instruments. They typically do not have large unfunded exposures which they would not be able to meet. See our response to Questions 21-24.
- Large exposure limits – The 25% large exposure limit does not take into account typical business arrangements adopted by commodities firms, which includes significant intra-group transactions. The main purpose of an authorised entity within an industrial group is to act as a window to the market for group (hedging) transactions on behalf of non-authorised entities of the group. Such intra-group transactions are currently considered as external exposures and therefore subject to a 25% concentration limit. Any LE regime should exempt intragroup trades and exposures held to CCPs and recognised exchanges.
- Capital buffers – capital buffers as macro-prudential instruments were introduced post-crisis to provide additional capital, reduce systemic risk and mitigate economic pro-cyclicality. None of those risks are presented by commodities firms, which are non-systemic, and as such the benefit of capital buffers for Commodities Dealers is questionable.
- Remuneration – The CRD IV remuneration policy has been developed in order to “tackle excessive risk taking” by certain categories of staff of credit institutions and in-scope investment firms. This is clearly not the risk that has been manifested by commodities traders. The CRD IV remuneration policy is complex and burdensome to implement and encourages a non-level playing field between the institutions which puts smaller firms at a competitive disadvantage.