9.2.3.1 Risk to Client

402. Risk to Client1 (RtC) intends to capture the risk that a customer or client of the investment firm is exposed to when dealing with that investment firm. RtC is intended to provide clients with the assurance that the investment firm has enough capital to adequately execute the services provided for the clients of the investment firm by not facing bankruptcy when the investment firm suffers losses. When the client asks the investment firm for investment advice, order processing or execution, or to manage his assets, the client can be harmed by “incorrect discretionary management [or] poor execution”.2 This is in itself not a justification for prudential requirements and should be covered by the market conduct requirements in MiFID II. However, ‘incorrect management or poor execution’ can result in the investment firm being held liable and as such have to reimburse its clients for its incorrect management, see also the discussion in Section 2.1.2 when discussing investment advice. As such, this can result in an increase of the operational risk of the investment firm due to the increased operational requirements in MiFID II. This liability perspective does necessitate prudential requirements as the liability risk for the investment firm increases when the assets under management of that investment firm increase and therefore the potential losses for the investment firm increase.

403. To adequately safeguard its clients, the investment firm should, therefore, hold capital in relation to the total assets it manages to cover these potential liability losses. With the K-Factor K-AUM, the IFR intends to address the risk associated with assets under management. According to the EC “the risks inherent in the financial instruments mostly reside with their clients, meaning the firm’s own risks from performing these services are limited. However, sufficient resources and arrangements are still required to underpin the functioning of these firms in an orderly way and ensure that their incentives align with the best interests of their clients”.3 Once again, this argumentation of the EC does not necessitate prudential regulation. By coupling prudential regulation with the amount of assets under management, there could come a situation where it is not in the best interest of the firm to increase the assets under management (e.g. through effective management of the portfolio) as that could lead to an increased capital requirement. However, when looking at the activity of asset management from the liability perspective, as discussed in Chapter 2, prudential regulation is needed to ensure that the functioning of the firm is in the best interest of the client. Furthermore, it could be argued that an increase in the assets under management will also increase the operational risk of the investment firm and that this operational risk in the actual management of the portfolios also needs to be covered by prudential requirements. Although the reasoning provided by the EC is in itself not fully convincing on the need for prudential supervision, there are risks associated with the investment services and activities captured under RtC which require a prudential regulatory response, as discussed in Chapter 2.

404. Under the CRD 2013 regime, certain investment firms are allowed to use a (professional) liability insurance instead of complying with an own funds requirement.4 One could argue that this (professional) liability insurance might be as effective as a prudential requirement to cover the liability risk described above. There are several drawbacks of a liability insurance that can hamper the effectiveness of the insurance to cover the prudential risk. For an insurer to pay out, it will first assess whether the event qualifies as an insured event. This might mean that not all the liability or operational risks an investment firm can suffer in its management of portfolios might be covered, thus leaving the investment firm with a loss that is not insured and is also not covered by capital requirements. Furthermore, the time of the actual payment by the insurer might be later than the time at which the investment firm suffers the loss. This could mean that the investment firm, in the time between suffering the loss and receiving the payment from the insurer, might be insolvent. Both drawbacks of a liability insurance mean that, despite the investment firm having an insurance, the prudential risk for the investment firm remains up and until the moment the insurer has actually paid out the claim by the investment firm. Therefore, a prudential requirement is still needed to fully mitigate these risks, notwithstanding the possible insurance an investment firm might have, and this option for using an insurance has thus been rightly removed in the IFR.

405. The EC also included assets under advice in the calculation of K-AUM. However, the EC gives no clear reasoning as to why providing investment advice would result in the same risk profile as having assets under management. The proposals also lack a clear calculation method for those assets under advice, which can lead to inaccurate or inappropriate outcomes of the K-AUM K-Factor. The only indication given is in the definitions of the IFR, where the European legislators define ‘investment advice of an ongoing nature’ as “the recurring provision of investment advice as well as the continuous or periodic assessment and monitoring or review of a client portfolio of financial instruments, including of the investment undertaken by the client on the basis of a contractual arrangement”.5 Within K-AUM the assets under advice are defined as “the value of assets that an investment firm manages for its clients under both discretionary portfolio management and nondiscretionary ar rangements constituting investment advice of an ongoing nature”.6 Although these definitions provide some clarity when compared with the original proposals, certain aspects remain unclear. For instance, if an advisor were to provide investment advice for a pension fund (suppose the adviser advises the pension fund to invest €100 million in certain bonds), would that adviser then have to include all the AUM of its client in its K-AUM calculations? Or would that advisor only have to include the amount for which it has given its advice? Or only when that client has acted on the advice given by the adviser? If there is a contractual agreement between the investment firm and the client for the investment firm to provide periodic advice on certain asset classes the client has invested in, this should be included in the K-AUM calculations. However, it is still unclear if this contractual agreement will result in all the assets of the client having to be included in the K-AUM of this specific investment firm adviser, or if only that part of the assets that are invested in the specific assets that the advice concerns? The EC acknowledged that the measurement of assets under advice might be problematic by referring explicitly to the measurement of investment advice in the review clause of the IFR.7 This, however, means that until the review has taken place in 2024,8 no immediate changes or corrections to this measurement of investment advice should be expected.

406. When the clients also entrust the investment firm with safeguarding or administering their assets and holding the monies belonging to the client, the client is exposed to further risks. Both the holding of client money and the safeguarding of assets result in an investment firm incurring additional risks for its clients, which are captured by the K-Factors K-CMH and K-ASA respectively. When the investment firm holds or has control of the financial instruments or funds of its clients, the operational risk of the investment firm increases. The prudential risks associated with asset segregation are described in Chapter 4. These K-factors intend to capture these risks; both the operational risks in the holding of the instruments or funds and the liability risk incurred by the investment firm. The IFR states in its recitals that K-ASA “captures the risk of safeguarding and administering customer assets, ensures that investment firms hold capital in proportion to such balances, regardless of whether they are on its own balance sheet or in third-party accounts”.9 With regard to K-CMH, a similar statement is made in the recitals: “K-CMH captures the risk of potential for harm where an investment firm holds the money of its clients, taking into account whether they are on its own balance sheet or in third-party accounts and arrangements under applicable national law provide that client money is safeguarded in the event of bankruptcy, insolvency, or entry into resolution or administration of the investment firm.

407. For both K-ASA and K-CMH, the EC concludes that the holding of client money and the safeguarding of assets holds risks that should be captured within a prudential supervisory regime. What these risks are exactly is not discussed further by the EC. The sections on K-ASA and K-CMH have seen extensive changes during the political negotiations of the IFR and IFR. As these changes might have a significant impact on the capital requirements of investment firms, the next sections will discuss these changes and the final texts in more detail.

408. In the IFR Proposal the EC concludes that the risks of K-ASA and K-CMH occur independently of the asset segregation method employed by the investment firm. In the Annex to the EBA report of 2017, the EBA stated that these K-factors are “in addition to the MiFID II organisational requirements”.10 This, however, ignored the fact that the asset segregation method used by an investment firm can have a significant impact on the actual risk profile of an investment firm, as discussed in Chapter 4. This might have led to a double counting of risks. The requirements of MiFID II require an investment firm to have in place an operational structure that should adequately safeguard the monies and securities belonging to a client, which should have an impact on the prudential regulatory response. An asset segregation method that mitigates the risks for the clients of an investment firm should thus also impact the risks described in IFR proposals. The Dutch Ministry of Finance also used a similar argumentation when telling the Dutch Parliament that these K-factors should be amended: “The purpose is that client monies and securities are segregated from an insolvency of the investment firm. This client risk is thus captured and mitigated by the organizational requirements of MiFID II”.11

409. The IFR, therefore, contains some amendments to K-ASA and K-CMH that take into account some of this overlap with the MiFID II organisational requirements and the resulting impact on the actual risk profile of an investment firm. Firstly, Recital 17 of the IFR now uses the wording “holding client monies or securities”,12 which is similar to the wording of the CRD 2013 and MiFID II, whereas the original IFR proposal used the wording “under their control” in the same recital. A similar change is made in the definition of CMH,13 where the wording “or controls” is deleted and the definition now only refers to “the amount of client money that an investment firm holds”.14 This “under their control” in the IFR Proposal could be interpreted as an investment firm that was allowed, under a tripartite agreement, to use the bank account of its client. As this tripartite agreement does not expose the investment firm to significant risks, as discussed in Chapter 4, having these segregated monies and securities fully included in these K-factors is a significant double counting of risks.

410. The European legislator thankfully acknowledged this and changed the proposals accordingly. This is further explained in Recital 24 of the IFR where the EC states that “K-CMH excludes client money that is deposited on a (custodian) bank account in the name of the client itself, where the investment firm has access to these client funds via a third-party mandate”.15 With this recital the EC explicitly acknowledges the impact certain forms of asset segregation have on the risk profile of an investment firm.

411. This recital seems to resolve the issues that the original proposals of K-CMH had, however the definition of “segregated accounts”16 appears to explicitly contradict this recital. According to this definition, segregated accounts are “accounts with entities where client money held by an investment firm is deposited in accordance with Article 417of Commission Delegated Directive (EU) 2017/ 59318and, where applicable, where national law provides that, in the event of insolvency or entry into resolution or administration of the investment firm, the client money cannot be used to satisfy claims in relation to the investment firm other than claims by the client”.19 This definition of segregated accounts should be used for the purposes of Table 1 in Article 15(2) of the IFR, which contains the applicable coefficients which apply the individual K-Factors. For K-CMH this table differentiates between client money held on segregated accounts and client money not held in segregated accounts.

412. How this will correspond with the Recital is difficult to assess. An investment firm that, based on Article 4 of Commission Delegated Directive (EU) 2017/ 593, deposits all the funds belonging to its clients in separate bank accounts in the name of the client with a (custodian) bank will therefore still have to hold capital for the funds deposited in that manner according to Article 15(2) and Article 4(1)(49) of the IFR. An investment firm that, however, receives a third- party mandate from its client to use the funds a client has already deposited in an existing bank account with its (custodian) bank, might not be caught by Article 15(2) and 4(1)(49) of the IFR as the investment firm does not receive those funds in a manner that falls within the scope of article 4 of Commission Delegated Directive (EU) 2017/593. The difficulty in this last example is the way any additional funds (e.g. through the sale of a financial instrument) of that client deposited in that existing bank account should be classified. It would seem logical to think that this would then fall under Article 4 of the Commission Delegated Directive. The unclear requirements of Article 15(2) and 4(1)(49) of the IFR and Recital 24 of the IFR will therefore place an additional burden on the (prudential) supervisory authorities responsible for the supervision based on the IFR, as they now also have to assess if segregated client funds would fall within the scope of Article 4 of the Commission Delegated regulation or not, since this will then directly affect the K-CMH capital requirement.

413. Although the changes made to CMH seem resolve certain issues, while simultaneously introducing other issues regarding segregated accounts, the definition of ASA, however, remains problematic. The definition of ASA still contains aspects that do not consider the effect of asset segregation methods,20 and therefore appear to ignore the organisational requirements of MiFID II. The amendments discussed above regarding the “controlling” of client money only affect K-CMH and have no impact on K-ASA. The definition of ASA states that ASA is “irrespective of whether assets appear on the investment firms own balance sheet or are segregated in other accounts”.21 K-ASA will thus include all assets the investment firm safeguards for its clients, even though they might be held by a custodian bank (with its own asset segregation requirements) or other fully segregated and independent entities. This will result in all investment firms that perform investment services such as portfolio management, transmission of orders and execution of orders being captured by this K-factor. It will then be virtually impossible for an investment firm that performs any of these investment services to qualify as a Class 3 investment firm as K-ASA should be zero for an investment firm to classify as Class 2.

414. K-ASA now seems to capture all the assets of the investment firms’ clients irrespective of who is actually safeguarding the assets and thus performing the segregation function. This is made explicit in the article describing the measurement of K-ASA, where it states that “where an investment firm has formally delegated the task of safeguarding and administration of assets to another financial entity, […], those assets shall be included in the total amount of ASA […]”.22What is meant with a “financial entity” is not defined in the IFR and will thus lead to discussions. This reference to a “financial entity” makes it difficult to assess which asset segregation methods would now fall within the scope of this K-Factor. This is further complicated by the term ‘formally delegated’, which is also not defined. How a supervisory authority should verify if an asset segregation method also constitutes a formal delegation of the safeguarding function, is not further elaborated upon in the IFR.

415. The choices made by the EC in its regulatory response to the risks of holding client monies and securities seem too simplistic. Instead of fully analysing the risks of holding monies or securities and the impact of the different methods of asset segregation used by investment firms or prescribed by member states, the EC has chosen to apply a one-size-fits-all approach, thereby also capturing in the requirements to hold capital, those asset segregation methods that do not pose any material risk for an investment firm or its clients.

416. The final K-Factor within RtC addresses the execution risk of client orders. A client can also incur risks towards its investment firm when the investment firm executes a client’s orders. For every order executed by the investment firm on behalf of the client “there is a risk that any faults of the firm leave its customers at a loss”.23 This operational risk is captured by the K-Factor K- COH. The definition of COH not only includes orders which the investment firm itself executes, but also those orders the investment firm receives from its clients and then transmits to another investment firm or bank.24 Similarly to the other K-Factors within RtC, the investment firm faces operational risks in the execution process of its business, but it might also face a liability risk towards its customer for any errors or faults in its execution process. To address the order execution risk, the IFR measures K-COH as “the sum of the absolute value of buys and the absolute value of sells for both cash trades and derivatives”.25 The actual measurement technique, however, appears not to address execution risk as it does not measure the amount of orders executed, but merely measures the absolute value of orders executed. An investment firm executing 1 order with an absolute value of €100 million will have a higher K-COH capital requirement then an investment firm executing 10 million orders of €1. Whereas the actual execution risk of that latter investment firm might be greater as it is processing far more orders. This is further complicated by the provisions of the IFR where it requires investment firms to use the notional amount of a derivative transaction in the calculation of its absolute value of orders.26

417. The second paragraph of Article 20 of the IFR contains several exemptions where executed orders do not have to be included in K-COH. Firstly, those orders that “arise from servicing of a client’s investment portfolio where the investment firm already calculates K-AUM in respect of that client’s investment or where that activity relates to the management of assets delegated to the investment firm not contributing to the AUM of that investment firm by virtue of Article 17(2)”,27 do not have to be included in K-COH for that investment firm. This is a logical exemption as the investment firm will already have to hold capital for the AUM managed for a client, and probably for the assets safeguarded for that specific client. Having to also hold capital for any order executed for that client will then result in a double counting of risks for that investment firm. Secondly orders executed by the investment firm “in its own name either for itself or on behalf of a client”28 shall be excluded. Those orders will most likely also result in a capital requirement either under RtM or RtF. Thirdly, any order which was not executed due to a timely cancellation of that order by the client29 may also be excluded from K-COH.

418. Investment firms have to include “transactions executed by the investment firms providing portfolio management services on behalf of investment funds”30 and “transactions which arise from investment advice in respect of which an investment firm does not calculate K-AUM”.31 These two types of transactions are included as they encompass executed orders by the investment firm that are not already captured by other K-Factors.

419. The resulting outcomes of these RtC K-Factors then need to be multiplied by the relevant coefficients32 of Paragraph 2 of Article 15 of the IFR. This will result in the nominal capital amount an investment firm is required to hold for its risk to clients. Although the proposals by the EC lack clarity on details and definitions (for instance, how to measure assets under advice), the overall concept seems to capture the risks of the core activities of an (asset manager) investment firm in a more tailored manner than under the current CRD 2013 and CRR regime.