8.4 Assessing systemic relevance of investment firms

331. The vital role an investment firm can play within financial markets is reflected in the criteria used by the FSB1 for assessing the systemic importance of financial institutions. The FSB identified three criteria for assessing systemic risk: “size (the volume of financial services provided by the individual component of the financial system); substitutability (the extent to which other components of the system can provide the same services in the event of a failure); and interconnectedness (linkages with other components of the system)”.2 These criteria can be used to identify the systemic importance of investment firms or the vital functions they might provide. However, these criteria have only been further explored to assess the systemic risk of banks,3 as the same report by the FSB limits the scope to a set of activities which do not capture the activities or services provided by investment firms, except those investment firms that operate a trading platform. The FSB report defines the following services and activities as of “critical importance [for] the continued provision [for] the financial system:

332. These services and activities are primarily provided by banks, perhaps with the exception of the last function as set out in the second paragraph. To a certain extent, investment firms active as market makers may fulfil some of the functions on the financial markets as referred to by the FSB. The investment services and activities described in Chapter 2 are not comprehensively captured in the scoping of the FSB report. No full assessment of the systemic importance of investment firms has thus been made5 on an international level. The FSB has investigated the vulnerabilities of asset managers,6 but this analysis focusses partly on the investment funds managed by these asset managers and the liquidity and leverage risks within these investment funds. Although these risks can, according to the FSB, lead to a systemic relevance of that asset manager, these fund managers will, in the European Union, be regulated under the AIFMD or UCITS and will not be investment firms as defined in MiFID.7 The report does, however, identify operational risks and risks in securities lending activities that might lead to systemic risks for asset managers.8 The operational risks identified by the FSB primarily focus on stressed market conditions and operational errors of an asset manager that could lead to a loss of confidence of investors in that asset manager and result in a ‘fire sale’ of assets managed by the asset managers, which in turn and, if the market conditions are facing extreme stress, could lead to problems and risks for other entities active in those financial markets.9 The FSB acknowledges, in Chapters 4.3 and 4.4 of its report, that these operational risks will most likely be addressed by “a number of regulatory and supervisory tools and market practises”. The FSB does advise to put in place requirements or guidance for asset managers “to have comprehensive and robust risk management frameworks and practices […] to enable orderly transfer of their clients’ accounts and investment mandates in stressed conditions”.10 Although the FSB does not make it explicit, this recommendation clearly indicates that a resolution framework for investment firms is indeed desirable since some (operational or financial) risks of investment firms can lead to risks for financial markets and its participants.

333. The securities financing risks the FSB identified in its report on asset managers are, however, according to the FSB, manageable. The main recommendation of the FSB for this risk is that “authorities should verify and confirm asset managers adequately cover potential credit losses from the indemnification provided to their clients”.11 There might be a systemic risk if investment firms engage in securities lending and, due to stressed market conditions or reputational incidents concerning the investment firm, the investment firms are not able to repay its clients for the securities it has lend to other parties. This might cause a chain affect where all securities lending transactions are questioned by market participants. The FSB however acknowledges, in Chapter 5.3 of its report, that “timely adoption of FSB policy recommendations should address most of the potential residual risks for financial stability associated with securities lending activities of asset managers and funds”.

334. In its “Opinion of the European Banking Authority on the First Part of the Call for Advice on Investment Firms”,12 the EBA provide a first indication on how to assess the systemic relevance of investment firms.13 According to the EBA, “systemic, interconnected and bank-like investment firms”14 can be identified with the following criteria: “A) systemic importance, B) interconnectedness with the financial system, C) complexity, D) bank-like activities”.15 The EBA then refers to the criteria it has developed for the “identification of Global Systemically Important Institutions (G-SIIs)16and […] Other Systemically Important Institutions (O-SIIs)17[as an] appropriate and suitable [methodology] to identify investment firms that should be subject in full to the CRD and CRR”.18 EBA, however, acknowledged that the methodology used to identify G-SIIs and O-SIIs was based on the existing prudential framework included in the CRD 2013 and the CRR, and that the O-SIIs framework might not be fit for purpose to assess systemically relevant investment firms under the new IFR and IFD framework.19 Firstly, EBA (implicitly) acknowledges that the G-SII framework is not relevant at all for the investment firm industry. G-SII’s are the 30 largest systemically important banks with a global footprint. Even the largest investment firms in Europe do not fit in this box. Secondly, as will be discussed in Section 9.2.1, using a criteria based on “bank-like” activities is difficult, as these activities purported to be bank-like (underwriting and dealing on own account) are not in itself activities that would classify an institution as a bank.20 The EBA therefore has only proposed three possibly useful criteria that relate to the size of an investment firm, its importance for or substitutability on financial markets and its complexity and interconnectedness.

335. The criteria used by the EBA to identify G-SIIs and O-SIIs are similar, but appear to be calibrated for large banking institutions. One of the main criteria used is the size of the institution.21 If we were to apply this criteria to an investment firm, only those investment firms which perform the investment activity of dealing on own account will be caught as this is the only investment service or activity22 that will result in significant balance sheet items. Investment firms that perform asset management services will usually not have a significant balance sheet size, even though they might manage billions of assets of their clients. See also Chapter 3 for a further discussion on the expected balance sheets of investment firms as compared to banks. Including the funds and securities belonging to clients of investment firms in the calculation of the total (asset) size of the investment firm will, however, also lead to incomparable results. Is an asset manager that manages €30 billion in assets of clients comparable with a market maker that has €30 billion of own account trading positions on its balance sheet? As such, simply looking at the size of a balance sheet, even with the inclusion of client funds and securities, will not capture all investment firms that might be systemically relevant in a jurisdiction.

336. Given the discussion above on the merits of the criteria proposed by the EBA for systemic investment firms and the criteria used for identifying G-SIIs and O-SIIs, the most promising criteria to adequately measure systemic relevance of an investment firm will be discussed in the next sections.

337. Firstly, systemic importance of an investment firm, measured through the “importance for the economy of the relevant Member State or the Union, capturing substitutability/financial institution infrastructure”23 and the resulting substitutability of that investment firm within financial markets. An asset manager that manages billions of assets, for instance for a pension fund, might be deemed systemically important by supervisory authorities in a member state, as the failure of this asset manager can have severe consequence for the financial markets and the economy of that specific country. Similarly substitutability, or the lack thereof, can lead to an investment firm being classified as systemically important. For instance an investment firm operating an MTF of OTF platform might, with the platform it is operating, provide a single point where certain financial instruments can be traded. If that platform were to cease operations, investors in those specific financial instruments might not be able to buy or sell to financial instruments which could severely impact financial markets.

338. Secondly, the complexity of an investment firm needs to be assed. A very complex investment firm might present difficulties for supervisory authorities if they attempt an orderly wind-down of that investment firm. If we use the example of the large asset manager above, the systemic relevance of that large asset manager can be reduced if the assets it manages are not complex and easily transferable to another asset manager. When the asset manager is more complex, for instance if the assets it manages are invested in illiquid or highly complex products, it will be more difficult to transfer those assets to another asset manager and as such the risk of a disorderly wind-down will increase.

339. Another aspect of complexity is the software used and developed by the investment firm. This is especially relevant when discussing investment firms that operate an MTF or OTF. These trading platforms usually operate on proprietary software of the investment firm. Given that this software is proprietary of the specific investment firm, the knowledge on the set up of the platform and the ‘inner workings’ of the software application will most likely only be known by employees of that specific investment firm. A very complex software landscape of that investment firm with limited knowledge of that software outside of the investment firm, will mean that the investment firm is very complex. If that investment firm were to fail, it will be difficult for other investment firms to take the place of the failing investment firm. Which would also require the complex investment firm to have sufficient capital available that its ‘survival period’ or ‘orderly wind-down’ period is sufficient for other investment firms to take its place even if this will take a longer period of time due to the complexity of the investment firm.

340. Complexity of an investment firm could also be measured through the funding profile of the investment firm. Certain investment firms that can be seen as “bank-like” investment firms, based on the proposals used by the EBA to identify systemically relevant investment firms, will not be considered as banks, as they do not take deposits. They are similar to banks in other aspects in that they grant credit to their clients and provide the “investment banking” activities that certain large (and predominantly US) banks24 provide within the European Union through subsidiary entities in the European Union that are regulated as MiFID firms. Because these “bank-like” investment firms do not take deposits, the funding of their business comes from both equity and from wholesale markets, whereas investment firms that are not bank-like typically do not rely on the wholesale market for the funding of their day-to-day business. This difference in funding profile makes for a more convincing reason why these “bank-like” investment firms need to be subject to a prudential regime designed for banks, as compared to the criteria used by the EBA in its opinion. Because these “bank-like” investment firms perform banking functions within the financial market, such as “(i) maturity transformation, (ii) liquidity transformation, (iii) credit risk transfer, and/or (iv) leverage”,25 they can also be seen as shadow banking entities26 which therefore should be treated in a similar way to a normal bank.

341. Another part of complexity is the interconnectedness of an investment firm. As previously discussed, investment firms operating an MTF or OTF could provide either a predominant or a single platform on which certain financial instruments are traded. This entails that these platform operators can be significantly interconnected with the functioning of (global) financial markets and as such the failure of the platform operator can have severe implication for (global) financial markets.

342. Interconnectedness can also occur for investment firms dealing on own account. For example, if the clearing institution used by that investment firm, receives a significant portion of the margins it requires from its clearing members from a single investment firm, the failure of that investment firm can have significant repercussions for that clearing institution. A possible subsequent failure of a clearing institution as a result of its larger investment firm client could have implications for the financial markets.