9.2.3.2 Risk to Market

420. Risk to Market (RtM) intends to capture the risks of “investment firms which deal on own account”,1 for their own risk and account, or which trade in their own name when executing client orders and is “based on the rules for market risk for positions in financial instruments, in foreign exchange, and in commodities in accordance with [CRR]”.2 An investment firm can take positions on its own account when having trading intent for itself.3 The firm thus seeks to gain from movements in financial markets for its own account. However, that is not the only possible route whereby an investment firm can have positions own its own balance sheet. It can also obtain these positions when trading for (or with) clients. The investment firm can be the counterparty for its clients, for instance when the client is seeking to hedge its FX or interest risk, the investment firm can try to find a counterparty willing to accept the trade with the client or it can accept the transaction itself and thus end up with a position entered into solely because of its client and not with trading intent. The investment firm is thus exposed to the market risk of these positions. Another possibility is that the investment firm receives an order from a client to buy certain shares, but there are no available trades that precisely match the client order. To fulfil the client order, the investment firm thus has to enter into a trade that comprises more shares than the client ordered. These residual shares (the amount exceeding the client order) will then be on the investment firm’s balance sheet. For these positions the investment firm is also exposed to the market risk of these financial instruments.

421. The market risk of an investment firm is captured by the K-factor K-NPR. This Net Position Risk means “the value of transactions recorded in the trading book of an investment firm”.4 The Net Position Risk is calculated in a similar way to the market risk capital requirement in the CRR, including the changes made to these requirements in the CRR 25 to adopt the Basel Committee standards introduced in the Fundamental Review of the Trading Book.6 This allows “investment firms to choose to apply the ‘standardised approach’7the ‘alternative standardised approach’8 under [CRR], or the option to use ‘internal models’.910 “The use of the latter two approaches is contingent on those approaches becoming applicable for credit institutions “not only for reporting purposes but also for own funds requirements purposes”.11 It is however unclear if the conditions that would allow a credit institution to apply the alternative approach, as set out in 325a of CRR2,12 would also apply for investment firms. This is further highlighted by the fact that the reference in IFR to the alternative approach is only to “Chapter 1a of Title IV of Part Three of [CRR2]”,13 whereas the conditions to apply the alternative approach as included in article 325a of the CRR2, are included in Chapter 1 of Title IV of Part Three of CRR2. When reading Recital 25 of the IFR, the EC seems to imply that the investment firm may choose the method it wants to use, without application of the criteria of article 325a of the CRR2. Article 22 of the IFR itself does not make explicit who is responsible for the choice of method; the investment firm or the supervisory authority? Nor does Article 22 of the IFR make explicit if the supervisory authority has to approve the usage of one of the methods by the investment firm.

422. This full alignment of the market risk requirements of K-NPR with the market risk regime of CRR2 can be questioned given the reasoning provided by the EC for introducing the IFR. If the CRR regime is indeed not appropriately capturing the risk profiles of investment firms, why would a new regime then have to rely fully on the CRR for its prudential treatment of trading book positions of investment firms? Furthermore, it makes the introduction of Class 1a and Class 1b seem rather futile as the prudential treatment of a trading book position is completely alike for firms subject to the requirements of the CRR and firms subject to the requirements of IFR. There might now actually be a regulatory arbitrage motivation for investment firms to qualify as a Class 1a, Class 1b or opt-in Class 1a, as the market risk capital requirement will not differ between CRR and IFR, whereas the RtC requirements that capture the investment firm specific risks are not included in the CRR regime. An investment firm can therefore evade the RtC requirements altogether if it were to fall within the scope of the CRR regime, as the CRR regime no longer has a specific capital requirement tailored for investment firms.

423. The EBA and the European Commission also acknowledged that a possible alternative method exists to address RtM for firms whose transactions are entirely centrally cleared. After supervisory approval these firms use a K-Factor based on the initial margin these firms have to post with their clearing member, K-CMG. An investment firm is allowed to use K-CMG only after supervisory approval and only when the investment firm fulfils the conditions in Paragraph 1 of Article 23 of the IFR:14 “a) The investment firm may not be part of a group also containing a bank; b) The execution and settlement of transactions of the investment firm takes place [under responsibility of and are guaranteed by a clearing member]; c) The calculation of total margin by the clearing member is based on an internal model that complies with Article 41 of Regulation (EU) No 648/2012; and d) The investment firms justifies it use of CMG to its competent authority based on its nature of its main activities and that the choice of CMG is not made to arbitrate capital requirements”.

424. In both risk measurement approaches (K-NPR and K-CMG) the investment firm should be capitalized for the risk of a potential loss on any transactions it enters into (both for its own risk and account and on own account when executing client orders). This is to ensure that a loss event for the investment firm has no significant repercussions for the (financial) markets in which the investment firm is active and for the servicing of the clients of that investment firm. Under the IFR proposals, the method in which the EC has combined K-NPR and K-CMG was questionable. According to Article 21 of the IFR proposal, the applicable capital requirement for RtM was the highest of K-NPR and K-CMG. As K-CMG is only applicable after supervisory approval and after the investment firm itself has asked for that approval, the practical use of K-CMG under the original IFR proposals was limited. Which firm would actively seek a capital requirement that will have a higher outcome than the standard applicable requirement of K-NPR? For K-CMG to be the applicable capital requirement under the original IFR proposal, the outcome would have needed to be higher than K-NPR, but then it would serve no purpose for an investment firm to seek permission for applying K- CMG. This shortcoming in the way K-NPR and K-CMG relate was also acknowledged by the EC. In the IFR this “higher of” requirement has been amended. Article 21 of the IFR now requires an investment firm to hold capital for RtM based on “either K-NPR or K-CMG”, giving investment firms the possibility to lower their RtM capital requirement based on K-NPR, if they comply with all conditions for K-CMG.

425. It is disappointing that the EC nor the EBA in its reports have analysed whether the market risk regime in the CRR is indeed the most appropriate model to capture the risks of an investment firm dealing for own account, especially given that an investment firm can, as discussed in Section 2.1.2, have multiple reasons for dealing on own account and the resulting risk, therefore, can have a different impact or significance for the risk profile of the investment firm. Does the investment firm have a trading intent, or are these positions the result of client activities? If the investment firm only deals on own account when executing client orders, the main risk is for the client of the investment firm, as in the case of risks covered under RtC. If the investment firm fails due its positions in financial instruments, it is the client who will suffer a loss of service, or losses on the financial instruments held by the client. The impact of the failure of the investment firm on financial markets should, for these client-oriented investment firms, be of less significance than the possible impact for clients. This aspect is not addressed by the IFR.

426. A capital requirement designed to ‘protect’ markets from failures only makes sense in the case of investment firms that deal on own account for their own risk and account (for instance large market makers or ‘investment banks’) and whose failure can have a significant impact on financial markets. The EC, however, concludes that “trading financial instruments, whether for the purposes of risk management, hedging and liquidity management or for taking directional positions on the value of an instrument over time, is an activity in which both credit institutions and investment firms [...] may engage and which is already addressed by [CRD 2013 and CRR]. In order to avoid an unlevel playing field which could lead to regulatory arbitrage between credit institutions and investment firms in this area, the capital requirements resulting from these rules to cover this risk should, therefore, continue to apply to these investment firms”.15 This justification of the EC to keep the CRR market risk requirements for firms trading in financial instruments ignores, one must hope unintentionally, those investment firms that only deal in financial instruments when executing client orders. Especially for these investment firms, the CRR market risk regime does not seem to be the most appropriate regime. Although the RtM risk factors are targeted at an investment firm’s positions in the trading book and thus the proprietary positions of an investment firm for its own risk and account, this also includes those positions entered into by the investment firm when servicing its clients.16

427. It would also have been beneficial if the EC had analysed whether an investment firm that deals on own account with trading intent, but has no external clients and offers no other investment services or activities, is exposed to similar risks incurred by a bank that also deals on own account but is also carrying out other activities, particularly deposit-taking, and if that investment firm therefore needs similar capital requirements as a bank for those trading positions. The K-CMG regime does seem like a first attempt to provide investment firms with a less intensive and complicated regime to address risks in the trading book (the margin model of a clearing member is no less complex than the market risk calculations under the CRR, but it is the clearing member who carries out those calculations instead of the investment firm). However, the RtM regime appears to be an easy solution by the legislator to apply an existing regime, without fully analysing if a different regime might have resulted in more appropriate capital requirements.