10.2 What are the prudential risks of investment firms?

494. The provision of the various investment services or activities and ancillary services will expose the investment firm to prudential risks. If we apply the framework, of operational and financial risks, discussed above in Section 10.1, to these investment services or activities1 and the ancillary services,2 the following risks can be identified.

495. The operational risks of an investment firm entails the possible failures in people, processes and technology and might be caused by simple incompetence, human error or fraud. As highlighted by Moloney when discussing agency costs, much of the regulatory response regarding these operational risks when providing investment services or activities has been focused on the conduct and operational requirements within the MiFID II framework. Although these MiFID II requirements should mitigate (part of) these operational risks, the MiFID II requirements do not address possible operational errors of incompetence, human error or fraud. The MiFID II requirements will only ensure that the administrative organisation and internal control mechanism of the investment firm are set up according to the MiFID II requirements. This does not mean that the actual performance and execution of these requirements will occur in the same manner as has been implemented in the administrative organisation. No matter how well an investment firm has established and implemented its administrative organisation and business processes to include these MiFID II requirements, operational errors can always occur. Even supervision by competent authorities on the compliance of an investment firm with these MiFID II requirements will not completely prevent operational risks from occurring within the business operations of an investment firm. Non-compliance with the MiFID II requirements will result in regulatory action by the competent authorities, but this will not address the possible financial consequences of an operational risk event.3

496. This is where a prudential regulatory response will be required. Any operational error might lead to an investment firm being held liable either by its client or by its counterparty on the financial markets. To prevent a single liability claim forcing an insolvency of the investment firm, it is necessary for that investment firm to assess the operational risks of its activities and to capitalize those operational risks. One could even argue that, by virtue of having the MiFID II requirements in place, the prudential operational risk of an investment firm increases, as the investment firm is held to a higher standard of conduct and operational requirements by its clients than an otherwise unregulated business will be, as discussed in Paragraph 36 of Section 2.1.2. The MiFID II requirements are intended to protect the clients and counterparties of an investment firm. Any operational error in the processes covered by the MiFID II requirements will, therefore, have a higher impact on those clients or counterparties than an operational error by an unregulated business.

497. Investment firms are further exposed to financial risks, which, in the case of an investment firm, will usually occur through a trading book4 position of that investment firm. If an investment firm, when performing an investment service or activity, will end up with a financial instrument on its own balance sheet, the investment firm is subject to the market risk on this financial instrument. The investment firm can be in this position as a result of dealing for its own risk and account and thus speculating on the price movement of the financial instruments for its gain. It is also possible that the investment firm will end up with a financial instrument if it cannot precisely match its client’s order on the financial markets but still chooses to execute it and take the remainder of the transaction in the financial instrument onto its own balance sheet, or when the investment firm is the counterparty for a client order. In these instances, the investment firm will be subject to the market risk on those positions. Furthermore, when performing underwriting activities, the investment firm might end up with the residual financial instrument of its client which it has failed to place on financial markets, but which it guaranteed to place successfully in its underwriting contract.

498. Credit risks, as discussed in Chapter 2, concerns the risk that a client or counterparty cannot fulfil its obligation towards the investment firm. This risk will predominantly be incurred by investment firms that either provide (investment) credit or that are active dealers on own account and as such are exposed to the credit risk of its counterparties on the financial markets.