2.1.2.4 Dealing on own account

57. 1) Introduction - Dealing on own account encompasses “trading against proprietary capital resulting in the conclusion of transactions in one or more financial instruments”.1 An investment firm dealing on own account will have financial instruments on its own balance sheet, or it may have a claim on certain rights or obligations regarding financial instruments2, and is thus exposed to the credit and market risk of these financial instruments. Market risk involves “a number of elements, including the risk of the market moving against a particular instrument, risks inherent in the instrument itself, and general market movement risk”.3 According to Moloney, “investment firms are [also] subject to other significant risks in the trading book”,4 such as counterparty risk. Even though banks can (and will) also perform the investment activity of dealing on own account, it is an investment activity and, as such, market risks are “closely [related] to those investment […] activities”.5

58. From a prudential supervision point of view one can make the distinction between: firstly, positions taken by the investment firm either with trading intent or positions taken by the investment firm with the intend to hold to maturity. Although both ‘positions with trading intent’ and ‘positions with intend to hold to maturity’ should be subject to a capital charge on these positions, the prudential risk for positions taken with a trading intend exposes the firm to market risk, whereas holding positions until maturity also exposes the firm to credit risk as that investment firm not only is exposed to changes in the valuation of the financial instrument on the financial markets, but also the ability of the party issuing that financial instrument to repay that financial instrument. However, this does not consider the possibility of hedging by the investment firm. For instance, a market maker6 will have a large trading book but will usually hedge any position it enters into, resulting in a lowered or fully mitigated market risk. From a balance sheet perspective, this market maker would have two separate positions, the market-making position and the corresponding hedge, which could require a prudential response to both positions if they are assessed separately. However, if one looks at this from a more economic perspective and considers the net risk position of this firm after hedging, the actual risk becomes much lower and the need for a prudential response is less warranted.

59. Secondly, there are positions for own account entered into by the investment firm as a result of not being able to precisely match its clients’ orders.7 Usually, when an investment firm is unable to precisely match its client’s order with the market, the transaction of the client will not be executed. However, the investment firm might choose to execute an order that does not precisely match its client’s order, just to be able to execute that order of the client. This choice by the investment firm to, for instance, execute an order of a larger number of shares then ordered by its client, is made to fulfil the investment firms’ obligations towards its client in a timely fashion and not have the client wait for a precisely matched trade to become available. This does have the consequence that the investment firm will retain the additional shares it has purchased, but which were not ordered by the client, for its own risk and account. The possibility that an investment firm will execute client orders without being able to precisely match that client order is addressed within the current prudential regulatory framework that acknowledges that these situations might occur and provides a specific prudential treatment for these situations in Article 29 paragraph 2 of the CRD 2013.

60. 2) Relevant risks - In the first case discussed in Paragraph 58, the investment firm is subject to the risk of movements in the price of the financial instrument itself or movements in the price of the instrument because of movements in the market.8 The investment firm can also be subject to the credit risk of the counterparty from whom the financial instrument is purchased (i.e. the company whose shares are purchased or the company whose bonds are purchased).9 In the second case discussed in Paragraph 59, the investment firm is still exposed to the same risks as in the first case, however, since the intention when entering into these contracts has never been to actually deal on own account, one would expect the investment firm to hold these positions only for as long as necessary to finalize the transaction for its clients. Although the market risk would be similar, the expectation is that in the second case firms will have these positions for a shorter period of time.

61. In both cases dealing on own account will result in prudential risks which can have an impact on the financial solidity of the investment firm. Once again, the question is whether this more balance sheet-oriented approach of assessing risks is indeed a true representation of the actual economic risks to which the investment firm is exposed. Investment firms that deal in very liquid financial instruments10 for their clients are exposed to relatively small risks. If a client wants to purchase shares in a company which has a very liquid stock, the investment firm might retain some of these shares if it is not able to precisely match its client’s order.11 But the expectation will be that the residual shares owned by the investment firm can be easily and readily sold off, leaving it exposed only for a short time period to the market risks too those shares. Conversely, if the client wants to purchase a very illiquid financial instrument, the investment firm might have problems in selling the residual instruments owned after fulfilling its client’s order. The exposure to the market risk of that illiquid instrument is thus much greater, and the resulting economic risk is higher, which should require a different regulatory response. Simply taking a balance sheet perspective in assessing market risks overlooks the question of whether a position is liquid or illiquid and the impact this has on the actual risk of an investment firm.12

62. It is also important to note that investment firms solely dealing on own account and which do not have any external clients, therefore, do not pose any risk to external clients. However, as they actively trade on the financial markets, these firms do have counterparties. These firms are subject to market risks for the positions they enter into, but since they have no external clients, one could ask whether any prudential requirements should be imposed. The EBA report on investment firms addresses this issue as follows: “For an investment firm solely dealing on own account, both the upside and the downside potential of a trading exposure are for the owners/traders of the firm. These investment firms have no external customers, and, in most cases, the owners of the firm are also the main risk takers or traders.”13 Prudential regulation intended to safeguard the interests of clients of an investment firm therefore does not seem logical for this type of investment firm, as there are no clients to protect.

63. This narrow interpretation of clients14, however, should not result in either an implicit or explicit reason not to impose any prudential requirements on these types of investment firms. As this investment firm is active on a financial market, it will always deal with a counterparty. This counterparty can be seen as a ‘client’ if we use a broader interpretation of clients. Prudential regulation should, therefore, protect these counterparty ‘clients’ from any financial difficulties of the investment firm that could interfere with the transactions entered into by the investment firm with that counterparty.

64. This then leads to the question if the requirements included in MiFID II on identifying when someone should be considered as a client, either a professional client or a retail client15, of the investment firm, should be similarly applied to the prudential regulatory framework. Where MiFID II purports to identify those persons to which an investment firm provides investment or ancillary services and based on the type of client offers more (for retail clients) or less (for professional clients) protection to those clients by applying all or part of MiFID II’s investor protection requirements. The prudential regulatory response should protect all those persons who interact with the investment firm without the distinction between the types of client. This could therefore mean that a counterparty might not be considered a client under MiFID II definitions, but that an adequate prudential regulatory response, as discussed above would still be beneficial no matter the qualification of the counterparty with whom such investment firm acts. The EBA’s report on investment firms16 further discusses the fact that these firms solely dealing on own account can have an impact on financial stability and that the capital requirements should focus on this potential risk to financial stability.

65. 3) Framework for assessing risks – Investment firms dealing on own account incur both the agency costs and the systemic risks identified by Moloney as discussed at the beginning of this Chapter. Those investment firms that deal on own account to fulfil client orders will likely incur agency costs as there will be information asymmetries between the investment firm and its client. This is also the case if we apply the broader definition of ‘clients’ as discussed above in Paragraphs 63 and 64. A counterparty can be seen as a ‘client’ in this broader scope. This counterparty client will also be subject to the information asymmetries and will have less information than the investment firm. The agency costs will also be incurred by investment firms solely dealing on own account that have no clients according to the MiFID II definition, but that interact with these ‘counterparty clients’.

66. Investment firms that have larger trading books (and are thus more actively dealing on own account) can pose a risk to the financial system itself. The failure of an investment firm that has a very large trading book or that is a market maker, can have severe consequences for the market in which it is active or the counterparties with which it trades. This is dependent, however, on the types of financial instruments which are part of that investment firm’s trading book and, for instance, whether there are any ongoing financial commitments entered into by the investment firm as part of a derivative contract with its counterparties. The riskiness of a large market-making firm with a significant balance sheet is dependent on the ability of the firm holding these positions to fully hedge its exposures, leaving little residual (market) risk incurred by the investment firm.

67. Moloney’s hypothesis that larger trading books of investment firms inherently pose a systemic risk therefore fails to consider the trading strategies and risk management of the individual firms themselves. The failure of a small (and sole) market maker in a very illiquid market might have more impact on the financial systems and financial stability than a very large market maker on the New York Stock Exchange with numerous competitors offering the same services.17

68. If we apply the framework for financial risks for investment firms that is proposed in Section 2.1.4 of this study, investment firms dealing on own account are exposed to operational risks and they are exposed to financial risks for the positions they enter into. The actual market risks, however, are influenced by the types of financial instruments themselves, the liquidity in the market of the financial instrument, the trading strategy, the hedging strategy employed and the duration of the exposure on the balance sheet of the firm itself.18 The regulatory response for investment firms dealing on own account should, therefore, not be solely based on the implications of the financial risks but should also consider the operational risks. Furthermore, being subject to these financial risks does not equate to systemic risk, which is an altogether different category of risk that should be related to the actual economic risk assessment of these financial risks.

69. Investment firms dealing on own account are also subject to operational risks in their trading activities, besides the financial risks they can incur through the financial instruments they would have on their balance sheet. When dealing on own account, any errors or failures in the internal processes of the investment firm that govern the dealing activity will result in operational risk and should, therefore, be included in a regulatory response.