2.1.2 Investment services and activities

33. Performing one or more of the nine investment services or activities, mentioned in paragraph 25 in Section 2.1, leads to firms being exposed to certain types of financial or operational risks. MiFID II contains several definitions1 of the various investment services and activities in Article 4 and provides additional clarification of certain investment services and activities in its recitals, although not all investment services and activities are further defined in MiFID II or its predecessors. However, both MiFID II and the prudential regime for investment firms included in the CRD 2013 and the CRR contain no further guidance on the types of (financial or operational) risks associated with these investment services and activities, nor do the directives which are predecessors to MiFID II, the CRD 2013 and the CRR. In the CAD 1993 the European legislators stated that the CAD should “provide a complementary framework for the supervision of the risks incurred by [credit institutions and investment firms], in particular market risks, and more especially position risks, counterparty/ settlement risks and foreign-exchange risks”.2 The CAD 2006 states, in its recitals, that “since investment firms face in respect of their trading book business the same risks as credit institutions, it is appropriate for the pertinent provisions of [CRD 2006]3relating to the taking up and pursuit of the business of credit institutions (1) to apply equally to investment firms”.4 In these recitals, the European legislator clarifies that investment firms that deal on own account are exposed to “market risks”. The other investment services and activities are not mentioned further in the CAD 1993 or CAD 20065 and their legal successors6 when framing the scope of applicability of prudential supervision rules.

34. In the following sections, this study will explore the types of risks that can be associated with the provision of the various investment services and activities. All investment firms are, however, exposed to certain risks which do not have to be directly related to the provision of a single investment service or activity. An investment firm, like any other business, is also exposed to operational risk7 when performing its day-to-day operations. Its systems or procedures can fail, or the personnel of the investment firm can make an error resulting in a financial loss for the investment firm, whether or not amplified by litigation risk in concurrence with the actual damage occurring.

35. Furthermore, an investment firm, like any other business, whether regulated or unregulated, is exposed to credit risk. For instance, if the investment firm has a bank account, it is exposed to the risk that the bank might not be able to repay the funds on that bank account. Similarly, the investment firm is exposed to the credit risks of its debtors.8

36. One aspect specific for investment firms needs to be addressed before discussing the various investment services and activities. MiFID II requires investment firms to comply with a set of regulations intended to govern the market conduct and operations of the investment firms. One could argue, however, that the MiFID II requirements increase an investment firm’s operational risk as they increase the client’s expectation of the level of service and performance of the investment firm. An investment firm failing to meet these increased levels of service or performance will face claims or actions either by the clients of the investment firm or by the supervisory authority responsible for the supervision of the MiFID II requirements. The MiFID II requirements are intended to increase the protection of investors9 and the recitals of MiFID II state “that weaknesses in corporate governance in a number of financial institutions, including the absence of effective checks and balances within them, have been a contributory factor to the financial crisis. Excessive and imprudent risk-taking may lead to the failure of individual financial institutions and systemic problems in Member States and globally. Incorrect conduct of firms providing services to clients may lead to investor detriment and loss of investor confidence. In order to address the potentially detrimental effect of those weaknesses in corporate governance arrangements, Directive 2004/39/EC should be supplemented by more detailed principles and minimum standards”.10 Placing greater requirements on investment firms through MiFID II increases the operational risk of an investment firm as the number of its processes in which an operational error can occur also increases and the expected level of competence by clients and supervisory authorities is also increased. In other words: the accepted number of errors and the accepted impact of those errors by the clients and supervisory authorities of the investment firm is lower as a consequence of the MiFID II requirements on the operational organisation of the investment firm. When assessing the risk profile of an investment firm, this should include the risks of this increased expectations by clients and supervisory authorities.

37. The next sections will describe the activity-specific risks of performing the investment services and activities, but not the general risks as mentioned above. Given that an investment firm can perform a wide variety of investment services and activities, one has to understand that, although all investment firms fall under the same legal definition, the total population of investment firms itself is very heterogeneous. This heterogeneity arises not only from the activities, but also from the size of the investment firms, the international footprint of the investment firm and whether it is part of a larger group.11 Where relevant, the impact of certain aspects on different subsets of investment firms will also be discussed.

38. The following sections will describe the risks associated with the various investment services and activities along the following (risk) dimensions. Prudential risks concern those risks that might require a prudential supervisory response. They cover those types of risks that might have a financial consequence and could thus impact the financial soundness of the investment firm. Within prudential risks, a distinction is made between operational risks and financial risks. Operational risks concerns those risks which occur within the operations of an investment firm and include liability risks. The final risk dimension are those risks concerning financial risks. This dimension, as discussed earlier, primarily concerns credit and market risks.

39. The next sections will discuss the various investment services and activities and will start with a short description on the service or activity, followed by a discussion of the risks associated with that service or activity and a reflection how these risks would fit in a framework for assessing the risk profile of investment firms.