2.1.2.7 Underwriting & placing without a firm commitment basis

77. 1) Introduction - This section will explore two investment services which are closely linked but have key differences that have a significant impact on the risk profile of the investment firm. The two activities discussed in this section are: (1) underwriting or placing of financial instruments with a firm commitment basis,1 and (2) placing of financial instruments without a firm commitment basis.

78. The processes and procedures of underwriting or placing of financial instruments with a firm commitment basis are similar to those of placing of financial instrument without a firm commitment basis. MiFID II does not contain a definition of these investment services, nor do the recitals of this directive contain any guidance on which activities should be covered by these investment services. As MiFID II does not contain any further guidance on these investment services, one can only rely on a linguistic explanation to identify the differences. These differences lie in the words ‘with’ and ‘without· a firm commitment basis. When performing the activity of underwriting/placing with firm commitment,2 the investment firm guarantees to its clients that the placing of financial instruments on the primary financial markets (sometimes also called issuance of a financial instrument3) for that client will “succeed”.4 In other words, the investment firm has an obligation to buy the financial instruments issued by its clients which the investment firm has not been able to sell to other buyers. The investment firm commits itself either to sell all the financial instruments its client purports to issue, or to buy those financial instrument which it has not been able to sell to third parties.

79. When placing financial instruments without a firm commitment basis, the investment firm does not commit too its client that it will be successful too distribute all financial instruments5 that the clients purports to issue. The investment firm acts as a ‘sales office’ with the intent to sell as many of the issued financial instruments as possible, but the risk of a failed issuance lies fully with the client of the investment firm.

80. When placing financial instruments, the investment firm can thus decide whether or not to guarantee the successful issuance of the financial instruments. The investment firm can either accept the risk of an unsuccessful issuance or decide not to accept it and to leave it with the client. It should be noted that in practice the difference between these two investment activities is negligible. An investment firm will usually only accept an “underwriting contract” with its clients once it has contacted possible investors in a “book building” process and has enough certainty from those investors that the issuance of its client’s financial instrument will succeed. By sounding out the interest in the possible issuance before formally accepting the contract, the investment firm can greatly reduce its risk of having to take the residual financial instruments of that issuance on its own books, whether temporarily or permanently. From the perspective of the investment firm, once enough possible investors are interested, it does not matter if the issuance is performed under the investment activity ‘with’ or ‘without’ a firm commitment basis.

81. It should be noted that this underwriting investment service, although part of the services included in MiFID II, will, in the European Union, usually be performed by a bank.6 This does not, however, impact the analysis of the specific risks associated with underwriting, nor does it entail that investment firms will not perform this investment service. Although it is predominantly performed by banks, there are still cases of investment firms performing this activity. With the rise of crowd funding platforms,7 which some SMEs use as an alternative means of funding, these platforms will in some cases need placing or underwriting permissions to create and place the financial instruments useful for these SMEs and appropriate for the clients of the crowd funding platform. Furthermore, as will be discussed in Chapter 9, it is particularly with a view on the carrying out of this investment service by a number of non-banks regulated as MiFID II investment firms, that in the new prudential regime for investment firms, specific rules are introduced for these firms offering ‘bank-like’ services.

82. 2) Relevant risks - An investment firm placing financial instruments without a firm commitment basis is exposed to less prudential risks than an investment firm that places them with a firm commitment basis. Investment firms placing instruments without a firm commitment basis can be seen as a sales office.8 The investment firm provides the service of offering its clients’ financial instruments to potential buyers, thereby relieving the client of the need to actively promote its issuance itself. The sale of a financial instrument for the client with no obligation for the investment firm to take the financial instrument on its own book will not directly lead to prudential risks on the investment firm’s balance sheet. It might lead to liability claims9 if the investment firm did not fulfil its obligations properly, but the act of selling the financial instrument itself poses no significant financial risks. It might in some instances lead to a settlement or delivery risk if the investment firm’s client is unable to deliver the financial instrument for the investment in that instrument or vice versa where the investor in that financial instrument is unable to pay for the financial instrument that he purchased. Depending on the specific details of the contract entered into by the investment firm and the client, the investment firm might be subject to these risks. However, since the provided investment service should be without a firm commitment basis, the risk of actually entering into a delivery or settlement risk for the investment firm should be limited, certainly if the offering concerned is an exchange driven transaction. The investment firm is thus exposed to an operational risk related to the process of creating a financial instrument and the subsequent placing of the instrument with the investors. Any errors in this process will lead to an operational risk that requires a regulatory response.

83. This is different when the investment firm guarantees the success of the issuance. By providing that guarantee (or firm commitment), the investment firm exposes itself to the risk of obtaining a position in its client’s financial instrument. The investment firm is thus exposed to the funding risk to settle the purchase price with its client, the risk of price movements in the instrument itself and to movements in the general market which may affect the price of the financial instruments. By providing the guarantee, the investment firm is first and foremost directly subject to the delivery and settlement risk, as the investment firm guarantees that the issuer of the financial instrument will receive the monetary value of the financial instruments and the investor will receive the financial instrument. The investment firm’s risk profile therefore increases significantly when performing the investment service of underwriting/placing on a firm commitment basis.

84. Investment firms providing underwriting services may additionally incur operational risks similar to those of investment firms providing only placing services without firm commitment.10 Providing a guarantee or not does not alter the process of financial instrument creation and placing that instrument with investors. As such, this process will expose the investment firm to operational risk. Investment firms providing underwriting services are also exposed to financial risks. They are exposed to a credit risk to the investors in the financial instrument up to the point at which the investor has actually transferred the funds used to purchase the instrument. But, more importantly, underwriters can be exposed to market and credit risk on the financial instrument created for their client and which the investment firm is unable to place with investors. This market and credit risk on the ‘residual’ position is affected by the time period for which the instruments are held by the investment firm.11 The longer the investment firm holds these residual instruments on its balance sheet, the longer it is exposed to the market and credit risk associated with them.

85. The time period for which residual instruments are held also gives another implicit indicator of risk.12 If the underwriting investment firm is unable to place part of the original issuance with investors, and that firm is subsequently unable to sell the residual instruments on the secondary market, this gives an indication of the credit rating and financial markets’ assessment of the investment firm’s client. So, the investment firm’s risk is driven not only by the market and credit risk of the financial instruments, but also by the credit rating of the client of the investment firm itself, as this might impact the timeframe for which the investment firm is exposed to the credit and market risks of these instruments.

86. 3) Framework for assessing risks – The risk profile of investment firms performing the service of placing financial instruments with or without firm commitment, can be assessed along the dimension of operational risk as this is the predominant risk these types of investment firms are exposed to. Investment firms that provide a firm commitment or perform underwriting services, however, can also be exposed to market risks and should therefore also be assessed along the financial risk dimension.