1 Introduction to investment firms and the applicable prudential frameworks

1. If a person or a company wants to access the financial markets by investing in listed securities, buying bonds, entering into derivative transactions to hedge currency risk, or any other type of transaction or contract related to a financial instrument, this person or company often uses an intermediary that has access to, knowledge about, or expertise in these financial markets. A bank can be used as the intermediary for the financial markets, but there are other actors whose business is the provision of investment services or activities.1 These “investment firms” are subject to requirements to protect financial markets and the clients and counterparties of these investment firms. As these investment firms play a crucial role in the financial markets, legislators around the world have considered it necessary to also apply a prudential risk treatment of the risks to which these investment firms are exposed in their day-to-day business. This study will focus on the choices made in the European Union as to prudentially regulate investment firms and whether the chosen regime does indeed capture the risks of an investment firm in an appropriate and proportional manner. This is especially relevant now that the European Commission has published a new prudential framework, as part of the Commission priorities for 2019-2024,2 included in the IFR3 and IFD,4 for investment firms which will replace the existing framework included in the CRD 20135 and the CRR6 for most European investment firms in June 2021 when the IFR and the national laws of the European member states implementing the IFD will apply. A theoretical analysis detailing the risks of investment firms and the way these risks can be best addressed within a prudential framework could help in evaluating if the choices made in the legislative process of the IFR and IFD are appropriately and proportionally addressing the risks that may develop within the businesses of investment firms.

2. Before discussing the questions that guided the investigation and the structure of this study, it is useful to briefly discuss what an investment firm is. An in-depth discussion on the specific activities an investment firm can perform on the basis of its authorisation as investment firm in the European Union is included in Chapter 2. Given the lack of a common global definition of what an investment firm is, a precise description of investment firms is difficult, as the activities commonly undertaken by investment firms and the roles they assume in the financial markets can differ between countries. To further add to the difficulties in explaining investment firms, there is no harmonised global term for identifying investment firms. The term ‘investment firm’ is used within the European Union, whereas the International Organisation of Securities Commissions (IOSCO) uses the term ‘securities firm’. Both expressions are used to identify firms that perform investment services such as brokering and execution of client orders, but also dealers, which trade on their own risk and account or for their clients, as well as asset managers, investment advisers and trading platforms. The latter seems to be a particular construction for the supervision of such platforms upheld in the European Union. This study will use the term investment firm, but it should be noted that, when discussing topics with relevance on a global scale, the underlying references will usually use the term securities firm. However, both expressions refer to the same set of regulated firms, albeit with possible differences.