1 MIFIDPRU 2.5 contains additional guidance on how a UK parent entity should apply the requirements in this chapter on a consolidated basis.

1. (1)

   1The initial capital requirement in MIFIDPRU 4.2.1R applies only at the point at which the FCA first grants permission to a MIFIDPRU investment firm to carry on investment services and/or activities. After a firm has been authorised as a MIFIDPRU investment firm, the permanent minimum capital requirement applies on an ongoing basis instead.

2. (2)

   Where a MIFIDPRU investment firm applies to vary its permissions to add new investment services and/or activities that would result in an increase in its permanent minimum capital requirement, the FCA would generally expect to refuse the application unless the firm demonstrates that it can comply with the new permanent minimum capital requirement.

3. (3)

   The FCA’s approach to the application of the initial capital requirement under MIFIDPRU is based on the existence of the permanent minimum capital requirement for MIFIDPRU investment firms. For the avoidance of doubt, this guidance does not affect the FCA’s approach to whether the initial capital requirement under another prudential sourcebook applies on an ongoing basis.

1. (1)

   1Under MAR 5A.3.5R (Proprietary trading), a firm that has permission to operate an organised trading facility may deal on own account in the following ways without requiring separate permissions for dealing on own account:

   1. (a)

      matched principal trading in the course of operating the OTF; or

   2. (b)

      dealing on own account in relation to sovereign debt instruments for which there is no liquid market.

2. (2)

   A firm that is operating an organised trading facility and does not wish to carry on the activities in (1) may apply to the FCA under section 55H of the Act for a limitation that prohibits the firm from carrying on the activities on the basis of that permission.

3. (3)

   The effect of MIFIDPRU 4.4.1R(2)(c) is that if a firm is operating an organised trading facility and is not subject to the limitation described in (2), the firm’s permanent minimum capital requirement is £750,000.

1The relevant permanent minimum capital requirement under this section applies to a collective portfolio management investment firm in parallel with its base own funds requirement under IPRU-INV 11. This means that a collective portfolio management investment firm must comply with both requirements, but they are not cumulative.

1. (1)

   1Where there is a material increase in the firm’s projected relevant expenditure that triggers the obligation in MIFIDPRU 4.5.7R, a firm should also consider the potential impact on its ICARA process and the conclusions documented in its last ICARA document. In particular, the firm should consider any potential impact on:

   1. (a)

      the liquid assets that the firm must hold to comply with MIFIDPRU 6, as the requirements in that chapter are calibrated by reference to the fixed overheads requirement;

   2. (b)

      the level of own funds and liquid assets that the firm must hold to comply with its obligations under MIFIDPRU 7; and

   3. (c)

      the calibration of the firm’s wind-down triggers.

2. (2)

   The review in (1) is particularly important if the firm’s own funds requirement was determined by the fixed overheads requirement immediately before the change occurred.

1. (1)

   1Under MIFIDPRU 4.5.1R, a MIFIDPRU investment firm is required to calculate its fixed overheads requirement based on its relevant expenditure as set out in its annual financial statements for the previous year.

2. (2)

   Under MIFIDPRU 4.5.7R, if there is a material increase in the firm’s projected relevant expenditure for the current year, the firm must recalculate its fixed overheads requirement on the basis of the projected increased relevant expenditure, taking into account the impact of that change.

3. (3)

   However, under MIFIDPRU 4.5.9R, if there is a material change that results in a decrease in the firm’s projected relevant expenditure for the current year, the firm must obtain permission from the FCA before substituting a reduced fixed overheads requirement calculated on the basis of the projected decrease.

4. (4)

   In many cases, a material change of the type specified in MIFIDPRU 4.5.7R(1) or MIFIDPRU 4.5.9R(1) would result from planned changes to the firm’s business. Examples of these changes may include:

   1. (a)

      starting or ceasing a major business line;

   2. (b)

      acquiring or disposing of a major business; or

   3. (c)

      undertaking a significant investment, upgrade or restructuring programme.

   A firm that is planning to implement a material change to its business should calculate the anticipated impact of that change on its fixed overheads requirement (and its broader own funds requirement) before executing the relevant change. This should include considering the potential impact on its ICARA process and its obligations under MIFIDPRU 7.

1. (1)

   1The rules and guidance in MIFIDPRU 4.7 to MIFIDPRU 4.16 explain how a MIFIDPRU investment firm should calculate each component of its overall K-factor requirement.

2. (2)

   The manner in which firms carry on activities that are potentially relevant to one or more K-factor metrics may vary considerably. It is not practical for the FCA to give an exhaustive set of rules and guidance covering every conceivable business arrangement that firms may operate when carrying on such activities.

3. (3)

   If a firm is unsure whether a particular arrangement is within scope of one or more components of the K-factor requirement, the FCA expects the firm to apply a purposive approach to the interpretation of the requirement, as required by GEN 2.2.1R. Among other factors, the FCA would therefore expect the firm to consider:

   1. (a)

      whether the arrangement is sufficiently analogous to another arrangement that is clearly covered by any rules or associated guidance;

   2. (b)

      the risks that the relevant component of the K-factor requirement is designed to address and whether the same or similar risks arise in relation to the arrangement in question; and

   3. (c)

      where the component of the K-factor requirement is calculated by reference to a specific investment service and/or activity, the approach that the firm has adopted to applying other rules or guidance elsewhere in the Handbook to the arrangement, where those rules or guidance refer to the same investment service and/or activity.

4. (4)

   The FCA expects that if asked, a firm will be able to justify the approach that the firm has taken to applying the K-factor requirement to a particular activity.

5. (5)

   MIFIDPRU investment firms are reminded that even if an activity does not contribute towards the K-factor requirement, they should still consider, in accordance with the requirements in MIFIDPRU 7, whether that activity may give rise to potential material risks of harm or may be relevant to the firm’s wind-down analysis.

1The definition of AUM does not include any amounts arising from the firm’s provision of the ancillary service in paragraph 3 of Part 3A of Schedule 2 to the Regulated Activities Order (i.e. providing advice to undertakings on capital structure, industrial strategy and related matters and advice and services relating to mergers and the purchase of undertakings).

1. (1)

   1The effect of MIFIDPRU 4.7.5R(2) is that when measuring the value of AUM at the end of each month, a firm must apply the relevant conversion rate on that date to the AUM attributable to that month. The AUM for each relevant preceding month should continue to be measured by reference to the conversion rate that was applicable at the end of that particular preceding month.

2. (2)

   For purposes of MIFIDPRU 4.7.5R(3), where a firm is carrying out a conversion that involves sterling, the FCA considers that an example of an appropriate market rate is the relevant daily spot exchange rate against sterling published by the Bank of England.

1. (1)

   1MIFIDPRU 4.7.8R and MIFIDPRU 4.7.9R apply where one entity delegates management of assets to another entity. For these purposes, delegation involves a delegating entity (“A”) assuming a duty to the relevant client to manage the assets, and A then delegating the performance of that duty (in whole or in part) to another entity (“B”).

2. (2)

   The following are not delegation for the purposes of MIFIDPRU 4.7.8R or MIFIDPRU 4.7.9R:

   1. (a)

      where A only arranges for B to provide a service directly to a client, so that B owes a duty directly to the client to manage the assets and A does not; or

   2. (b)

      where A advises a client to use B’s management services for the client’s assets, but A does not assume any responsibility to the client for managing the assets.

3. (3)

   MIFIDPRU 4.7.8R states that a MIFIDPRU investment firm cannot reduce its AUM by delegating management of assets to another entity. This is because the firm will normally continue to owe a duty directly to the client, even if performance of that duty has been delegated (wholly or partly) to another entity.

4. (4)

   However, MIFIDPRU 4.7.9R(1) permits a firm to which the management of assets has been formally delegated to exclude the value of the assets when measuring its AUM if the delegating entity is a financial entity. However, if the delegation does not meet the requirements to be a formal delegation, the firm may not exclude the relevant assets from its measurement of AUM. The definition of a financial entity covers:

   1. (a)

      entities that are subject to an AUM-based capital requirement that is similar to the K-AUM requirement;

   2. (b)

      an insurance undertaking that forms part of the same financial conglomerate as the firm if the FCA is the coordinator for that financial conglomerate; and

   3. (c)

      an undertaking that is part of the same investment firm group as the firm, provided that the investment firm group is subject to prudential consolidation under MIFIDPRU 2.5 and both entities are included within the resulting consolidated situation of the UK parent entity of that investment firm group.

5. (5)

   MIFIDPRU 4.7.9R(1) is a limited exclusion that applies where assets under management have been delegated to the firm by a financial entity. This reflects the fact that the financial entity will either have a minimum AUM-based capital requirement or the FCA will have additional supervisory powers to take into account the position of the financial entity because it forms part of the same financial conglomerate or prudential consolidation group as the firm. However, even where a financial entity is included within the same financial conglomerate or investment firm group to which MIFIDPRU 2.5 applies, MIFIDPRU 4.7.9R(1) may be disapplied by MIFIDPRU 4.7.9R(2) for sub-delegation arrangements. This is because extended chains of delegation may involve additional operational risks.

6. (6)

   MIFIDPRU 4.7.9R(2) applies if a firm is managing a portfolio under sub-delegation arrangements. Its effect is illustrated by the following example: Firm A (a third country entity that is a financial entity) formally delegates the management of a portfolio of assets to Firm B (a MIFIDPRU investment firm). Firm B formally sub-delegates the management of part of the portfolio to Firm C (another MIFIDPRU investment firm). Firm B may apply the exclusion in MIFIDPRU 4.7.9R(1), on the basis that Firm A is a financial entity. However, if Firm B applies the MIFIDPRU 4.7.9R(1) exclusion, Firm C cannot also exclude the value of the sub-delegated assets from Firm C’s measurement of AUM. This is because MIFIDPRU 4.7.9R(2) disapplies the MIFIDPRU 4.7.9R(1) exclusion if the delegating entity has already applied a similar exclusion in relation to the same portfolio.

7. (7)

   MIFIDPRU 4.7.9R(2) also applies if the delegating entity is a financial entity in a third country and is applying an equivalent exclusion. For example, Firm D (an entity in a third country) delegates the management of a portfolio to Firm E (a financial entity in a third country). Firm E sub-delegates the management of part of that portfolio to Firm F (a MIFIDPRU investment firm). The third country rules to which Firm E is subject permit Firm E to exclude the value of the assets delegated by Firm D from Firm E’s AUM-based capital requirement. If Firm E is relying on that exclusion, Firm F cannot rely on the exclusion in MIFIDPRU 4.7.9R(1).

1Where a financial entity (“A”) provides investment advice of an ongoing nature to a MIFIDPRU investment firm (“B”) and B undertakes discretionary portfolio management, the arrangement does not fall within MIFIDPRU 4.7.9R. This is because the arrangement is not a formal delegation of the management of assets by A to B, but involves 2 distinct activities: ongoing investment advice provided by A and discretionary portfolio management undertaken by B. In this situation, if A is a MIFIDPRU investment firm, it must include any assets in relation to which it is providing the advice in its measurement of AUM. Where B undertakes discretionary portfolio management in relation to the same assets, B must also include those assets in its own measurement of AUM.

1 MIFIDPRU 4.10.26G to MIFIDPRU 4.10.32G and MIFIDPRU 4 Annex 12G contain additional guidance on the interaction between the measurement of a firm’s AUM and the measurement of a firm’s COH.

1. (1)

   1The definition of investment advice of an ongoing nature includes:

   1. (a)

      the recurring provision of investment advice; or

   2. (b)

      investment advice given in the context of the continuous or periodic assessment and monitoring, or review of a client portfolio of financial instruments, including of the investments undertaken by the client on the basis of a contractual arrangement.

2. (2)

   In either case, the firm must provide investment advice as part of the relevant arrangement. This means that the firm must provide a personal recommendation to the client. Therefore, where a firm merely provides generic advice to a client that does not result in a personal recommendation, the firm does not need to include the value of any assets that are the subject of the generic advice in its measurement of AUM. Firms should refer to the guidance in PERG 13.3 for further information on investment advice, personal recommendations and generic advice.

3. (3)

   For example, a firm may undertake a periodic review of a client’s portfolio to assess whether the balance between investments in equities and fixed income products is appropriate. If the firm advises the client only in general terms to invest a higher proportion of the portfolio in equities and a lower proportion in bonds, this would not normally constitute investment advice, unless the firm also gave advice on investing in specific equities or bonds. Provided that the firm does not give advice relating to specific investments (i.e. a personal recommendation), it therefore would not need to include the value of the portfolio when measuring its AUM.

1. (1)

   1When giving investment advice of an ongoing nature, the assets that the firm must include within its measurement of AUM will depend on the scope of the firm’s obligation to provide investment advice.

2. (2)

   In some circumstances, a firm may have assumed a duty to provide investment advice in relation to the client’s entire portfolio. For example, a financial adviser may agree to carry out periodic reviews of a client’s entire portfolio and to make recommendations to the client about the specific financial instruments in which the client should invest. In that case, the firm must include the entire value of the client’s portfolio (to the extent that the portfolio consists of financial instruments) in the firm’s measurement of AUM. This is because the firm has assumed a duty to provide investment advice of an ongoing nature in relation to the entire portfolio.

3. (3)

   In other situations, the scope of the firm’s duty to provide investment advice may be more limited. For example, a firm may agree with a client that the firm will provide investment advice only on a particular subset of assets or only when specifically requested by the client. In that case, the firm’s duty to provide investment advice of an ongoing nature is limited to the relevant subset of assets, or the specific financial instruments in respect of which the client requests advice. Therefore, the firm would be required to include only the value of those particular assets or financial instruments when measuring its AUM.

4. (4)

   A firm may have assumed different duties in respect of different parts of a client’s portfolio. For example, a firm may have agreed to carry out a general review of whether the client’s portfolio is appropriately balanced in a manner that would constitute only generic advice, rather than a personal recommendation. However, the firm may also be under a duty to provide investment advice on the equities held within the portfolio. In that case, the general review would not constitute investment advice (as it is only generic advice) and therefore the firm does not need to include the entire value of the client’s portfolio in the firm’s measurement of AUM. However, as the firm does have an ongoing duty to provide investment advice in relation to the equities held in the portfolio, the firm must include the value of those assets within its measurement of AUM.

5. (5)

   Where a firm provides recurring investment advice to a client without assuming a continuing duty, the firm is only required to include the value of the particular financial instruments in respect of which it provides investment advice in the firm’s measurement of its AUM.

1. (1)

   1Investment advice of an ongoing nature includes arrangements involving periodic or continuous investment advice and arrangements involving recurring investment advice.

2. (2)

   Periodic or continuous investment advice is most likely to arise where a firm agrees with a client that the firm will keep the client’s portfolio under review or will provide advice to the client at various points during a specified period. For example, a firm may agree to manage a client’s portfolio on a non-discretionary basis so that the firm has an ongoing duty to make personal recommendations to the client, but the client decides whether to proceed with each transaction. Alternatively, the firm may agree with the client to review the client’s portfolio on, for example, a quarterly basis and to provide the client with personal recommendations following each review.

3. (3)

   Recurring investment advice does not require the firm to have assumed an ongoing or periodic duty to provide investment advice to the client. Instead, the firm provides investment advice to the same client repeatedly, even though there is no agreement with the client to establish a formal ongoing relationship. When considering whether investment advice is recurring for these purposes, a firm should assess whether, in substance, the type and pattern of advice that it provides is similar to periodic or continuous advice. This means that a firm cannot prevent what are, in substance, ongoing advisory arrangements for a client from constituting investment advice of an ongoing nature by artificially separating them into multiple individual agreements to provide advice to that client. If requested by the FCA, a firm should be able to justify why the firm has concluded that a particular set of advisory arrangements with a client does not constitute investment advice of an ongoing nature.

4. (4)

   Investment advice of an ongoing nature does not include genuinely isolated or sporadic instances of investment advice provided to the same client that do not, in substance, amount to ongoing arrangements. However, a firm should assess the potential harms arising from any investment advice that is not investment advice of an ongoing nature as part of its ICARA process.

1. (1)

   1Where a firm provides investment advice in the context of the continuous or periodic assessment and monitoring or review of a client portfolio of financial instruments, the value of AUM that the firm includes in respect of that portfolio should be determined by the scope of the firm’s duty to the client.

2. (2)

   If the firm is under a duty to review the client’s entire portfolio and provide investment advice as a result, the value of all financial instruments in the portfolio should be included in AUM. If the firm’s duty is limited to specific financial instruments, only those financial instruments need to be included in AUM.

1The requirement in MIFIDPRU 4.7.18R(2) is illustrated by the following example:

1. (1)

   On 1 March, the firm reviews the client’s entire portfolio of financial instruments and provides investment advice to the client. The value of the client’s portfolio is 100 on that date. The firm is required to carry out its next review of the client’s portfolio on 1 June. The firm would include a value of 100 in its AUM for each of March, April and May.

2. (2)

   On 1 June, the firm reviews the client’s entire portfolio again and provides further investment advice to the client. The value of the client’s portfolio on that date is 110. The firm would include a value of 110 in its AUM for June and each subsequent month until the time of the next review, or until the firm’s duty to carry out a review of the client’s portfolio ends (if earlier).

1. (1)

   1Where a firm provides recurring investment advice to a client, the value of AUM that the firm must include in respect of that client should be measured by the value of the financial instruments that are the subject of the relevant investment advice.

2. (2)

   Under MIFIDPRU 4.7.5R, to calculate its average AUM, a firm must take the 15 most recent monthly values of AUM and exclude the most recent 3 months before calculating the arithmetic mean of the remaining values. MIFIDPRU 4.7.21R explains how a firm should measure the monthly value of AUM when it is providing recurring investment advice to a client.

1. (1)

   1Generally, a MIFIDPRU investment firm should be holding client money in one or more segregated accounts. Under MIFIDPRU 4.8.9E, where a firm complies with the applicable requirements of CASS 7 in relation to an amount of client money, there is a presumption that the client money is being held in a segregated account.

2. (2)

   As a result, the K-CMH requirement for non-segregated accounts is most likely to be relevant where:

   1. (a)

      the K-CMH requirement applies on a consolidated basis and:

      1. (i)

         the consolidated situation includes one or more entities to which CASS does not apply, such as third country entities, that receive money from customers; and

      2. (ii)

         the arrangements under which the entity in (i) holds money received from customers do not meet the conditions in MIFIDPRU 4.8.8R (as they apply on a consolidated basis under MIFIDPRU 2.5.30R); or

   2. (b)

      a MIFIDPRU investment firm has not complied with the CASS 7 requirements, in which case the firm should treat any non-compliant arrangements as non-segregated accounts for the purposes of calculating any K-CMH requirement that includes that period of non-compliance.

3. (3)

   However, the scenario in (2)(b) does not affect any obligation that the firm has under CASS, or under any other rule, to take specified action or to notify the FCA where the firm has identified that it has breached the requirements of CASS.

1As a result of the restrictions in SUP 12.6.5R and SUP 12.6.15R, the FCA generally expects that MIFIDPRU 4.8.3R would not be directly relevant to MIFIDPRU investment firms on an individual basis. However, where this section applies on a consolidated basis in accordance with MIFIDPRU 2.5 (Prudential consolidation), the UK parent entity must include any CMH attributable to a tied agent of a third country investment firm included within the consolidated situation.

1. (1)

   1The definition of CMH includes only client money which is MiFID client money. Therefore, client money which is received in connection with business other than MiFID business does not need to be included within a MIFIDPRU investment firm’s calculation of CMH, except to the extent that MIFIDPRU 4.8.6R applies.

2. (2)

   The definition of MiFID client money includes the following:

   1. (a)

      money deposited into a client bank account in accordance with CASS 7.13.3R;

   2. (b)

      money originally received in connection with MiFID business which a firm has placed in a qualifying money market fund in accordance with CASS 7.13.3R(4). This means that while the units or shares in the relevant qualifying money market fund must still be treated by the firm as client assets for the purposes of CASS and must be dealt with in accordance with CASS 7.13.26R, the value of those units or shares must be included in CMH for the purposes of MIFIDPRU;

   3. (c)

      an amount of the firm’s own money that the firm has paid into its client bank account for the purposes of CASS 7.13.65R where the firm is applying alternative approach mandatory prudent segregation; and

      1. (i)

         prudent segregation;

      2. (ii)

         alternative approach mandatory prudent segregation; or

      3. (iii)

         clearing arrangement mandatory prudent segregation; and

   4. (d)

      money received from a client in connection with MiFID business which a firm has allowed a third party (such as an exchange, a clearing house or an intermediate broker) to hold in accordance with CASS 7.14 (Client money held by a third party).

3. (3)

   Where a firm controls money under a mandate in accordance with CASS 8, the money is not MiFID client money if it is not client money received or held by the firm. A firm is not required to include any money it controls but does not hold within its calculation of CMH.

4. (4)

   Although money that is not MiFID client money does not contribute to the K-CMH requirement, a MIFIDPRU investment firm should still consider any potential material harms that may arise in connection with receiving money from clients as part of their ICARA process under MIFIDPRU 7. This includes any material harms that may arise in relation to amounts received that are not treated as client money, such as under a title transfer collateral arrangement.

1 MIFIDPRU 4.8.6R applies only for the purposes of determining how the client money concerned should be treated for the purposes of MIFIDPRU. It does not affect how the client money should be treated for the purposes of other provisions in the Handbook (such as CASS or COBS) or under any other legislation.

1The effect of MIFIDPRU 4.8.9E is that if a MIFIDPRU investment firm complies with the provisions of CASS specified in MIFIDPRU 4.8.9E(2) for a particular arrangement for client money, it can proceed on the basis that the client money is being held in a segregated account for the purposes of the K-CMH requirement. However, if the firm does not comply with the relevant CASS provisions in relation to a client money arrangement, this will generally be evidence that the relevant client money should be treated as being held in a non-segregated account for the purposes of calculating the K-CMH requirement.

1Where consolidation under MIFIDPRU 2.5 (Prudential consolidation) applies to an investment firm group, MIFIDPRU 2.5.30R and MIFIDPRU 2.5.31R explain how to calculate the consolidated K-CMH requirement.

1. (1)

   1Under MIFIDPRU 4.8.13R(1), a firm must measure its CMH at the end of each business day. The relevant amount should reflect any subsequent adjustment that the firm must apply as a result of any requirement to carry out internal reconciliations in relation to client money (for example, under CASS 7.15). Therefore, where an internal reconciliation subsequently identifies that the amount of CMH recorded for a particular business day is incorrect, the firm should update the relevant amount to reflect the correct figure.

2. (2)

   Where the K-CMH requirement applies on a consolidated basis, the guidance in (1) also applies in relation to any reconciliations carried out in accordance with the requirements of the jurisdiction in which any third country entity included in the consolidated situation is based.

1Due to the limited types of activities in respect of which a tied agent may be exempt from the requirement for authorisation in the UK (as explained in SUP 12.2.7G), the FCA generally expects that MIFIDPRU 4.9.2R would not be directly relevant to a MIFIDPRU investment firm on an individual basis. However, where MIFIDPRU 4.9 applies on a consolidated basis in accordance with MIFIDPRU 2.5 (Prudential consolidation), the UK parent entity must include any ASA attributable to a tied agent of a third country investment firm included within the consolidated situation.

1. (1)

   1The definition of ASA includes only client assets held by a MIFIDPRU investment firm in the course of MiFID business. Therefore, client assets which are held in connection with business other than MiFID business do not need to be included within a MIFIDPRU investment firm’s calculation of ASA, except to the extent that MIFIDPRU 4.9.6R applies.

2. (2)

   As explained in MIFIDPRU 4.8.5G, the definitions of MiFID client money and CMH include amounts that a MIFIDPRU investment firm has placed with qualifying money market funds in accordance with CASS 7.13.3R(4). As a result, although the resulting units or shares in a qualifying money market fund may be treated as client assets for the purposes of the custody rules, under MIFIDPRU 4.9.4R, their value must be included in CMH not in ASA.

3. (3)

   Although client assets that a firm holds other than in the course of MiFID business do not contribute to the K-ASA requirement, a MIFIDPRU investment firm should still consider any potential material harms that may arise in connection with receiving assets from clients as part of its ICARA process under MIFIDPRU 7.

4. (4)

   As part of its ICARA process, a firm should also consider material harms that may arise in relation to amounts received that are not treated as client assets for the purposes of the custody rules but in relation to which the firm may have future obligations to a client, such as under a title transfer collateral arrangement.

1The values used by a firm under MIFIDPRU 4.9.8R should be consistent with the information on client assets in any relevant regulatory data reported by the firm to the FCA, and in any internal or external reconciliations and records maintained in accordance with CASS 6.6 (Records, accounts and reconciliations) unless a rule or relevant guidance requires the firm to take a different approach.

1The effect of MIFIDPRU 4.9.11R is that a firm will not reduce its level of ASA by delegating the safeguarding of assets to a third party. However, a firm will increase the level of its ASA by accepting the delegation of safeguarding and administration of assets to the firm by a third party. This reflects the harm that may result from a breach of the firm’s direct safeguarding responsibilities or the firm’s responsibilities in relation to the selection, appointment and periodic review of any third party to which the firm has delegated safeguarding.

1The definition of COH includes orders that a firm handles when carrying on either of the following types of MiFID business:

1. (1)

   reception and transmission of client orders; and

2. (2)

   execution of orders on behalf of a client.

1 MIFIDPRU 4.10.6G to MIFIDPRU 4.10.17G contain further guidance on whether particular arrangements are included within the measurement of COH.

1Where a firm executes an order in its own name (irrespective of whether the order is ultimately for the benefit of a client), the order is included within the firm’s measurement of its DTF under MIFIDPRU 4.15 (K-DTF requirement) and not within its measurement of COH under this section.

1Recital 44 of MiFID describes transactions that result from a firm bringing together 2 or more investors (such as introducing an issuer to a potential source of funding), but where the firm does not otherwise interpose itself within the chain of execution of any resulting order. In practice, this is most likely to be relevant in the context of corporate finance business or private equity business. A firm may exclude these transactions from its measurement of COH provided that its role does not go beyond this “extended” definition of reception and transmission. This is further described in the guidance in PERG 13.3 (Investment Services and Activities).

1A firm that trades in a matched principal capacity will be placing orders in its own name. These orders must therefore be included in the measurement of the firm’s DTF and are not included in the calculation of COH.

1. (1)

   1The FCA understands that activities that are described as involving “name give-up” may take different forms.

2. (2)

   In certain cases, a firm may distribute indications of interest that indicate a willingness to enter into a transaction, but do not have fixed terms. The firm may then pass the names of the counterparties to each other following a match to allow them to facilitate the trade. These indications of interest and name-passing are not included within the measurement of COH. However, this does not mean that every transaction which begins with an indication of interest is outside the scope of COH. Where a firm is subsequently instructed to transmit an order on firm terms, or to execute an order, that transaction will be within scope of COH, even if the order results from a process that began with an initial indication of interest.

3. (3)

   In some circumstances, a firm may disseminate orders on firm terms that result in a transaction as soon as they are confirmed by the recipient, following which the firm will disclose the name of the relevant counterparty. This activity is included within the measurement of COH because it involves reception and transmission of an order on firm terms.

1. (1)

   1A firm may facilitate trading by its clients on exchanges. Once a transaction has been executed, the relevant trade is then given up to the client’s clearing firm.

2. (2)

   A firm should consider the exact capacity in which it is acting, and whether it incurs any liability as principal, when determining whether orders resulting from exchange give-up activities are included within the measurement of COH.

3. (3)

   If the firm enters into the transaction in its own name and therefore incurs principal liability, even for a short period, in relation to the trade before it is given up, the order should be included within the firm’s measurement of DTF and not within its measurement of COH.

4. (4)

   If the firm does not incur liability as principal and merely acts as agent in the name of a third party in relation to the trade, the order should be included within the firm’s measurement of COH.

1. (1)

   1A firm may be involved in negotiating a bilateral trade in relation to an exchange-traded instrument between counterparties that takes place off-exchange because the size of the trade exceeds certain specified levels. In some cases, the exchange may provide communications functionality to facilitate the block trades, but the trades are not executed on the exchange’s public market.

2. (2)

   A firm must determine the capacity in which the firm is acting in relation to the block trade to determine if the value of the trade should be included in the firm’s measurement of COH.

3. (3)

   If the firm enters into the block trade in its own name and the trade is then given up to a client, the firm should include the value of that trade in its measurement of DTF.

4. (4)

   If the firm executes the block trade as agent by committing the client to the terms of the trade, the firm should include the value of that trade in its measurement of COH.

5. (5)

   If the firm receives firm terms of the block trade from the client and transmits the terms to the counterparty in order for the counterparty to confirm the terms to create a binding transaction, the firm should include the value of that trade in its measurement of COH.

1A firm may be a member of an exchange and may provide functionality whereby trades can be executed and booked directly into the account of the relevant client. In this case, the FCA considers that the trades should be included in the firm’s measurement of COH, as the firm is still being used to execute the relevant trade.

1. (1)

   1A firm which is operating a multilateral trading facility or operating an organised trading facility does not need to include any orders it handles solely in that capacity in its measurement of COH. However, it should consider as part of its ICARA process whether that activity gives rise to the risk of material potential harm which may require it to hold additional own funds or liquid assets under MIFIDPRU 7.

2. (2)

   However, if the operator of an organised trading facility is engaging in matched principal trading, as permitted by MAR 5A.3.5R, any matched principal trades are included in its measurement of DTF under MIFIDPRU 4.15 (K-DTF requirement).

1A firm that executes client orders on a multilateral trading facility or an organised trading facility when the firm is not acting in the capacity of the trading venue operator must include the orders in its measurement of COH (unless the firm executes the orders in its own name, in which case it must include the orders in its measurement of DTF).

1In certain circumstances, the same firm may both act as the operator of a multilateral trading facility or an organised trading facility and also submit an order on that trading venue on behalf of a client. In this case, although the firm is not required to measure COH in relation to its role as the operator of the trading venue, it must still measure COH (or DTF if it is possible to enter into transactions in its own name on the trading venue and it is executing in that capacity) in relation to the order that it executes for the client.

1. (1)

   1The effect of MIFIDPRU 4.10.4R(4) is that where a firm receives a client order but that order is not ultimately executed, it does not have to include the value of that order in its measurement of COH. However, as part of its ICARA process, a firm should consider whether the fact that an order has not been executed gives rise to any material risks to the firm or to its clients. This may depend on the reasons why the client order has not been executed.

2. (2)

   If, for example, the order was not executed because market conditions did not allow the firm (or another entity to whom the order was ultimately transmitted) to achieve an appropriate outcome for the client, this may be consistent with the firm’s contractual and regulatory duties. In that case, this may not give rise to any additional material risks.

3. (3)

   However, if the firm failed to transmit or execute an order because of an oversight or an internal systems failure, this may indicate that the firm has been failing in its duties to its client or in its regulatory obligations. Alternatively, the firm may have successfully transmitted an order, but failed to select an appropriate entity to receive and execute the order, and therefore may have failed to comply with its obligations to act in the best interests of the client when transmitting the order. In this case, the firm should consider as part of its ICARA process whether the failures may give rise to material risks and how these risks should be addressed.

1. (1)

   1Although failure to achieve the execution of an individual order does not necessarily indicate potential material harms, a series or pattern of failures may be evidence of potential material harms.

2. (2)

   A firm’s analysis under its ICARA process is separate from the application of any individual regulatory or other legal duties owed to an individual client. Therefore, while a firm may conclude that an isolated oversight in relation to a client order does not give rise to the risk of material harm under the ICARA process, this does not affect any obligations that the firm owes to the client.

1. (1)

   1Under the general approach in MIFIDPRU 4.10.20R(2), a firm determines the gross value of an order by multiplying the market price of the instrument by the quantity of the instrument being purchased or sold.

2. (2)

   However, MIFIDPRU 4.10.20R(5) permits (but does not require) a firm to calculate the value of an order by reference to the consideration paid or received by the client for the instruments (i.e. net of transaction costs), provided that the transaction costs are included in the gross value of the order and are not paid by the client to the firm separately.

3. (3)

   For example, Firm A executes an order for a client to buy 100 shares. The total cost of the order, including transaction costs, is £100. The client receives shares worth £88, after the firm uses £12 to cover transaction costs. Under the standard approach in MIFIDPRU 4.10.20R(2), the firm may record the value of the order in its COH as £100 (i.e. the gross cost of the order). The firm may, for example, choose this approach for reasons of simplicity and administrative convenience.

4. (4)

   Alternatively, in the example above, the firm may apply the approach under MIFIDPRU 4.10.20R(5) to record the value of the order in its COH as £88 (i.e. net of transaction costs paid by the client in relation to the transaction).

5. (5)

   However, a firm cannot rely on MIFIDPRU 4.10.20R(5) to reduce the value of an order by transaction costs that are paid separately by the client to the firm. For example, Firm B executes an order for a client to buy 100 shares. The total cost of the order is £100. The client additionally pays £12 to Firm B for transaction costs. In this case, the firm must record the net value of the order under MIFIDPRU 4.10.20R(5) in its COH as £100 (and not £88), as the transaction costs have been paid separately.

6. (6)

   The effect of MIFIDPRU 4.10.19R(2) is that when measuring the value of COH at the end of each business day, a firm must apply the relevant conversion rate on that date to any amounts in foreign currencies forming part of the COH attributable to that business day. The COH for each preceding business day should continue to be measured by reference to the conversation rate that was applicable on that preceding day.

7. (7)

   For the purposes of MIFIDPRU 4.10.19R(3), where a firm is carrying out a conversion that involves sterling, the FCA considers that an example of an appropriate market rate is the relevant daily spot exchange rate against sterling published by the Bank of England.

1For cash trades relating to exchange-traded options, the amount paid or received under MIFIDPRU 4.10.20R(2) is the premium paid for the option.

1. (1)

   1The effect of MIFIDPRU 4.10.23R is to permit a firm that receives and transmits orders that are cash trades to determine the COH attributable to the orders using an alternative approach. A firm may either:

   1. (a)

      apply the standard approach in MIFIDPRU 4.10.20R(2) and use the price at which the relevant order was ultimately executed, once this has been confirmed by the entity that executes the order; or

   2. (b)

      apply the alternative approach in MIFIDPRU 4.10.23R and use a deemed price that is determined by reference to the limit price of the order or, if there is no limit price, the end-of-day market price at the time at which the order is transmitted.

2. (2)

   However, a firm must not use the alternative approach in MIFIDPRU 4.10.23R for regulatory arbitrage to reduce its K-COH requirement. To prevent this, a firm may only apply the alternative approach either:

   1. (a)

      in relation to all cash trades that the firm receives and transmits; or

   2. (b)

      in relation to cash trades that the firm receives and transmits where the firm does not receive timely information from the broker about the terms on which the order was executed. In this case, the firm must apply the standard approach in MIFIDPRU 4.10.20R(2) in relation to all other cash trades. This is designed to ensure that the firm can record daily information for COH in circumstances where information about the ultimate execution of the order is otherwise missing or significantly delayed.

1 MIFIDPRU 4.10.27G to MIFIDPRU 4.10.32G and MIFIDPRU 4 Annex 12G explain the circumstances in which a firm must include orders that arise in connection with portfolio management or investment advice in, or may exclude orders from, its measurement of COH.

1. (1)

   1The basic definition of COH includes:

   1. (a)

      orders that the firm executes when providing execution services for a client; and

   2. (b)

      orders that the firm has received from a client and transmitted to another entity for execution.

2. (2)

   The rules and guidance in MIFIDPRU 4.10.28R to 4.10.32G explain how this definition applies in particular scenarios and certain exclusions or modifications that may apply.

1The exclusions in MIFIDPRU 4.7.9R, MIFIDPRU 4.10.28R and MIFIDPRU 4.10.29R(3) may result in a firm that carries on delegated portfolio management having no K-AUM requirement or K-COH requirement in relation to all or part of a delegated portfolio. Where one or more exclusions apply, a firm should still assess as part of its ICARA process whether the activity of providing delegated portfolio management may give rise to potential material harms that may need to be covered by additional financial resources. Firms should refer to the rules and guidance in MIFIDPRU 7 for additional information on the ICARA process.

1. (1)

   1MIFIDPRU 4.10.29R does not apply where a financial entity (“A”) carries on portfolio management in relation to a portfolio and a MIFIDPRU investment firm (“B”) provides investment advice of an ongoing nature to A in relation to that portfolio. In this situation, A has not delegated portfolio management to B. Instead, A provides the service of portfolio management to A’s client, and B provides the separate service of investment advice to A. If A is a MIFIDPRU investment firm, A will include the value of the relevant portfolio when calculating its K-AUM requirement. B will calculate its own K-AUM requirement in relation to the same portfolio.

2. (2)

   Although MIFIDPRU 4.10.29R does not apply in this scenario, B may benefit from the separate exclusion in MIFIDPRU 4.10.28R(2) and therefore would not be required to include any orders that result from its ongoing investment advice within B’s calculation of COH, because B will calculate a K-AUM requirement in relation to the relevant portfolio.

1When measuring COH for the purposes of MIFIDPRU 4.10.19R, a firm must include:

1. (1)

   an order that the firm executes, or receives and transmits, as a result of providing investment advice (other than investment advice of an ongoing nature, if the firm calculates a K-AUM requirement in relation to the advice) to a client and subsequently receiving instructions from the client to transmit or execute the relevant order; and

2. (2)

   an order that a firm receives from another firm (“X”), where:

   1. (a)

      X provides investment advice (including investment advice of an ongoing nature) to a client;

   2. (b)

      as a result of the advice in (a), the client instructs X to place an order with the firm; and

   3. (c)

      the firm executes or receives and transmits the order received from X.

1References to trading book positions in MIFIDPRU include all trading book positions of the firm, including positions in:

1. (1)

   equity instruments;

2. (2)

   debt instruments (including securitisation instruments);

3. (3)

   collective investment undertakings;

4. (4)

   foreign exchange;

5. (5)

   gold; and

6. (6)

   commodities and emissions allowances.

1. (1)

   1For the purposes of the definition of a position held with trading intent in relation to the trading book, positions arising from client servicing include those arising out of contracts in relation to which a firm is acting as principal (even in the context of activity described as ‘broking’ or ‘customer business’). This applies even if the nature of the business means that the only risks incurred by the firm are counterparty risks (i.e. no market risk charges apply).

2. (2)

   If the nature of the business means that the only risks incurred by the firm are counterparty risks, the position will generally still be a position held with trading intent.

3. (3)

   The FCA understands that business carried out under International Uniform Brokerage Execution (“Give-Up”) Agreements involve back to back trades as principal. If so, positions arising out of business carried out under such agreements should be allocated to a firm’s trading book.

1A MIFIDPRU investment firm that deals on own account is also subject to the K-CON requirement in accordance with MIFIDPRU 5.

1A MIFIDPRU investment firm that has permission to operate an organised trading facility may rely on that permission to:

1. (1)

   carry out matched principal trading in certain types of financial instruments with client consent, in accordance with MAR 5A.3.5R(1); and

2. (2)

   deal on own account in illiquid sovereign debt instruments in accordance with MAR 5A.3.5R(2).

In either case, the firm will be dealing on own account and is therefore subject to the requirements in MIFIDPRU 4.11.4R and MIFIDPRU 4.11.5R to the extent relevant to the transactions it undertakes. MIFIDPRU 5 explains how the K-CON requirement applies to such firms.

1. (1)

   2Certain market risk provisions in the UK CRR (in the form in which it stood on 31 December 2021) require a firm to consider the underlying credit risk attaching to a position under the UK CRR Standardised Approach to credit risk. In certain cases, the credit risk rules require a firm to determine the risk attaching to the position by reference to “credit quality steps”, which are mapped to credit ratings issued by particular credit rating agencies. As the credit risk requirements in the UK CRR are no longer directly relevant under MIFIDPRU, the FCA will no longer be maintaining an FCA version of the ECAI credit quality step mappings in BTS 2016/1799 for these purposes.

2. (2)

   The effect of MIFIDPRU 4.12.2BR is that where a firm needs to determine the underlying credit risk of a position for the purposes of the K-NPR requirement by reference to credit quality steps, the firm should use the updated ECAI mappings maintained by the PRA for the purposes of the Standardised Approach to credit risk as it applies to CRR firms under the PRA Rulebook.

1 MIFIDPRU 4.12.8R to MIFIDPRU 4.12.65G contain rules and guidance setting out requirements for internal models and explaining the factors that the FCA will consider when deciding whether to grant permission to use an internal model.

1. (1)

   1The methodology for identifying the risks in MIFIDPRU 4.12.8R and calculating additional own funds for VaR and sVaR models is called the “Risks not in VaR (RNIV) framework”. A firm is responsible for identifying these additional risks and this should be an opportunity for risk managers and the firm’s management to better understand the shortcomings of the firm’s models. Following this initial assessment, the FCA will engage with the firm to provide challenge and ensure an appropriate outcome.

2. (2)

   The RNIV framework is intended to ensure that own funds are held to meet all risks that are not captured, or not captured adequately, by the firm’s VaR and sVaR models. These include, but are not limited to, missing and/or illiquid risk factors such as cross-risks, basis risks, higher-order risks, and calibration parameters. The RNIV framework is also intended to cover event risks that could adversely affect the relevant business.

3. (3)

   A firm should systematically identify and measure all risks that are not captured, or not captured adequately. This analysis should be carried out at least quarterly, but the FCA may request more frequent analysis. The measurement of these risks should capture the losses that could arise due to the risk factor(s) of all products that are within the scope of the permission for the relevant internal model, but are not adequately captured by the relevant internal model.

4. (4)

   On a quarterly basis, the firm should identify and assess individual risk factors covered by the RNIV framework. The FCA will review the results of this exercise and may require that firms identify additional risk factors as being eligible for measurement.

5. (5)
   1. (a)

      Where sufficient data is available, and where it is appropriate to do so, the FCA expects a firm to calculate a VaR and sVaR metric for each risk factor within scope of the framework. The stressed period for the RNIV framework should be consistent with that used for sVaR. No offsetting or diversification may be recognised across risk factors included in the RNIV framework. The multipliers used for VaR and sVaR should be applied to generate a K-NPR requirement.

   2. (b)

      If it is not appropriate to calculate a VaR and sVaR metric for a risk factor, a firm should instead measure the size of the risk based on a stress test. The confidence level and capital horizon of the stress test should be commensurate with the liquidity of the risk, and should be at least as conservative as comparable risk factors under the internal model approach. The capital charge should be at least equal to the losses arising from the stress test.

1If a MIFIDPRU investment firm has notified the FCA under MIFIDPRU 4.12.10R that a model meets the minimum standards for a particular option type, but is subsequently unable to demonstrate to the FCA that the model meets those minimum standards, the FCA may apply a capital add-on and agree a risk mitigation plan. If a firm does not comply with the risk mitigation plan within the mandated timeframe, the FCA may take further supervisory measures. This may include variation of a firm’s Part 4A permission so that the firm is no longer allowed to trade the relevant option types.

1The sophistication of a pricing model used to calculate own estimates of delta for use in the standardised approach for options should be proportionate to the complexity and risk of each option and the overall risk of the firm’s options trading business. In general, the FCA considers that the risk of sold options will be higher than the risk of the same options when bought.

1Delta should be recalculated at least daily. A firm should also recalculate delta promptly if there are significant movements in the market parameters used as inputs to calculate delta.

1The pricing model used to calculate delta should be:

1. (1)

   based on appropriate assumptions that have been assessed and challenged by suitably qualified parties independent of the development process;

2. (2)

   independently tested, including validation of the mathematics, assumptions and software implementation; and

3. (3)

   developed or approved independently of the trading desk.

1A firm should use generally accepted industry standard pricing models for the calculation of own deltas where these are available, such as for relatively simple options.

1The IT systems used to calculate delta should be sufficient to ensure delta is calculated accurately and reliably.

1A firm should have adequate systems and controls in place when using a pricing model to calculate delta. This should include the following documented policies and procedures:

1. (1)

   clearly defined responsibilities of the various areas involved in the calculation;

2. (2)

   frequency of independent testing of the accuracy of the model used to calculate delta; and

3. (3)

   guidelines for the use of unobservable inputs, where relevant.

1A firm should ensure its risk management functions are aware of weaknesses of the model used to calculate a delta. Where a firm identifies weaknesses, it should ensure that estimates of delta result in a prudent contribution to the K-NPR requirement. The outcome should be prudent across the whole portfolio of options and underlying positions at all times.

1For the purposes of article 327(2) of the UK CRR, the convertible should be:

1. (1)

   treated as a position in the equity into which it converts; and

2. (2)

   the component of the firm’s K-NPR requirement attributable to the general and specific risk in its equity instruments should be adjusted by making:

   1. (a)

      an addition equal to the current value of any loss that the firm would make if it did convert to equity; or

   2. (b)

      a deduction equal to the current value of any profit that the firm would make if it did convert to equity (subject to a maximum deduction equal to the K-NPR requirement that would be attributable to the notional position underlying the convertible).

1Article 331(2) of the UK CRR (Interest rate risk in derivative instruments) sets out conditions that must be met before a firm not using interest rate pre-processing models can fully offset interest rate risk on derivative instruments. One of the conditions is that the reference rate (for floating-rate positions) or coupon (for fixed-rate positions) should be ‘closely matched’. The FCA will normally consider a difference of less than 15 basis points as indicative of the reference rate or coupon being ‘closely matched’ for the purposes of this requirement. A firm that wishes to use sensitivity models to calculate interest rate risk on derivative instruments in accordance with article 331(1) of the UK CRR should refer to MIFIDPRU 4.12.66R.

1. (1)

   1The FCA’s starting assumption is that all overshootings should be taken into account to calculate addends. If a firm believes that an overshooting should not count for that purpose, it should seek a variation of its VaR model permission from the FCA in accordance with MIFIDPRU 4.12.4R to exclude the overshooting.

2. (2)

   An example of when a firm’s overshooting might properly be disregarded is when it has arisen as a result of a risk that is not captured in a firm’s VaR model but against which own funds are already held.

1 MIFIDPRU 4.12.24G to MIFIDPRU 4.12.38G set out guidance for the derivation of notional positions for standardised approaches to market risk under the UK CRR.

1Futures or forwards on a basket or index of debt securities should be converted into forwards on single debt securities as follows:

1. (1)

   futures or forwards on a single currency basket or index of debt securities should be treated as either:

   1. (a)

      a series of forwards, one for each of the constituent debt securities in the basket or index, of an amount that is a proportionate part of the total underlying the contract, according to the weighting of the relevant debt security in the basket; or

   2. (b)

      a single forward on a notional debt security; and

2. (2)

   futures or forwards on multiple currency baskets or indices of debt securities should be treated as either:

   1. (a)

      a series of forwards (using the method in (1)(a)); or

   2. (b)

      a series of forwards, each one on a notional debt security to represent one of the currencies in the basket or index, of an amount that is a proportionate part of the total underlying the contract according to the weighting of the relevant currency in the basket.

1Notional debt securities derived through this treatment should be assigned a specific risk position risk adjustment and a general market risk position risk adjustment equal to the highest that would apply to the debt securities in the basket or index.

1The debt security with the highest specific risk position risk adjustment within the basket might not be the same as the one with the highest general market risk position risk adjustment. A firm should select the highest percentages, even if they relate to different debt securities in the basket or index, and regardless of the proportion of those debt securities in the basket or index.

1Where a debt security pays coupons in one currency but will be redeemed in a different currency, it should be treated as:

1. (1)

   a debt security denominated in the coupon’s currency; and

2. (2)

   a foreign currency forward to capture the fact that the debt security’s principal will be repaid in a different currency from that in which it pays coupons, specifically:

   1. (a)

      a notional forward sale of the coupon currency and purchase of the redemption currency, in the case of a long position in the debt security; or

   2. (b)

      a notional forward purchase of the coupon currency and sale of the redemption currency, in the case of a short position in the debt security.

1Other futures, forwards, and swaps for which a treatment is not specified in article 328 of the UK CRR (Interest rate futures and forwards) should be treated as positions in zero specific risk securities, each of which:

1. (1)

   has a zero coupon;

2. (2)

   has a maturity equal to that of the relevant contract; and

3. (3)

   is long or short, as set out in the table in MIFIDPRU 4.12.29G.

1Interest rate swaps or foreign currency swaps with a deferred start should be treated as two notional positions (one long, one short). The paying leg should be treated as a short position in a zero specific risk security with a coupon equal to the fixed rate of the swap. The receiving leg should be treated as a long position in a zero specific risk security that also has a coupon equal to the fixed rate of the swap.

1The maturities of the notional positions in MIFIDPRU 4.12.30G are set out in the table in MIFIDPRU 4.12.32G.

1For interest rate risk, a firm should treat a swap (such as an equity swap) with only one interest rate leg as a notional position in a zero specific risk security:

1. (1)

   with a coupon equal to that on the interest rate leg;

2. (2)

   with a maturity equal to the date that the interest rate will be reset; and

3. (3)

   that is a long position if the firm is receiving interest payments and is a short position if making interest payments.

1. (1)

   1A firm should treat a foreign currency forward, future or contract for differences as two notional currency positions as follows:

   1. (a)

      a long notional position in the currency that the firm has contracted to buy; and

   2. (b)

      a short notional position in the currency that the firm has contracted to sell.

2. (2)

   In (1), the notional positions should have a value equal to either:

   1. (a)

      the contracted amount of each currency to be exchanged in a forward, future or contract for differences held outside the trading book; or

   2. (b)

      the present value of the amount of each currency to be exchanged in a forward, future or contract for differences held in the trading book.

1. (1)

   1A firm should treat a foreign currency swap as:

   1. (a)

      a long notional position in the currency in which the firm has contracted to receive interest and principal; and

   2. (b)

      a short notional position in the currency in which the firm has contracted to pay interest and principal.

2. (2)

   In (1), the notional positions should have a value equal to either:

   1. (a)

      the nominal amount of each currency underlying the swap if it is held outside the trading book; or

   2. (b)

      the present value amount of all cash flows in the relevant currency in the case of a swap held in the trading book.

1Where a forward, future or contract for differences settles according to:

1. (1)

   the difference between the price set on trade date and the price prevailing at contract expiry, the notional position should:

   1. (a)

      equal the total quantity underlying the contract; and

   2. (b)

      have a maturity equal to the expiry date of the contract;

2. (2)

   the difference between the price set on trade date and the average of prices prevailing over a certain period up to contract expiry, a notional position should be derived for each of the reference dates used in the averaging period to calculate the average price, which:

   1. (a)

      equals a fractional share of the total quantity underlying the contract; and

   2. (b)

      has a maturity equal to the relevant reference date.

1Commitments to buy or sell at the average spot price of the commodity prevailing over some period between trade date and maturity should be treated as a combination of:

1. (1)

   a position equal to the full amount underlying the contract with a maturity equal to the maturity date of the contract, which should be:

   1. (a)

      long, where the firm will buy at the average price; or

   2. (b)

      short, where the firm will sell at the average price; and

2. (2)

   a series of notional positions, one for each of the reference dates where the contract price remains unfixed, each of which should:

   1. (a)

      be long if the position under (1) is short, or short if the position under (1) is long;

   2. (b)

      be equal to a fractional share of the total quantity underlying the contract; and

   3. (c)

      have a maturity date of the relevant reference date.

1The forward cash leg of a repurchase agreement or reverse repurchase agreement should be treated as a notional position in a zero specific risk security that:

1. (1)

   is a short notional position in the case of a repurchase agreement and a long notional position in the case of a reverse repurchase agreement;

2. (2)

   has a value equal to the market value of the borrowing or deposit;

3. (3)

   has a maturity equal to that of the borrowing or deposit, or the next date the interest rate is reset (if earlier); and

4. (4)

   has a coupon equal to:

   1. (a)

      zero, if the next interest payment date coincides with the maturity date; or

   2. (b)

      the interest rate on the borrowing or deposit, if any interest is due to be paid before the maturity date.

1 MIFIDPRU 4.12.40G to MIFIDPRU 4.12.65G describe some of the standards that the FCA expects to be met when it is considering an application under MIFIDPRU 4.12.4R to use an internal model.

1A firm should be able to demonstrate that it meets the risk management standards in article 368 of the UK CRR (Qualitative requirements) on a legal entity and business-line basis where appropriate. This is particularly important for a subsidiary in a group subject to matrix management where the business lines cut across legal entity boundaries.

1A VaR model permission generally sets out the broad classes of position within each risk category in its scope. It may also specify how individual products within one of the classes may be brought into or taken out of the scope of the VaR model permission. The broad classes of permission are:

1. (1)

   linear products, which comprise securities with linear pay-offs (such as bonds and equities) and derivative products which have linear pay-offs in the underlying risk factor (such as interest rate swaps, FRAs, and total return swaps);

2. (2)

   European, American and Bermudan put and call options (including caps, floors, and swaptions) and investments with these features;

3. (3)

   Asian options, digital options, single barrier options, double barrier options, look-back options, forward-starting options, compound options and investments with these features; and

4. (4)

   all other option-based products (such as basket options, quantos, outperformance options, timing options, and correlation-based products) and investments with these features.

1A firm should ensure that the data series used by its VaR model is reliable. Where a reliable data series is not available, the firm may use proxies or any other reasonable value-at-risk measurement if the model meets the requirements in article 367(2)(e) of the UK CRR (Requirements on risk measurement). The technique must be appropriate and must not materially understate the modelled risks.

1Data may be insufficient if, for example, it contains missing data points or data points that contain stale data. For less liquid risk factors or positions, the FCA expects the firm to make a conservative assessment of those risks, using a combination of prudent valuation techniques and alternative VaR estimation techniques to ensure there is a sufficient cushion against risk over the close-out period, which takes account of the illiquidity of the risk factor or position.

1A firm is expected to update data sets to maintain standards of reliability in accordance with the frequency set out in its VaR model permission, or more frequently if necessary due to volatility in market prices or rates. This is in order to ensure a prudent calculation of the VaR measure.

1. (1)

   1In determining whether it is appropriate for a firm to use empirical correlations within risk categories and across risk categories within a model, the FCA will consider whether such an approach is sound and implemented with integrity. In general, the FCA expects a firm to determine the aggregate VaR measure by adding the relevant VaR measure for each category, unless the firm’s permission provides for a different method of aggregating VaR measures that is empirically sound.

2. (2)

   The FCA does not expect a firm to use the square root of the sum of the squares approach when aggregating measures across risk categories unless the assumption of zero correlation between these categories is empirically justified. If correlations between risk categories are not empirically justified, the VaR measures for each category should simply be added to determine its aggregate VaR measure. However, to the extent that a firm’s VaR model permission provides for a different way of aggregating VaR measures:

   1. (a)

      that method applies instead; and

   2. (b)

      if the correlations between risk categories used for that purpose cease to be empirically justified then the firm is expected to notify the FCA immediately.

1A firm should demonstrate its ability to comply with the requirements for a VaR model permission. In general, a firm should have a back-testing programme in place and should provide 3 months of back-testing history.

1A firm should carry out a period of initial monitoring or live testing before the FCA will recognise a VaR model. This will be agreed on a firm-by-firm basis.

1The FCA will take into account the results of internal model validation procedures used by the firm to assess the VaR model when assessing the firm’s VaR model and risk management.

1 MIFIDPRU 4.12.50G to MIFIDPRU 4.12.53G provide further guidance on how a firm should comply with the requirements in article 366 of the UK CRR (Regulatory back testing and multiplication factors).

1If the day on which a loss is made is day n, the value-at-risk measure for that day will be calculated on day n-1, or overnight between day n-1 and day n. Profit and loss figures are produced on day n+1, and back-testing also takes place on day n+1. The firm’s supervisor should be notified of any overshootings by close of business on day n+2.

1Any overshooting initially counts for the purpose of the calculation of the plus factor, even if subsequently the FCA agrees to exclude it. Therefore, where the firm experiences an overshooting and already has 4 or more overshootings during the previous 250 business days, changes to the multiplication factor resulting from changes to the plus factor become effective at day n+3.

1A longer time period generally improves the power of back-testing. However, a longer time period may not be desirable if the VaR model or market conditions have changed to the extent that historical data is no longer relevant.

1The FCA will review a firm’s processes and documentation relating to the derivation of profit and loss used for back-testing when assessing a VaR model permission application under MIFIDPRU 4.12.4R. A firm’s documentation should clearly set out the basis for cleaning profit and loss. To the extent that certain profit and loss elements are not updated every day (for example, certain reserve calculations), the documentation should clearly set out how such elements are included in the profit and loss series.

1Under MIFIDPRU 4.12.6R, a firm must provide the FCA with details of any significant planned changes to the VaR model before those changes are implemented. This must include detailed information about the nature of the change, including an estimate of the impact on VaR numbers and the incremental risk charge. Material changes to internal models or material extensions to the use of internal models will require prior approval from the FCA.

1The use of overlapping intervals of 10-day holding periods for article 365 of the UK CRR (VaR and sVaR calculation) introduces an autocorrelation into the data that would not exist should truly independent 10-day periods be used. This may give rise to an under-estimation of the volatility and the VaR at the 99% confidence level. To obtain clarity on the materiality of the bias, a firm should measure the bias arising from the use of overlapping intervals for 10-day VaR and sVaR when compared to using independent intervals. A report on the analysis, including a proposal for a multiplier on VaR and sVaR to adjust for the bias, should be submitted to the FCA for review and approval.

1Under article 365 of the UK CRR (VaR and sVaR calculation), a firm that uses an internal model for calculating its K-NPR requirement must calculate, at least weekly, a sVaR of their current portfolio. The FCA would expect a sVaR internal model to contain the features in MIFIDPRU 4.12.57G to MIFIDPRU 4.12.60G before the FCA will grant permission to use the relevant model.

1A firm should calculate the sVaR measure to be greater than or equal to the average of the second and third worst loss in a 12-month time series comprising of 250 observations. The FCA expects, as a minimum, that a corresponding linear weighting scheme should be applied if the firm uses a larger number of observations.

1A firm should ensure that the sVaR period chosen is equivalent to the period that would maximise VaR, given the firm’s portfolio. A stressed period should be identified at each legal entity level at which capital is reported. Therefore, group level sVaR measures should be based on a period that maximises the group level VaR, whereas entity level sVaR should be based on a period that maximises VaR for that entity.

1The firm should consider whether the use of antithetic data in the calculation of the sVaR measure is appropriate to the firm’s portfolio. The firm should provide a justification to the FCA for using or not using antithetic data as part of an application to use an internal model.

1In its application to use an internal model, the firm should explain the reasons for the choice of absolute or relative shifts for both VaR and sVaR methodologies. In particular, the firm should evidence the statistical processes driving the risk factor changes for both VaR and sVaR.

1Under article 372 of the UK CRR (Requirement to have an internal IRC model), a firm that uses an internal model for calculating own funds requirements for specific risk of traded debt instruments must also have an internal incremental default and migration risk (IRC) model in place to capture the default and migration risk of its trading book positions that are incremental to the risks captured by its VaR model. When the FCA considers a firm’s application for permission to use an IRC internal model under MIFIDPRU 4.12.4R, it expects that the matters in MIFIDPRU 4.12.63G to MIFIDPRU 4.12.65G will be included to demonstrate compliance with the standards in article 372.

1The FCA expects the IRC model to capitalise pre-default basis risk. In this respect, the model should reflect that in periods of stress the basis could widen substantially. The firm should disclose to the FCA its material basis risks that are incremental to those already captured in existing market risk capital measures (VaR-based and others). This must take into account actual close-out periods during periods of illiquidity.

1The price/spread change model used to capture the profit and loss impact of migration should calibrate spread changes to long-term averages of differences between spreads for relevant ratings. These should either be conditioned on actual rating events, or use the entire history of spreads regardless of migration. Point-in-time estimates are not acceptable, unless the firm can demonstrate that they are as conservative as long-term averages.

1To achieve a soundness standard comparable to those under the Internal Ratings Based (IRB) approach, loss given default (LGD) estimates should reflect the economic cycle. Therefore, the FCA expects a firm to incorporate dependence of the recovery rate on the economic cycle into the IRC model. If the firm uses a conservative parameterisation to comply with the IRB standard of the use of downturn estimates, the firm should submit evidence of this in its quarterly reporting to the FCA. A firm should note that for trading portfolios that contain long and short positions, downturn estimates will not be a conservative choice in all cases.

1 MIFIDPRU 4.13.1R(2) is intended to cover the risks arising from proprietary trades that form part of a portfolio for which a firm has a K-CMG permission. Where trades have settled, the resulting proprietary position of the firm may no longer be included within the margin requirement calculated by the clearing member or authorised central counterparty for that portfolio and therefore would not contribute to the firm’s K-CMG requirement. The firm should therefore include these positions within its calculation of the K-NPR requirement to take account of the resulting market risk. For these purposes, a firm is not required to apply this approach to a position that results from client servicing.

1In an application for a K-CMG permission, a firm must identify each portfolio for which it wishes to calculate a K-CMG requirement.

1 MIFIDPRU 4.13.6R requires a MIFIDPRU investment firm to determine the amount of margin that is required under the relevant margin model of each clearing member (or, for a self-clearing firm, of each authorised central counterparty) for portfolios in respect of which the firm has been granted a K-CMG permission. For these purposes, the clearing member’s (or, where applicable, authorised central counterparty’s) margin model must satisfy the criteria in MIFIDPRU 4.13.14R. The effect of MIFIDPRU 4.13.6R is that if, notwithstanding the requirement under the margin model, the MIFIDPRU investment firm agrees with the clearing member or authorised central counterparty to provide a different amount of margin, it is the amount required under the model that must be used for the purposes of calculating the firm’s K-CMG requirement and not the amount of margin that is actually provided by the firm. This ensures that the firm’s K-CMG requirement is not artificially reduced by commercial negotiations that may result in the clearing member or authorised central counterparty accepting a lower amount of margin than the model requires.

1The calculation in MIFIDPRU 4.13.5R means that for each trading day during the calculation period, the firm must calculate the total combined margin in accordance with MIFIDPRU 4.13.6R provided to all clearing members in aggregate in respect of the relevant portfolios. The K-CMG requirement is then calculated on the basis of the third highest daily aggregate amount.

1The FCA may revoke a K-CMG permission for a portfolio where one or more of the conditions in MIFIDPRU 4.13.9R is no longer met in relation to that portfolio. The FCA may review the appropriateness of any K-CMG permissions as part of any SREP it undertakes in relation to the firm in accordance with MIFIDPRU 7.

1. (1)

   1MIFIDPRU 4.13.14R(2) permits the output of a margin model of a clearing member or authorised central counterparty to be adjusted to meet the criteria in MIFIDPRU 4.13.14R(1)(a). The adjustment is used solely to determine the K-CMG requirement of a firm. It does not affect the actual amount of margin that the clearing member or authorised central counterparty will receive from the firm, which will continue to be determined by the underlying (unadjusted) model.

2. (2)

   For example, the clearing member’s or authorised central counterparty’s original margin model may produce margin requirements that are sufficient to cover losses that may result from at least 95% of the exposures movements over a two-business day holding period. This would not meet the minimum criteria in MIFIDPRU 4.13.14R(1)(a). To determine the firm’s K-CMG requirement, the output of that model may be adjusted to produce a requirement that would cover losses that may result from at least 99% of the exposures movements over that same holding period. If the conditions in MIFIDPRU 4.13.14R(3) and (4) are satisfied, the minimum criteria in MIFIDPRU 4.13.14R(1)(a) will be deemed to be met when the adjustment is applied. This is the case even though the actual margin received by the clearing member or authorised central counterparty is determined by the underlying (unadjusted) model.

1Where the margin model of a clearing member uses parameters that are more conservative than the minimum criteria in MIFIDPRU 4.13.14R(1), the output of the model may be adjusted downwards under MIFIDPRU 4.13.14R(2) to produce margin requirements that are consistent with the minimum criteria. The requirements in MIFIDPRU 4.13.14R(3) and (4) still apply to a downwards adjustment. A firm is not required to apply a downwards adjustment to a more conservative model.

1The FCA will consider whether the firm’s reasons for choosing a K-CMG requirement under MIFIDPRU 4.13.9R(2)(f) have taken adequate account of the nature of, and risks arising from, the firm’s trading activities, including whether:

1. (1)

   the main activities of the firm are essentially trading activities that are subject to clearing and margining under the responsibility of a clearing member; and

2. (2)

   other activities performed by the firm are immaterial in comparison to those main activities.

1. (1)

   1For the purposes of MIFIDPRU 4.13.9R(2)(g), the fact that a K-CMG permission for a portfolio may result in a K-CMG requirement that is lower than the equivalent K-NPR requirement for that portfolio does not automatically mean that the choice to apply a K-CMG requirement has been made with a view to engaging in regulatory arbitrage in a disproportionate or prudentially unsound manner.

2. (2)

   When considering whether the condition in MIFIDPRU 4.13.9R(2)(g) is satisfied, a firm should consider whether the K-CMG requirement that would result from the relevant K-CMG permission more closely reflects the underlying economic risk of the relevant portfolio when compared with the equivalent K-NPR requirement for the same portfolio.

3. (3)

   The FCA considers that even in circumstances where the K-CMG requirement is considerably lower than the equivalent K-NPR requirement, this does not automatically prevent a firm from meeting the conditions for a K-CMG permission. A significant difference between the two requirements may result from the calculation of the K-CMG requirement being better adapted for capturing the economic risks of the particular portfolio in question. For example, the margin model underlying the K-CMG requirement may have been specifically designed for firms that specialise in trading that type of portfolio. A firm that is applying for a K-CMG permission should provide a clear explanation of how the conditions in MIFIDPRU 4.13.9R(2) are satisfied for the portfolio. The firm should keep the appropriateness of a K-CMG permission under regular review as part of its ICARA process.

1Where a firm has submitted a notification in MIFIDPRU 4.13.20R(2), the FCA will not normally grant another K-CMG permission for the same portfolio until at least 24 months after the previous K-CMG permission ceased to apply.

1. (1)

   1The effect of MIFIDPRU 4.14.1R(2)(b) is that where a firm is authorised to deal on own account, it must include in the calculation of its K-TCD requirement any transactions specified in MIFIDPRU 4.14.3R(2)-(7). This applies even if the firm’s involvement in the transaction does not constitute dealing on own account and the transaction may not be recorded in its trading book.

2. (2)

   A firm that is not authorised to deal on own account is not subject to the K-TCD requirement under MIFIDPRU 4.14.1R, even if it is involved in a transaction that would otherwise fall within MIFIDPRU 4.14.3R(2)-(7).

1. (1)

   1If a derivative contract has a negative replacement cost, a firm should still calculate a PFE in relation to that contract if it is possible for the replacement cost to become positive before the maturity date.

2. (2)

   As the replacement cost of an individual written option can never be a positive amount, written options are exempt from the requirement to calculate a PFE, unless they are subject to netting with contracts other than written options for the purposes of calculating PFE in accordance with MIFIDPRU 4.14.14R and MIFIDPRU 4.14.16R.

3. (3)

   If a written option is subject to netting for the purposes of calculating PFE, a firm may cap the PFE in relation to that option at an amount that would result in a replacement cost of zero.

1. (1)

   1MIFIDPRU 4.14.14R(2) defines the main asset classes to which derivative contracts should be assigned to calculate the potential future exposure of a netting set. For example, a single name equity derivative would be allocated to the equity single name asset class in MIFIDPRU 4.14.22R, while a credit derivative would be allocated to the credit asset class in that rule.

2. (2)

   MIFIDPRU 4.14.14R(3) requires basis transactions or volatility swaps that would otherwise fall within one of the main asset classes in MIFIDPRU 4.14.14R(2) to be allocated to separate asset classes. The separate asset classes are defined according to the relevant risk factor or pair of risk factors.

3. (3)

   For example, an equity index future on Equity Index A and another equity index future on Equity Index B would be allocated to the same asset class under MIFIDPRU 4.14.14R(2)(a), as they both fall within the asset class (i.e. equity indices) in MIFIDPRU 4.14.22R. However, a volatility swap that references Equity Index A must be allocated to a separate class under MIFIDPRU 4.14.14R(3)(b), but can be grouped with another volatility swap that also references Equity Index A (i.e. the same risk factor).

4. (4)

   For derivative contracts relating to foreign exchange, a firm may net contracts relating to a currency pair (for example, USD/EUR) against contracts relating to the inverse pair (i.e. in this example, EUR/USD) by treating one pair as a long position and the inverse pair as a short position.

5. (5)

   For interest rate derivative contracts that have multiple legs, the firm should add together the notional amounts of the positive (receive) and negative (pay) legs, after adjusting for the duration and the supervisory delta in accordance with the calculation of the effective notional amount in MIFIDPRU 4.14.20R. The net amount should then be included in the calculation of PFE.

1. (1)

   1If a derivative contract has a negative replacement cost, a firm should still calculate a potential future exposure (PFE) in relation to that contract if it is possible for the replacement cost to become positive before the maturity date.

2. (2)

   As the replacement cost of an individual written option can never be a positive amount, written options are exempt from the requirement to calculate a PFE, unless they are subject to netting with contracts other than written options for the purposes of calculating PFE in accordance with MIFIDPRU 4.14.18R.