MIFIDPRU 7.7 ICARA process: assessing and monitoring the adequacy of liquid assets

1. (1)

   1The overall financial adequacy rule requires a firm to hold adequate liquid assets to ensure that:

   1. (a)

      the firm is able to remain financially viable throughout the economic cycle, with the ability to address any potential harm that may result from its ongoing activities; and

   2. (b)

      the firm’s business can be wound down in an orderly manner.

2. (2)

   To comply with the overall financial adequacy rule, a firm must therefore hold the sum of the basic liquid assets requirement and the higher of:

   1. (a)

      the amount of liquid assets that the firm requires to fund its ongoing business operations, taking into account potential periods of financial stress during the economic cycle; or

   2. (b)

      the additional amount of liquid assets that a firm would need to hold when commencing its wind-down process to ensure that the firm could be wound down in an orderly manner.

3. (3)

   The firm should use the analysis it produces under MIFIDPRU 7.7.2R to ensure that it complies with the overall financial adequacy rule.

4. (4)

   The liquid assets threshold requirement is the amount of liquid assets that a firm needs to hold at any given time to comply with the overall financial adequacy rule.

1. (1)

   1When considering the liquid assets that are required to fund its ongoing business operations under MIFIDPRU 7.7.2R(1), a firm should consider, among other factors:

   1. (a)

      the ordinary level of liquid assets that would typically be required to operate the firm’s underlying business, taking into account any seasonal variations;

   2. (b)

      any material harms that may realistically occur during the next 12 months and their potential impact on the firm’s liquidity position;

   3. (c)

      any liquid assets that a firm may need to use as collateral or to meet margining requirements; and

   4. (d)

      any estimated gaps in funding, including during periods of severe but plausible stress.

2. (2)

   The liquid assets that a firm requires at any given time during the 12-month period in MIFIDPRU 7.7.2R(1) may fluctuate, depending on the timing of a firm’s expected liabilities and the nature of its business. Therefore, a firm should divide the 12-month period into quarters and assess the highest amount of liquid assets that it would require in each quarter. The FCA accepts that forecasts of the liquid assets that a firm requires may become less accurate for later quarters, but expects firms to use a 12-month time horizon to ensure that adequate attention is given to potential harms and significant liquidity outflows that may occur during that period.

3. (3)

   As a firm’s liquidity requirements are typically dynamic in nature, MIFIDPRU 7.7.2R requires a firm to update its liquid assets assessment where there has been a material change in the firm’s business model or operating model. This ensures that the firm updates its liquidity analysis to reflect material changes in its circumstances that may affect the availability of liquid assets or the firm’s liquidity requirements, while also assessing future needs over a rolling 12-month time horizon.

4. (4)

   As part of its reporting obligations under MIFIDPRU 9, a firm must report liquidity information to the FCA on a regular basis. The FCA will use this information to monitor both the liquid assets that the firm is holding and the firm’s assessment of its liquid assets threshold requirement.

1. (1)

   1A firm’s basic liquid assets requirement provides a minimum level of core liquid assets that the firm must maintain at all times. The purpose of the basic liquid assets requirement is to ensure that the firm always has a minimum stock of liquid assets to fund the initial stages of its wind-down process if wind-down becomes necessary. The firm cannot, therefore, use the value of the core liquid assets that it holds to meet the basic liquid assets requirement as liquid assets for the liquidity needs of its ongoing business.

2. (2)

   The basic liquid assets requirement may, however, be insufficient to provide the liquid assets that the firm has assessed would be necessary to facilitate an orderly wind-down as part of its wind-down planning under MIFIDPRU 7.5.7R. Therefore, the firm may identify that it needs to hold an additional amount of liquid assets to meet its funding needs as part of the wind-down process. This is not necessarily the whole amount of the liquid assets that would be required to fund the entire wind-down process, because in some circumstances, the firm may reasonably expect to generate additional liquid assets during wind-down. However, the firm should identify if it could have a funding gap during the wind-down process that the firm needs to cover by holding more liquid assets at the point that wind-down begins.

3. (3)

   The following diagram summarises the process that a firm should undertake to determine its liquid assets threshold requirement:

   

* When a firm assesses the amount of liquid assets it needs for ongoing operations, it cannot use the value of the core liquid assets held to meet the basic liquid assets requirement to fund those operations.

** The basic liquid assets requirement may be insufficient to provide the liquid assets that the firm has assessed would be necessary to facilitate an orderly wind-down. Therefore, the firm may identify that it needs to hold an additional amount of liquid assets (above the basic liquid assets requirement) 3to meet its funding needs to commence its wind-down process.The amount of additional liquid assets under assessment (B), therefore, does not include the amount of the basic liquid assets requirement (as explained in MIFIDPRU 7.7.3G(2)(b)).3

*** Unless otherwise specified by the FCA.

1. (4)

   3The following example illustrates how to determine the firm’s liquid assets threshold requirement once assessment (A) and assessment (B) have been calculated:

   1. (a)

      A firm has a basic liquid assets requirement of £1,000,000 under MIFIDPRU 6.

   2. (b)

      Through its ICARA process, the firm assesses that it needs a total amount of liquid assets of:

      1. (i)

         3£1,500,000 for ongoing operations under assessment (A); and

      2. (ii)

         £5,000,000 for an orderly wind-down, which means that the firm’s additional amount of liquid assets (above the basic liquid assets requirement) under assessment (B) is £4,000,000.

   3. (c)

      As assessment (B) (£4,000,000) is higher than assessment (A) (£1,500,000), assessment (B) (£4,000,000) is added to the firm’s basic liquid assets requirement of £1,000,000.

   4. (d)

      The firm’s liquid assets threshold requirement would, therefore, be £5,000,000 (the sum of the basic liquid asset requirement (£1,000,000) and assessment (B) (£4,000,000)).

1When considering whether a non-core liquid asset meets the requirement in MIFIDPRU 7.7.6R(3), a firm should take into account the following principles:

1. (1)

   low risk: assets that are less risky tend to have higher liquidity. High credit standing of the issuer and a low degree of subordination tends to increase an asset’s liquidity. Low duration, low legal risk, low inflation risk and denomination in a convertible currency with low foreign exchange risk all tend to enhance an asset’s liquidity;

2. (2)

   ease and certainty of valuation: an asset’s liquidity tends to increase if market participants are more likely to agree on its valuation. Assets with more standardised, homogenous and simple structures tend to be more fungible, promoting liquidity. The pricing formula of a high-quality liquid asset should be easy to calculate and not depend on strong assumptions. The inputs into the pricing formula should also be publicly available. In practice, this should rule out the inclusion of most structured or exotic products;

3. (3)

   low correlation with risky assets: the stock of assets should not be subject to wrong-way (highly correlated) risk. For example, assets issued by financial institutions are more likely to be illiquid in times of liquidity stress in the financial sector;

4. (4)

   listed on a developed and recognised exchange: being listed tends to increase an asset’s transparency and liquidity;

5. (5)

   active and sizable market: the asset should have an active market at all times. This means that:

   1. (a)

      there should be historical evidence of market breadth and market depth. This could be demonstrated by low bid-ask spreads, high trading volumes, a large and diverse number of market participants, and the existence of a repo market. Diversity of market participants reduces market concentration and increases the reliability of the liquidity in the market; and

   2. (b)

      there should be robust market infrastructure in place. The presence of multiple committed market makers increases liquidity as quotes will most likely be available for buying or selling the asset;

6. (6)

   low volatility: assets whose prices remain relatively stable and are less prone to sharp price declines over time will have a lower probability of triggering forced sales to meet liquidity requirements. Volatility of traded prices and spreads are simple proxy measures of market volatility. There should be historical evidence of relative stability of market terms (e.g. prices and haircuts) and volumes during stressed periods; and

7. (7)

   flight to quality: historically, the market has shown tendencies to move into these types of assets in a systemic crisis. The correlation between proxies of market liquidity and financial system stress is one simple measure that could be used.

1The FCA considers that a minimum haircut of no less than that in the range specified in the table in MIFIDPRU 7.7.12G is likely to be appropriate for the purposes of MIFIDPRU 7.7.10R.

1For the purposes of applying MIFIDPRU 7.7.10R and 7.7.11G to shares or units in a CIU:

1. (1)

   where a firm is aware of the exposures underlying the CIU, it may look through to the underlying exposures to assign an appropriate haircut;

2. (2)

   where a firm is not aware of the exposures underlying the CIU, it should assume that the CIU invests, up to the maximum amount allowed under its mandate, in the highest risk assets permissible; and

3. (3)

   in either case, a firm should consider applying an additional haircut to reflect any additional loss of value that could result from the underlying exposures being held through a CIU.

1. (1)

   1The notification requirement in MIFIDPRU 7.7.14R does not replace a firm’s obligations under:

   1. (a)

      Principle 11 to disclose appropriately to the FCA anything relating to the firm of which the FCA would reasonably expect notice; or

   2. (b)

      the general notification requirements in SUP 15.3.

2. (2)

   Where a firm has submitted a notification under MIFIDPRU 7.7.14R, the notification will generally discharge a firm’s obligations under Principle 11 and the general notification requirements in SUP 15.3 in relation to the matters contained in the notification. However, a firm must still consider whether the FCA should be notified of developments before any of the notification indicators in MIFIDPRU 7.7.14R occur. In addition, Principle 11 and SUP 15.3 may require a firm to notify the FCA of additional material information that is not specifically referenced in MIFIDPRU 7.7.14R.

3. (3)

   A MIFIDPRU investment firms should notify the FCA at an early stage of any significant event which creates a material risk of a firm ceasing to hold adequate financial resources, even if the impact of that event has not yet fully materialised.

1. (1)

   1The table in MIFIDPRU 7.7.17G explains the interventions that the FCA would generally expect to make where a MIFIDPRU investment firm has breached, or there is evidence that the firm may be at risk of breaching, its liquid assets requirements. The table sets out the points at which the FCA would normally intervene and what actions it would normally take. Note that unlike for own funds, there is no early warning indicator requirement in relation to liquid assets.

2. (2)

   The FCA would generally expect that the interventions in the table would be cumulative – i.e. in a declining prudential situation, as the firm hits each intervention point in turn, the FCA would take some or all of the actions associated with that particular point. The actions are intended to be proportionate and progressively stronger responses to address the prudential concerns raised by each intervention point.

3. (3)

   However, if the firm experiences a sudden adverse event which causes the firm to hit multiple intervention points simultaneously, the FCA may immediately take the actions associated with the most severe point.

4. (4)

   The actions specified in the table do not prevent the FCA from taking alternative or additional actions in appropriate cases. The purpose of the table is to provide greater clarity for firms on the FCA’s general expectations and approach to interventions, to assist firms’ own planning and responses.