MIFIDPRU 7 Annex 2 Additional guidance on assessing potential harms that is relevant for firms dealing on own account or firms with significant investments on their balance sheet

Purpose

2.1

G

(1)

This annex contains guidance on how a MIFIDPRU investment firm should assess the potential harms arising from its business as part of its ICARA process. This guidance is primarily intended to be relevant to firms that deal on own account or hold significant investments on their balance sheets. It should be interpreted in light of the firm’s individual business model.

(2)

Firms are reminded that their ICARA process must be proportionate to the nature, scale and complexity of their activities. This guidance should be interpreted by reference to what is proportionate for a particular firm.

2.2

G

A firm that deals on own account or holds significant investments on its balance sheets may be at increased risk of events that result in significant losses or other harm to the firm. In turn, this may increase the risk of a firm defaulting on its obligations to counterparties or becoming insolvent and entering a disorderly wind-down.

Examples of situations that may result in material harm to the firm

2.3

G

The following are examples of situations that may result in harm to the firm:

(1)

material adverse changes in the book value of the firm’s assets;

(2)

the failure of the firm’s clients or counterparties; and

(3)

losses incurred or payments due in connection with positions taken by the firm in financial instruments, foreign currencies and commodities (irrespective of whether those positions form part of the firm’s trading book or not).

2.4

G

When a firm is assessing potential harms connected with material changes in the book value of the firm’s assets, the following non-exhaustive list of factors may be relevant:

(1)

changes in the creditworthiness or the default of a client or counterparty, where that change or default may result in the firm realising assets below their book value or recording impairments, revaluations or write-downs;

(2)

changes in market conditions which may affect relevant prices, indices or rates, including changes in equity, debt or foreign exchange markets or interest rates;

(3)

operational events or natural disasters that may affect the value of the firm’s assets;

(4)

any concentration of the firm’s assets in relation to a specific:

(a)

client or counterparty (or group of connected clients or counterparties);

(b)

economic sector or sub-sector; or

(c)

geographical market.

This concentration assessment should not be limited to the particular risks covered by the requirements in MIFIDPRU 5, but should involve a broader assessment of the risks that may arise in relation to the concentration;

(5)

whether any of the firm’s assets are, or have a value which depends on, complex products, such as interests in securitisations or structured products which are complex or opaque;

(6)

the extent to which the firm has used leverage (including contingent leverage); and

(7)

whether the firm has any exposures under off-balance sheet items, such as commitments or guarantees.

2.5

G

When a firm is assessing potential harms arising from the failure of its clients or counterparties, the following non-exhaustive list of factors may be relevant:

(1)

changes in the creditworthiness or the default of a client or counterparty, which may result in direct losses for the firm or the need to revalue or replace transactions;

(2)

changes in market conditions which may result in the firm incurring greater costs to replace a transaction that the client or counterparty has failed to settle;

(3)

the risk that collateral received from the client or counterparty may not be as effective as expected at covering the losses arising from that client or counterparty’s failure or default; and

(4)

any concentration of the firm’s exposures in relation to the client or counterparty or the economic sector or geographical market in which that client or counterparty is active.

2.6

G

Where a firm is subject to the K-TCD requirement or the K-CON requirement, the FCA would generally expect the firm to consider whether those requirements are sufficient to cover the harms that may result from the failure of its clients or counterparties to fulfil their obligations. In some cases, those requirements may not apply in relation to the client, counterparty or position in question, or may not adequately address the relevant risks. Where this is the case, the firm should consider other measures to address the potential harm.

2.7

G

Where a firm is assessing potential harms arising from the firm’s positions in financial instruments, foreign currencies and commodities, the following non-exhaustive list of factors may be relevant:

(1)

the extent to which the relevant position may involve risks that are not adequately captured by the firm’s K-NPR requirement, K-CMG requirement or K-CON requirement, such as:

(a)

basis risk between certain products;

(b)

risks arising from approximate valuations applied to non-linear products;

(c)

the risk that large movements in pegged currencies may be underestimated; or

(d)

risks arising from inadequate proxy market data;

(2)

whether a position is illiquid or distressed, or whether it may become so under severe but plausible market conditions, and how this may affect the expected holding period for that position;

(3)

the extent to which it is possible to hedge a position under both normal, and severe but plausible, market conditions;

(4)

whether a position is difficult to value because of a lack of recent observable market data;

(5)

whether the intra-day exposure associated with a position differs significantly from the end-of-day exposure;

(6)

any known weaknesses in any model used by the firm to assess the risks arising from the position; and

(7)

the concentration of the portfolio in which the position is held, including by reference to:

(a)

issuers or counterparties;

(b)

economic sectors or sub-sectors; and

(c)

geographical markets.