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24th May 2023 | Insights

IFR/D must be reformed

The findings in latest Proprietary Trading Management Insight Report are deeply concerning and should set alarm bells ringing in Brussels and beyond.

In the wake of massive increases in capital charges and additional governance requirements following the introduction of the Investment Firms Prudential Regime (IFR/D), we found that over a quarter of proprietary trading firms based in the EU and UK are considering giving up their Mifid II licences.

Even if only half followed through on this, the impact on liquidity in European markets would be immense. Regulators in the EU and UK must act now to ease the burden on proprietary trading firms.

While most proprietary trading firms accepted the merits of Mifid II when it was first launched in the mid-2010s, the automatic addition of new rules has become unsustainable for many. Some high-profile firms have already given up their Mifid licence and now trade only on markets outside the EU while continuing to locate in the block.

The great unfairness for firms with Mifid licences is that firms in the US are able to trade on European markets without the burden of Mifid II and its associated regulations.

Unless this is addressed, Europe is likely to experience a continual drip of departures of proprietary trading firms and an absence of new start-ups, furthering liquidity issues and undermining the integrity of its capital markets.

Already, firms are facing lower opportunities in the UK and Europe the latest report found. This will only accelerate unless the EU takes remedial measures ahead of the review of IFR/D in 2025.

The main issue that firms have with IFR/D is its lack of proportionality. Firms that Acuiti spoke with reported facing capital charges of many multiples of the margin required by their clearing firms under the new rules.

While temporary exemptions or partial exemptions have been granted by some national regulators, the fact remains that IFR/D as it is currently written will have a devastating impact on the European proprietary trading community.

For many firms a Sword of Damocles hangs over them, facing either an annual squeeze that for many will become too great or a cliff edge when the exemption expires.

Proprietary trading firms do not deal with client money. Therefore the capital at risk is that of the shareholders and other stakeholders. This is not taken into account in the current regulatory framework.

Nor are the current rules in any way proportionate. That a proprietary trading firm with margin requirements in the low tens of millions, based on the risk its positions pose as judged by its clearing member, should face capital charges of more than €100m, as we found in the report, is clearly absurd.

IFR/D must be rewritten to ensure that capital charges reflect the risk of the firm’s bankruptcy to the wider financial system. Derivatives exposures must be calculated on a non-notional basis and realistic netting has to be taken into account to reflect the actual risk a firm is exposed to.

But more fundamentally, the EU and UK regulators must consider the risk that proprietary trading firms pose to the financial system. Competition between firms is intense and historic failures of large institutions, such Ronin Capital in 2020, have had very little to zero impact on the stability of financial markets.

At the very least, the rules should be rewritten so that most proprietary trading firms in the UK and EU are classified as Class 3 firms – a designation specifically designed to apply to smaller, non-interconnected firms. In addition, no proprietary trading firm should be classified as a Class 1 firm in which they are effectively regulated as a bank.

Regulators have long mis-understood proprietary trading firms. To continue to do so risks eliminating many firms’ ability to operate, the exact reverse of what the regulations are intended to do. A review of the regulation is scheduled for 2025. This should be brought forward to prevent any more damage being done to the market.