The Investment Firms Directive is a legislative act adopted by the European Union in 2019 to regulate investment firms operating in the EU financial markets. It introduces stricter prudential and conduct requirements for investment firms to ensure investor protection, market integrity and financial stability. The new rules recognize the diverse risk profiles of different investment firms and aim to be proportionate to the systemic risks they may pose. Key aspects of the directive include revised capital and liquidity standards, improved governance and risk management, transparency requirements, and strengthened supervisory powers. The directive came into effect on June 26th 2021 with a phasing-in period until 2026 for certain provisions. It is expected to have a significant impact on the competitiveness and operations of EU investment firms.
Classification system regulating firms based on size and activities
A core aspect of the investment firms directive is the new classification system it introduces for investment firms. Based on their size, interconnectedness, complexity of activities and risk profiles, firms will be categorized as small and non-interconnected firms, other investment firms and credit institutions. This aims to ensure a targeted and proportionate application of prudential requirements on firms. Smaller, less risky firms face simpler rules while systemic investment firms conducting bank-like activities will follow the existing banking rulebook.
Revised capital and liquidity requirements improving resilience
The directive revises the capital and liquidity requirements for investment firms to make them relate better to the key risks firms face. New K-factor rules link capital charges more directly to operational risks from firms’ activities. This includes metrics based on assets under management, client money held, assets safeguarded and administered, client orders handled and trading flow posed from firm positions. Higher liquidity requirements are also aimed at improving firms’ resilience to unexpected fluctuations.
Strengthened governance and risk management obligations
Investment firms will need to improve their governance and risk management capabilities under the new rules. This includes setting up nomination and remuneration committees, ensuring diversity of management boards and enhancing firms’ internal control functions. Updated risk management policies and procedures will need to cover new risk categories relevant to firms’ specific business models and activities. Firms also face expanded reporting requirements on governance and risk metrics.
The investment firms directive overhauls the EU regulatory regime for investment firms. Its risk-based requirements aim to improve resilience and investor protections while supporting the diverse investment services sector.