Commodity trading firms ─ currently outside the scope from the regulatory prudential framework in the EU ─ now need to prepare themselves to face increased regulation. The prudential framework, a new rule book developed by the European Commission (EC) will soon be enforced on this type of firm. For many, this will be the first time any meaningful capital, liquidity and reporting regime has applied to them. The ‘prudential holiday’ that many commodity trading firms have enjoyed, will soon be coming to an end. 

The prudential framework is designed to be simpler and more proportionate to a firm’s operations. This framework requires the vast majority of investment firms to adapt to a new set of capital and liquidity requirements as well as a new reporting regime. Likely to come into force by the end of 2019, some firms may be hit very hard with requirements to maintain significantly greater levels of capital. Firms must assess the impact these rules will have on their capital, liquidity, remuneration and disclosures.

We are running a series of articles to assess the material areas of change imposed by the new prudential framework on different firm types. We previously assessed the impact on Exempt CAD firms and on MiFID managers. Now, in the third in our series, we examine the regime’s impact on the capital and liquidity requirements on commodity trading firms.

What does the prudential framework mean for commodity trading firms?

Thanks to an extension negotiated as part of the European Banking Authority’s (EBA) investment firm review (the very same review that gives us this new prudential framework), many commodity trading firms are currently exempt from the regulatory capital framework. The rationale behind this exemption was that there was little point asking these firms ─ which had recently been brought into the regulatory fold by MiFID II ─ to implement one prudential regime only to have to change to another shortly afterwards. 

Commodity trading firms are still very much in the throes of embedding their approach to MiFID II to bring them into alignment with the industry overall. So, for these firms, the recent few years and those to come are a period of unprecedented regulatory change. Adapting to the new prudential framework will require careful navigation, as both the additional compliance requirements and cost of the capital will impact senior management’s strategic choices.

The priority for firms at this stage will be to ensure their approach to MiFID II, which came into force on 3 January 2018, is fully deployed and embedded. Compliance teams can add considerable value to their organisation at this time by providing senior management with careful planning around the scope and cost of the new requirements, as well as insight into how the changes could potentially shape opportunities for the firm over the medium-term. As these firms did not previously have a prudential capital framework, a compliance program will need to be created from scratch. 

Why is this change happening?

Most investment firms are currently governed by the prudential capital framework for banking, as set out by Capital Requirements Directive (CRD) and Capital Requirements Regulation (CRR). This framework has been ill-suited to most investment firms and regulators have long wanted to apply arrangements for calculating regulatory capital in the sector.

When will this change happen?

The European Commission published its proposed directive and regulation in December 2017. This followed on from the circulation of the European Banking Authority’s (EBA) Opinion in September 2017, laid out the agency’s proposals. The new requirements will need to pass through the EU’s normal law-making process, so we expect that firms will have to be compliant with the new regime by the end of 2019.

So, what’s a commodity trading firm to do?

Under the new framework, firms will fall into one of three categories for prudential capital calculation purposes. Those firms which qualify for the first category – firms which are considered systemically important – will have to comply with the entire Capital Requirements Directive IV (CRD IV). Firms will fall into the other two categories depending on the size and volume of the business they handle. As a first step, firms should explore the proposals to see which category they will fall into.

Next, firms should review the proposals, looking particularly at the following areas:

• New prudential capital calculations

There will be many new concepts here for those commodity trading firms previously exempt from a prudential framework, including the Initial Capital Requirement (ICR) and the Fixed Overheads Requirement (FOR). Firms may also be subject to a variety of additional charges, called the K-factor requirements, for risks to customers, markets and the firm.

• Liquidity risk calculations

Firms should consider what they may have to hold – be it one month of their FOR charge or more.

• Potential for group consolidation

Depending on a firm’s situation, the provisions for group consolidation could potentially prove helpful. Firms should develop an understanding of this area as soon as is practical, if applicable.

• Pillar II and Pillar III requirements

Firms should not leave these to be an afterthought. Pillar II’s Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP) will be a hefty amount of work for firms. The outcome could also give rise to the need to hold additional capital. The governance requirements of Pillar III need to be baked into the overall approach the firm takes to compliance with the prudential framework.

• Reporting

Although the reporting framework for firms has not been fine-tuned yet, it’s likely that standards will mandate a specific reporting language, similar to XBRL used under the COREP regime now. Adopting to this methodology will take time and could require the purchase of software, so firms should be sure to scope this into their overall project plan once the final details are known.

For many commodity trading firms, the coming of the new prudential framework may seem to be both costly and complex at first blush. For most firms, this will mean that it will have a very direct impact on overall strategy for the medium-term. So, even though it may take some time for the overall rules to be finalised, it would make sense for firms to begin to understand the potential ramifications of this new prudential capital framework on the firm’s future direction.