Aligning MiFID II Matched Principal Trading Requirements to the Prudential Regulatory Framework for Investment Firms

By Panayiotis Antoniou,
CEO, MAP Risk Management Services Ltd (MAP RMS)

MIFID I (Directive 2004/39/EC) raised the need to re-examine whether or not investment firms that execute client orders on a matched principal basis are to be regarded as acting as principals. As a result, MIFID II introduced the definition of ‘matched principal trading,’ which is defined as a transaction where the facilitator interposes itself between the buyer and the seller to the transaction in such a way that it is never exposed to market risk throughout the execution of the transaction. In this case, both sides are executed simultaneously, and the transaction is concluded at a price where the facilitator makes no profit or loss other than a previously disclosed commission, fee or charge for the transaction.

Prior to MIFID II, Investment Firms (IF) dealing in transactions on a matched principal basis could have an initial capital requirement of €125.000 as per the provisions of European Directive 2013/36/EC (CRD).

The above was possible based on Article 29(2) of CRD, which afforded national competent authorities the possibility to allow IFs authorised to provide the investment service of dealing on own account operating on a principal basis under certain conditions to have €125.000 initial capital requirement instead of €730.000. However, following the implementation of the new regulatory framework European Directive 2019/2034 (IFD) in June 2021, the capital requirement for such IFs has now been set at €750.000.

The change in approach by EU legislators is further illustrated under Recital 3 of the Investment Firm Regulation (IFR), which states that, “The risks which investment firms themselves incur and pose for their clients and the wider markets in which they operate depend on the nature and volume of their activities, including whether investment firms act as agents for their clients and are not party to the resulting transactions themselves, or whether they act as principals to the trades”.

In addition to MiFID II providing a definition for ‘matched principal trading’, Recital 24 of MiFID II clarified that dealing on own account when executing client orders should include firms executing orders from different clients by matching them on a matched principal basis (back-to-back trading) and should be regarded as acting as principal and subject to the provisions of MIFID II, covering both the execution of orders on behalf of clients and dealing on own account.

The above provisions allow for the conclusion that a matched principal trading is, in the first place, a form of dealing on own account with all other forms of dealing on own account sometimes flagged as “principal capacity”. Consequently, matched principal trading is available only for investment firms possessing both aforementioned authorisations.

The new Prudential Framework for Investment Firms (IFR) takes into account the particular business practices of different types of investment firms, especially their size and interconnectedness with other financial and economic actors.

Since 2021, a new level of proportionality to IFs has been established when addressing risk. The IFR calls indicators for specific risks to clients, markets and firms themselves via so-called K-Factors. For dealing on own account, investment firms shall manage their trading book and calculate the respective K-factor requirement for their own positions. K-factors are quantitative indicators that reflect the risk that the new prudential regime addresses. They are divided into three groups, and they aim to capture the risk the investment firm can pose to clients (‘RtC’), to market access (‘RtM’), or the investment firm itself (‘RtF’) (Art. 15 – IFR). Irrespective of whether an IF is acting as principal or on a matched principal basis, it should calculate and report to the competent authority all applicable K-Factors, taking into consideration the total volume of transactions executed under the aforementioned investment services.

To this end, ‘matched principal trading’ will be incorporated into the IF’s business and operating model when preparing the Internal Capital and Risk Assessment (ICARA) Process, which is the Pillar II process under IFR. The ICARA will ensure that the IF is able to monitor and manage potential material harms to ensure that it is able to remain financially viable throughout the economic cycle.



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