Buy-side firms could face increased scrutiny of their trading practices under new supervisory guidelines

New guidelines published by ESMA and the European Banking Authority will allow for an assessment used to take supervisory measures to address risks and concerns among investment firms.

The European Securities and Markets Authority (ESMA) and the European Banking Authority (EBA) have published final guidelines on common procedures and methodologies for the supervisory review and evaluation process (SREP) for investment firms.

The finalised guidelines are based on the Investment Firms Directive (IFD) and look to harmonise the supervisory practices regarding the SREP of investment firms.

Developed jointly with the EBA, the guidelines set out the common process and criteria for the assessment of the main SREP elements including business model; governance arrangements and firm-wide controls; risks to capital and capital adequacy; and liquidity risk and liquidity adequacy.

As part of the new guidelines, competent authorities will have to assess whether investment firms perform a comprehensive assessment of the risks which are material to their business and operating model, to the composition of their portfolio or to their trading strategies.

ESMA states that this should include an assessment of these risks in the context of cyclical economic fluctuations and of the impact such fluctuations may have on the investment firms’ ability to meet its own funds’ requirements, to finance ongoing business operations or an orderly wind-down.

Elsewhere, the guidelines call for an assessment of inherent market risk, in which competent authorities should determine the main drivers of the investment firm’s market risk exposure and evaluate the risk of significant prudential impact on the investment firm. This will also include the assessment of the prudent valuation framework for trading book positions.

A common scoring framework will be utilised to allow for consistency and comparability of assessment, differentiating between risks and viability scores. The scores of individual risks and SREP elements will then be brought together to establish an overall SREP score, which reflects the assessment of the viability of the investment firm.

The assessment’s outcome will be used as a basis to take any necessary supervisory measures to address specific risks and concerns. ESMA and EBA stated that guidance is provided on the application of supervisory measures, including quantitative capital and liquidity measures as well as other qualitative measures as necessary.

Common procedures and methodologies for SREP are specified by the guidelines, which are proportionate to the nature, size and activities of investment firms. Distinct categories are used to classify investment firms which translate into different frequency, depth and intensity of the assessments, and the engagement of the competent authority.

The next steps will include the translation of the guidelines into the official EU languages and the publication of the new framework onto EBA and ESMA’s websites. Competent authorities will then have two months after publication to report whether they comply with the new guidelines.

The full guidelines can be accessed here.