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The MiFID II Product Governance Requirements

The Markets in Financial Instruments Directive (MiFID II) contains a new requirement relating to product approval.

Article 16(3) defines specific rules for firms producing or distributing financial instruments, defined as being shares, bonds, derivatives or units within a collective investment scheme.

  • Implications

    Product producers and distributors will be facing requirements that are far greater in scope than those associated with the current RPPD (Responsibilities of Providers and Distributors for the Fair Treatment of Customers) regulatory guidance.

    Specifically, in summary from the Directive:

    • an investment firm producing financial instruments for sale to clients shall maintain, operate and review a process for the approval of each financial instrument and significant adaptations of existing financial instruments before they are marketed or distributed to clients. The process must specify an identified target market of end clients and ensure that all relevant risks to that target market are assessed and the intended distribution strategy is consistent with the target market;
    • firms must regularly review the financial instruments they offer or market, taking into account any event that could materially affect the potential risk to the identified target market, to assess whether the financial instrument remains consistent with the needs of that market and whether the intended distribution strategy remains appropriate. Stress testing must occur;
    • an investment firm which manufactures financial instruments must also make available to any distributor all appropriate information on the financial instrument and the product approval process, including the identified target market of the financial instrument;
    • where an investment firm offers or recommends financial instruments which it does not manufacture, it shall have in place adequate arrangements to obtain the information on the financial instrument and the product approval process, including the identified target market of the financial instrument, and to understand the characteristics and identified target market of each financial instrument;

    ESMA (the European Securities and Markets Authority) has set out six categories that product manufacturers should use as a basis for defining the target market for each product.  These are:

    • the type of client at whom the product is targeted
    • that client’s knowledge and experience
    • the client’s financial situation, with a focus on the ability to bear losses
    • the client’s risk tolerance and compatibility of the risk/reward profile of the product with the target market
    • the client’s objectives
    • the client’s needs

    Firms engaged in collaborating on the manufacture of products will be required to have a written agreement setting down the respective responsibilities of both parties.

  • Next steps

    The FCA will shortly be releasing a new sourcebook, titled “Product Governance and Product Intervention” (PROD). This is expected to be around 30 pages long.

    It will apply to:

    • all MiFID and CRD credit institutions
    • Article 3 exempt firms
    • branches of third country firms (covering products they manufacture or distribute from a UK branch)

    Other firms that manufacture or distribute financial instruments or structured deposits should take account of PROD as guidance.

    It is highly advisable for firms to examine existing guidance (including RPPD) and review these via gap analysis against the MiFID II statements. The MiFID provisions should not represent or require significant change for those firms already in compliance with existing guidance.

    It is recommended that firms ask questions about their existing practices.

    Questions should include:

    Product approval:

    • do products undergo an appropriate approval process? Are process improvements required?
    • is a review required of the activities of product design personnel and the product approval committee(s)?
    • is board engagement and sign off of new products or product revisions adequate?
    • Is there a recognisable and coherent product distribution strategy? Does it constitute part of the product approval process, as it should?

    Target market identification:

    • are end investors clearly identified?
    • is the pathway for investor identification clearly demonstrable?
    • is the process for clarifying investor needs clear and unambiguous?
    • could we demonstrate and prove that investors need the product? Can we do so with supporting objective evidence including in-depth research?
    • are we engaged in good practice – i.e. offering products to investors that we have identified as being required and suitable for their needs or are we promulgating bad practice by creating a product and then trying to persuade investors to buy it?
    • can we respond to changes in the target market?
    • Do we monitor external factors that might change the definition of our target market (as opposed to consciously changing the target market)? How will we respond if this happens?

    Stress testing:

    • have our products been stress tested and shown to be robust? Can we readily produce evidence to support that?
    • have all the risks associated with the product been correctly identified?
    • is it clear how these risks fit with our identified target market and its needs? What would be the position if there was no longer a fit?
    • are all the risks adequately and comprehensively disclosed to potential investors?

    Charging structure:

    • is there confidence that the charging structure is fair?
    • is it clear how the charging structure compares to similar products distributed to similar target markets?
    • are we making the charging structure clear to investors?

    Manufacturer/distributor liaison:

    • do we clearly understand the distribution chain?
    • are we clear what data we need to collect and pass on to our distributor?
    • are we able to engage in the required data collection and can we meaningfully interpret data once captured? Do we need to appoint and work with an external data services provider?
    • do we have in place the resources and tools to analyse and report on the distribution channels? Are we doing this adequately and with sufficient rigour?
    • do the distributors know the product in-depth or only “vaguely”? Do they require further education about the features of the product? If so, what is the most effective way of doing this? How do we measure success?

    Agreements/contracts:

    • do we need to revisit and revise if required, our existing distribution agreements?
  • How can Thistle help you?

    Thistle will continue to keep this area under review and will issue further updates where necessary. For more information, email info@thistleinitatives.co.uk or call 0207 436 0630.