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Circular C261 (ESMA Guidelines on MiFID II product governance requirements )

Summary of ESMA Guidelines on MiFID II product governance requirements (CySEC Circular C261 – 30.03.2018)


Through Circular C261, the Cyprus Securities and Exchange Commission (“CySEC”) wishes to inform CIFs that the ESMA Guidelines on MiFID II product governance requirements have been adopted by CySEC and therefore they should make every effort to comply with these Guidelines.

The ESMA Guidelines provide more clarity on the product governance obligations for CIFs. In this respect, please note the following:

Guidelines for Manufacturers

Identification of the potential target market by the manufacturer: categories to be considered

The potential target market identification by manufacturers should not be solely conducted on the basis of quantitative criteria but needs to be based on sufficient qualitative considerations as well.

Manufacturers should use the list of categories set out in these guidelines as a basis for identifying the target market for their investment products. Manufacturers should not exclude any of the five below mentioned categories. If, in the manufacturers view, these five categories are too restrictive to identify a meaningful target market, additional categories may be added.  Manufacturers should use the following list of five categories:

  • The type of clients to whom the product is targeted
  • Knowledge and experience: The firm should specify the knowledge that the target clients should have about elements such as: the relevant product type, product features and/or knowledge in thematically related areas that help to understand the product.
  • Financial situation with a focus on the ability to bear losses: The firm should specify the percentage of losses target clients should be able and willing to afford and if there are any additional payment obligations that might exceed the amount invested (for example, margin calls). This could also be phrased as a maximum proportion of assets that should be invested.
  • Risk tolerance and compatibility of the risk/reward profile of the product with the target market: The firm should specify the general attitude that target clients should have in relation to the risks of investment.
  • Clients’ Objectives and Needs: The firm should specify the investment objectives and needs of target clients that a product is designed to meet, including the wider financial goals of target clients or the overall strategy they follow when investing.

Manufacturers should clearly define the concepts and terminology used when defining the target market across the five categories listed above.

Identification of the potential target market: differentiation on the basis of the nature of the product manufactured

The identification of the potential target market should be done in an appropriate and proportionate manner, considering the nature of the investment product. This means that the target market identification should consider the characteristics of the product including its complexity (including costs and charges structure), risk-reward profile or liquidity, or its innovative character. Consequently, for more complicated products, such as structured products with complicated return profiles, the target market should be identified with more detail and the simpler a product is, the less detailed a category may be. However, in all cases, the target market must be identified at a sufficiently granular level to avoid the inclusion of any groups of investors for whose needs, characteristics and objectives the product is not compatible.

Articulation between the distribution strategy of the manufacturer and its definition of the target market

According to Article 16(3) of MiFID II, the manufacturer shall ensure that its intended distribution strategy is consistent with the identified target and, according to Article 24(2) of MiFID II, the manufacturer needs to take reasonable steps to ensure that the financial product is distributed to the identified target market. A manufacturer should determine the extent of clients’ information necessary to the distributor to properly assess the target market for its product.

Guidelines for Distributors

Timing and relationship of target market assessment of the distributor with other product governance processes

The distributor’s target market identification should be conducted as part of the general decision making process about the range of services and products the distributor is going to distribute. In particular, distributors should take responsibility to ensure, from the very beginning, the general consistency of the products that are going to be offered and the related services that will be provided with the needs, characteristics and objectives of target clients.

The decision making process about the service and product universe in combination with the target market identification process should directly influence the way in which the firm’s daily business is conducted. Firms should especially focus on the investment services through which the products will be offered to their respective target markets. Distributors should decide which products are going to be recommended or offered or actively marketed to certain groups of clients. Distributors should also decide which products will be made available to clients at their own initiative through execution services without active marketing, considering that in such situations the level of client information available may be very limited.

In any case the distributor assesses that a certain product will never be compatible with the needs and characteristics of its existing or prospective clients, it should refrain from including the product in its product assortment.

Relation between the product governance requirements and the assessment of suitability or appropriateness

The obligation of the distributor to identify the actual target market and to ensure that a product is distributed in accordance with the actual target market is not substituted by an assessment of suitability or appropriateness and has to be conducted in addition to, and before such an assessment.

Identification of the target market by the distributor: categories to be considered

Distributors should use the same list of categories used by manufacturers, as a basis for defining the target market for their products.

distributor need to specify the actual target market, considering the boundaries of the potential target market set by the manufacturer. Distributors should base their target market on their information and knowledge of their own client base and the information received from the manufacturer or information that has been obtained by the distributor itself via desk research. Distributors should use the manufacturer’s more general target market assessment together with existing information on their clients or prospective clients to identify their own target market for a product that is the group of clients to whom they are effectively going to offer the product through the provision of their services.

To this end, distributors should conduct a thorough analysis of the characteristics of their client base. Usually, the target market assessment of the distributor will occur after the manufacturer has communicated its target market to him. However, it is possible that manufacturer and distributor could define both the manufacturer’s target market and the distributor’s target market.

When distributors define their product assortment, they should pay particular attention to situations where they might not be able to make a thorough target market assessment by virtue of the type of services they provide.

Identification of the target market: differentiation on the basis of the nature of the product distributed

  • The identification of the target market assessment by the distributor should also be done in an appropriate and proportionate manner, considering the nature of the investment product, in line with what described above.
  • Where the manufacturer has identified a target market for simpler, more common products the distributor’s target market identification does not necessarily have to result in a refinement of the manufacturer’s target market.


Identification and assessment of the target market by the distributor: interaction with investment services

Distributors are required to identify and assess the circumstances and needs of the group of clients to whom they are effectively going to offer or recommend a product, so as to ensure the compatibility between that product and the respective target clients.

In this regard, it should be noted that, on one hand, the ex-ante assessment of the actual target market is influenced by the services provided, since it can be conducted more or less thoroughly depending on the level of client information available, which in turn depends on the type of services provided and the conduct of rules attached to their provision (in particular, investment advice and portfolio management allow for the acquisition of a wider set of information on clients compared to the other services). On the other hand, the target market assessment influences the decision on the type of services that are going to be provided in relation to the nature of the product and the circumstances and needs of the identified target clients, considering that the level of investor protection varies for different investment services, depending on the rules that apply at the point of sale. In particular, investment advice and portfolio management services allow for a higher degree of investor protection, compared to other services provided under the appropriateness regime or under execution-only.

It is therefore expected that when distributors define their product assortment, they pay particular attention to situations where they might not be able to conduct a thorough target market assessment by virtue of the type of services they provide. In this respect, firms should pay particular attention to the distribution strategy suggested by the manufacturer.

In cases that products are characterised by complexity/risk features, as well as for situations where there might be significant conflicts of interest it is most important that distributors take into due consideration all relevant information provided by the product manufacturer, both in terms of potential target market and distribution strategy.

Distribution strategy of the distributor

When a manufacturer is an entity not subject to MiFID II and thus it is not obliged to identify a distribution strategy, the distributor should define its own distribution strategy in light of information on its client base and type of services provided.

If the manufacturer considers that the features of a given product are compatible with a distribution strategy through non-advised services, the distributor may still decide that the characteristics of its existing or prospective clients. On the contrary, the distributor could decide, in certain circumstances, to take a less prudent approach in relation to the distribution strategy defined by the manufacturer.

Portfolio management, portfolio approach, hedging and diversification

When providing investment advice adopting a portfolio approach and portfolio management to the client, the distributor can use products for diversification and hedging purposes. The identification of a target market by the distributor is without prejudice to the assessment of suitability. This means that, in certain cases, permissible deviations between the target market identification and the individual eligibility of the client may occur if the recommendation or sale of the product fulfils the suitability requirements conducted with a portfolio view as well as all other applicable legal requirements.

The distributor is not required to report sales outside of the positive target market to the manufacturer if these sales are for diversification and hedging purposes and if these sales are still suitable given the client’s total portfolio or the risk being hedged.

Sales of products into the negative target market should always be reported to the manufacturer and disclosed to the client, even if those sales are for diversification or hedging purposes.

Regular review by the manufacturer and distributor to respectively assess whether products and services are reaching the target market

Article 16(3) MiFID II and Articles 9 and 10 of the MiFID II Delegated Directive require manufacturers and distributors to review products on a regular basis to assess whether the product remains consistent with the needs, characteristics and objectives of the identified target market and whether the intended distribution strategy remains appropriate.

Manufacturers should consider, on a proportionate basis, what information they need in order to complete their review and how to gather that information. To support reviews by MiFID manufacturers, distributors must provide them with information on sales and, where appropriate, any other relevant information that may be the outcome of the distributor’s own periodic review.

In relation to the reporting of information on sales outside the manufacturer’s target market, distributors should be able to report any decisions they have taken to sell outside the target market or to broaden the distribution strategy recommended by the manufacturer and information on sales made outside the target market.

Distribution of products manufactured by entities not subject to MiFID II product governance requirements

Firms that distribute products that have not been manufactured by entities subject to the MiFID II product governance requirements are expected to perform the necessary due diligence so as to provide an appropriate level of service and security to their clients compared to a situation where the product had been designed in accordance with the MiFID II product governance requirements.

Where a product has not been designed in accordance with the MiFID II product governance requirements the information gathering process or the target market identification may be affected:

  • Target market definition: The distributor shall determine the target market also when the target market is not defined by the manufacturer
  • Information gathering process: The distributors shall take all reasonable steps to ensure that the level of product information obtained from the manufacturer is of a reliable and adequate standard, to ensure that products will be distributed in accordance with the characteristics, objectives and needs of the target market.

The obligation referred to above is relevant for products sold on primary and secondary markets and shall apply in a proportionate manner, depending on the degree to which publicly available information is available and the complexity of the product. Thus, information about simpler, more common products, such as ordinary shares, will usually not require an agreement with the manufacturer but can be derived from the manifold information sources published for regulatory purposes for such products.

Where the distributor is not in a position to obtain in any way sufficient information on products manufactured by entities not subject to the MiFID II product governance requirements, the firm would be unable to meet its obligations under MiFID II and, consequently, should refrain from including them in its product assortment.

 

Application of product governance requirements to the distribution of products that were manufactured before the date of application of MIFID II.

Products manufactured and distributed before 3 January 2018 should not fall within the scope of the product governance requirements as defined by MiFID II.

Products which were manufactured before 3 January 2018 but which are distributed to investors after 3 January 2018 should fall within the scope of product governance requirements applicable to distributors, in particular, the requirement to identify a target market for any financial product. However, a target market should be assigned by the manufacturer to such products, at the latest, following the next product review process cycle that is conducted according to Article 16(3) of MiFID II after 3 January 2018. The distributor should then consider this target market in its own review process.

Guidelines on issues applicable to both Manufacturers and Distributors

Identification of the ‘negative’ target market and sales outside the positive target market

The firm needs to consider whether the product would be incompatible with certain target clients (“negative” target market). When doing so, the firm should apply the same categories and principles as stated above. In line with the approach followed for the identification of the ‘positive’ target market, the manufacturer, who does not have a direct relationship with end-clients, will be able to identify the negative target market on a theoretical basis.

Some of the target market characteristics used in the positive target market assessment by manufacturers and distributors will automatically lead to opposing characteristics for investors for whom the product is not compatible. When assessing a potential negative target market, the number and detail of factors and criteria will depend on the nature, especially the complexity or the risk-reward profile, of the product.

There might be situations where products could be sold outside the positive target market. However, these instances should be justified by the individual facts of the case, the reason for the deviation should be clearly documented and, where provided, included in the suitability report. As the negative target market is an explicit indication of those clients for whose needs, characteristics and objectives the product is not compatible and to whom the product should not be distributed, the sale to investors within this group should be a rare occurrence, the justification for the deviation should be accordingly significant and is generally expected to be more substantiated than a justification for a sale outside the positive target market.

 

Application of the target market requirements to firms dealing in wholesale markets (i.e. with professional clients and eligible counterparties)


Professional clients and eligible counterparties as part of the intermediation chain


The requirements set out in Article 16(3) MiFID II apply irrespective of the nature of the client (retail, professional or eligible counterparty). At the same time Articles 16(3) and 24(2) MiFID II specify that the clients to be targeted shall be the “end-clients”. This means that a firm does not need to specify a target market for other firms (professional clients and eligible counterparties) within the intermediation chain, but rather it needs to design the target market with the end-client in mind.

Where a professional client or an eligible counterparty buys a product with the intention to sell it on to other clients, therefore acting as a link in the intermediation chain, they should not be considered as “end-clients”. In such a case, the professional client (or eligible counterparty) would be acting as distributor and therefore should comply with the product governance requirements applicable to distributors.

Professional clients and eligible counterparties as end-clients


The MiFID client categorisation framework calibrates conduct of business protections to the needs of each client category (i.e. retail clients, professional clients and eligible counterparties).

MiFID II requires firms to ensure that the products they manufacture and/or distribute are designed to meet the needs of an identified target market of end-clients within the relevant category of clients.

For professional clients as end-clients


Firms are entitled to assume that professional clients have the required knowledge and experience to understand the risks attached to the particular products or services for which

they have been classified as a professional client16. MiFID nonetheless, makes a distinction between per se professional clients and elective professional clients – providing that clients in the latter category should not be presumed to possess the knowledge and experience comparable to per se professional clients. Therefore, firms should, when carrying out their target market identification, consider the differences in assumed knowledge between retail and professional clients and, within the professional client category, elective professional clients and per se professional clients.

It is possible that some products will have a widely defined target market that might include both retail and professional clients. However, some other products, in particular products that have complex risk profiles, will have a more narrowly defined target market.

For eligible counterparties as end-clients

MiFID II seeks to increase the protections afforded to non-retail clients, extending certain information and reporting requirements to firms’ dealings with eligible counterparties. While firms are not obliged to apply the requirements in Article 24 of MiFID II when entering into transactions with eligible counterparties (Article 30(1) of MiFID II), they will still need to ensure that they act “honestly, fairly and professionally” and communicate in a way that is “fair, clear and not misleading” in their dealings with eligible counterparties. Furthermore, the requirements set out in Article 16(3) of MiFID II apply irrespectively of the nature of the client (retail, professional or eligible counterparties), 85. Where the target market of end-clients is composed solely of eligible counterparties, the overall assessment is likely to be less comprehensive.

Source: ESMA Guidelines on MiFID II product governance requirements

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