MiFID II brings in for the first time at European level detailed product governance requirements for investment firms, which include the identification of a product’s “target market”. The requirements cover both firms that manufacture products and those that offer or recommend products to clients (ie distributors). ESMA is now consulting on guidelines for investment firms on identifying the target market.
The guidelines will also impact UCITS and AIF managers. Although they are not directly subject to MiFID II, fund distributors are and they will have to seek information from fund managers about their product governance process and the identified target market of the fund. The Insurance Intermediation Directive includes similar provisions and EIOPA’s guidelines for insurance firms are likely to be closely aligned with ESMA’s for investment firms. ESMA’s proposals are therefore of interest to all three sectors.
Under MiFID II, for all products, whether sold or marketed to retail or professional investors or to eligible counterparties, manufacturers must put in place proper product governance processes, from inception and throughout the life of the product. They must ensure that products are manufactured to meet the needs of an identified target market of end-clients, that their distribution strategy is compatible with the target market, that they take reasonable steps to ensure that the products are distributed to the identified target market (which requires a regular flow of data from distributors), and that they periodically review the identification of the target market.
ESMA states that the guidelines should be applied in a proportionate manner, taking into account the nature, scale and complexity of a firm’s business and considering the nature of the product. For simpler and more common products that are compatible with the mass retail market, the target market can be identified with less detail than e.g. CFDs or structured products with complicated return profiles. However, the guidelines also require the identification of the “negative” target market (i.e. not only to which sort of investors the product is targeted but also to whom it is not intended to be sold). Moreover, there may be a grey area in between the positive and negative identifications.
The guidelines distinguish between how the requirements should be met by manufacturers and by distributors, and recognize that some MiFID financial products (including shares and investment funds, for example) are not issued by firms that are themselves subject to MiFID II. In these cases, the requirements fall squarely on the distributors, but fund managers will wish to provide information to distributors so that their funds can be distributed without undue restriction.
ESMA proposes a base line of six categories that manufacturers should use for defining a product’s target market: the type of client; their knowledge and experience; their financial situation, with a focus on ability to bear losses; their risk tolerance and compatibility of the product’s risk/reward profile; their objectives; their needs. It acknowledges that manufacturers do not usually have direct contact with the end client. Therefore, the target market identified by the manufacturer may be abstract, whereas distributors should define the target market in a more granular way, taking the manufacturer’s definition and overlaying detailed knowledge and analysis of its own client base.
The target market identification is distinct and serves a different purpose from the suitability and appropriateness test, but established market or distributor practice can be drawn upon to assist with some aspects of the target market identification process.
Manufacturers should employ a distribution strategy that favors the sale of the product to its target market (e.g. discretionary mandates, advised or execution-only, and face-to-face or online). The distributor must seek to ensure that the product ends up with the “correct” type of client or in the relevant component of their portfolio (i.e. to reflect their short, medium or long term objectives and needs) or so as to create a suitably diversified portfolio. However, the sale of a product to a client within the product’s identified negative target market “should be a rare occurrence and the justification for the deviation should be accordingly significant”.
Overall, the draft guidelines are in much better shape that early drafts seen by some in the industry. Firms will wish, though, to consider carefully how they would apply the guidelines in practice and respond to ESMA by the deadline of 5 January 2017.