New product governance requirements came into force on 3 January 2018 in the shape of the amended European Markets in Financial Instruments Directive II (MiFID II) and its transposition into national law. Based on the concept of corporate governance, this term signifies a responsible and sustainable manufacturing and distribution process for financial products that is not (solely) geared towards the goal of maximising the company’s profits, but above all towards clients’ interests (see the “Product governance” info box). The new rules cover the entire life cycle of the financial products concerned.

Paradigm shift towards greater product supervision

The reason why the lawmakers introduced the new rules was the insight gained from the 2007/2008 financial crisis: complex products such as securitisations and leveraged products contributed significantly to the evolution and escalation of the crisis. Moreover, such financial instruments were distributed directly and indirectly – for example packaged into other structured products – to professional clients and retail investors, making them accessible to a broad range of investors.

As a result, the European lawmakers initiated a paradigm shift in 2010 in the shape of the revised MiFID Financial Markets Directive, broadening the previous supervisory law perspective in the field of investor protection: prior to this, regulatory activities mainly addressed financial services and distribution, but now there is a much stronger focus on products as well. The new requirements affect the entire life cycle of the financial instrument – from its manufacture, through its circulation in the market, down to the end of the product. The new requirements are aimed at “manufacturers” (who design and develop the products) and distributors and impose obligations on both of them through three new master processes: the product approval procedure, the process of communication between manufacturers and distributors, and the product review process.

Manufacturer’s product approval procedure

The product approval procedure lies at the heart of product governance. It specifies the manufacturer’s manufacturing process and uses numerous process steps to ensure that a new product is compatible with the interests and needs of the clients, and does not represent a threat to the orderly functioning or stability of financial markets. Before a product can be put into circulation, for example, the manufacturer must examine it to identify potential conflicts of interest, subject it to cost control and review it in a scenario analysis.

The manufacturer also has to identify a target market for each product (see “Target market” info box). In addition, the manufacturer defines a distribution strategy for the product and ensures that staff members and agents who are significantly involved in manufacturing financial instruments have the necessary expertise.

In practice, manufacturers often designate a two-stage product approval procedure: in the first stage, products in a particular product category – such as closed-ended alternative investment funds (AIFs) and plain vanilla bonds – pass through some of the process steps mentioned above. The second step defines the parameters that are specific to the individual instrument. For example, the manufacturer determines the risk class of the instrument in line with the defined target market. In BaFin’s view, such a two-stage procedure for product approval is generally allowed under the principle of proportionality.

Distributor’s product approval procedure

Just like the manufacturers, the distributors must also establish and implement a product approval procedure. However, since they do not manufacture products, the procedure plays a different role at this point: the firm has to decide on the basis of individual process steps whether to include a product or a service in its product range. This applies regardless of whether the products in question are simple or complex, or whether they are advised or non-advised business. If appropriate, however, the principle of proportionality means that the relevant process steps can be more or less extensive or detailed, depending on the type of product or service.

A firm should only include a product or service in its offering if it is certain that it can meet the legal requirements and take client interests into account in the distribution process. When deciding whether or not to add a new product, distributors – similar to the manufacturers – consider aspects such as potential conflicts of interest and staff expertise from the distribution perspective.

Distributors review the manufacturer’s target market identification and distribution strategy in light of the requirements of the distributors’ own clients. While manufacturers tend to make their decisions at a more theoretical level that is remote from contact with clients, it is the distributor’s responsibility to ensure the practical implementation of the manufacturer’s target market specifications and distribution strategy, and to adapt them accordingly.

Like the manufacturer, the distributor should also take its decision responsibly in the best interests of the client – and with in-depth knowledge of the product or service. To do this, it must anticipate the distribution process, the legal requirements to be complied with and their interaction with the characteristics and needs of the clients.

Reconciliation of the target market by the firm

If a firm has added a financial product to its offering, it is required to take into account the target market at the time of distribution each time it makes a sale. The firm examines whether the product is compatible with the characteristics of the individual client. To do this, it reconciles the target market data with the corresponding characteristics of the client.

Not all five target market categories have to be reconciled in each specific case. Distributors may match the depth of the examination to the investment service provided. For example, if the client is advised, the firm must in any case collect detailed information about the client for the additional suitability assessment that has to be performed. It can and must then perform all aspects of the target market reconciliation. But if the client approaches the firm on the client’s own initiative about purchasing a financial product without receiving advice, a comprehensive reconciliation will usually not be possible. In such a case, the firm will only examine the target market to the extent that it has the relevant information. As a rule, as a minimum the appropriate category and the knowledge and experience of the client will then be reviewed. If the distributor does not examine the target market in full, it must inform the client about the limited reconciliation

Product review process

Once the manufacturer and the distributor have finally brought a financial product into circulation, they are both required to monitor the product until the end of its life. This product review process ensures that modifications can be made at any time, for example to the target market and the distribution strategy, or that other responses can be made to changes affecting the product.

As a general principle, the manufacturer is best placed to assess how certain events will impact the functioning of the product, its risk or return, or its performance, among other things. In addition, as well as general opportunities for responding – for example, by informing the distributor and adapting the distribution strategy – the manufacturer has further options: as a rule, only the manufacturer will be in a position to make subsequent changes to a product. Nevertheless, the product review obligation also affects distributors, who can react better, for instance, in situations in which a manufacturer is no longer able to act, for example because it is insolvent.

Communication between manufacturers and distributors

It is therefore necessary for manufacturers and distributors to exchange information about the relevant products so as to ensure effective product governance. In the first instance, the manufacturer must establish and maintain a process for transmitting appropriate information from the product approval process to distributors. In turn, the distributors must be in a position to receive the information from the manufacturer and to use it in their own product approval procedure, for example by reviewing the manufacturer’s target market for any necessary modifications.

The German market has developed a minimum standard for identifying target markets so that manufacturers and distributors can use the same language for this exchange. It contains specifications for the individual target market categories and the distribution strategy. Although manufacturers and distributors are free to use their own communication standards to coordinate the information, the advantage of using the target market standard is that the information can also be exchanged via a data service provider. In the German market, this is WM Datenservice.

In the first step, manufacturers act as transmitters and distributors as receivers, but in the second step the law requires communication with reversed roles: distributors are required to support the manufacturer in its product governance process by providing it with appropriate sales information and other relevant information resulting from their own product governance process.

Product governance and administrative practice

As one of the most important innovations of MiFID II, product governance has already received much attention from the supervisory authorities. As early as June 2017, ESMA adopted the “Guidelines on MiFID II product governance requirements”, which expand on the requirements of MiFID II and its Delegated Directive regarding the identification of the target market. BaFin included these guidelines as a new BT 5¹ in the revision of its Minimum Requirements for the Compliance Function and Additional Requirements Governing Rules of Conduct, Organisation and Transparency for Investment Services Enterprises (MaComp) issued in April 2018, and thus implemented all aspects of its content.

In addition, BT 5 explains the aforementioned methodology for identifying the target market in the context of advisory business, non-advised business or execution-only business. Finally, there are also some specific features relating to portfolio management that have to be taken into account in product governance. For example, firms have the choice: Do they identify and reconcile the target market at the level of the individual financial product or transaction, as is the case in investment advice? Or do they define target markets for the investment strategies and reconcile these target markets with the client’s characteristics? In this case, they only have to examine the individual transaction for conformity with the investment strategy.

In addition to MaComp, BaFin also makes available interpretative decisions in the form of FAQs on MiFID II conduct of business rules in accordance with sections 63ff. of the Securities Trading Act (WpHG). It uses these FAQs to expand on the statutory product governance requirements, for example with information about the content and scope of the product governance compliance report.

Outlook

It remains to be seen whether the intention of the European lawmakers will be met and the MiFID II product governance requirements will lead to a more responsible and sustainable manufacturing and distribution process for financial products. It is above all the responsibility of the management boards of the firms to cultivate a good product governance culture. It should be considered that product governance cannot be completely standardised. Risk indicators, cost factors and many other product characteristics can be determined quantitatively and calculated automatically. However, it is equally important to assess the product qualitatively from the clients’ perspective with a sense of their needs, characteristics and objectives.

There is a good reason why the lawmakers placed product intervention as a further product supervision tool alongside product governance. This allows BaFin to intervene in situations where there are considerable investor protection concerns about products due to deficiencies in product governance. Equally, this also means that it will not be necessary for BaFin to intervene if product governance is successfully implemented and practised.

BaFin is currently conducting a market survey on product governance in order to obtain an overview of the implementation status of the new requirements. BaFinJournal will report separately on the results.

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