ESMA lays out product governance guidelines for sale of financial products

ESMA has published its final report on product governance guidelines under the Markets in Financial Instruments Directive II (MiFID II).

The guidelines (55-page / 714KB PDF) set out a series of steps for companies involved in the production and sale of financial products and services to follow to enhance investor protection by regulating all stages of the life-cycle of products or services. The requirements aim to ensure that companies which manufacture and distribute financial instruments and structured deposits act in their clients’ best interests.

Producers and distributors must identify a target market for their products, using not just quantitative but also qualitative measures. ESMA said it had decided to develop guidelines focusing on target market assessment in order to ensure the “common, uniform and consistent” application of the MiFID II product governance requirements.

Factors which companies must specify include the knowledge that target clients should have about the products into which they are investing, the extent to which a potential client can bear losses, and the risk/reward attitude of the target market. Distributors must define their target markets on a more “concrete level” than manufacturers.

“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,” the guidelines said.

ESMA said investment companies' decision-making processes about their service and product universe, together with the identification of a target market, “should directly influence the way in which the firm's daily business is conducted”.

Producers and distributors also need to decide if a product is incompatible with certain clients, applying the same principles as those used to identify target markets. ESMA said companies needed to apply proportionality to their identification processes for both target markets and 'negative' target markets.

Where a company is selling a product that was not designed in accordance with the MiFID II product governance requirements, it must still determine a target market and ensure it has relevant information in order to distribute the product. 

The final report follows a consultation paper issued in October last year. Following the responses to the consultation and advice from the Securities Markets Stakeholder Group, ESMA modified the guidelines in some areas such as the topic of portfolio diversification and provided practical examples in order to ease the application of the guidelines.

Authorities regulating the companies to whom the guidelines apply need to incorporate them into their supervisory practices, and have two months to declare whether or not they will comply with the guidelines.

MiFID II applies from 3 January 2018. The second iteration of the directive updates the existing MiFID rules applicable to investment services across the European Economic Area (EEA), taking into account developments in the trading environment since the original directive came into force as well as aiming to strengthen investor protection and increase market resilience. The revised regime will also apply to a broader range of financial instruments, trading venues and techniques, including the use of algorithmic high-frequency trading.

The directive's implementation was delayed a year to allow technical work to be finished.

ESMA recently clarified the scope of the transparency and transaction reporting requirements for over-the-counter financial instruments, which are also covered by the directive.