With less than 5 months left before the deadline for MiFID II on 3 January 2018, firms are still grappling with the implementation of MiFID II. One key area is the new product governance framework which has been enacted with the objective of ensuring that firms act in the best interests of their clients during all stages of the product lifecycle process. Areas which have caused much contention within the legislation are the definition of “target market”, the new expansive obligations of the distributor and manufacturer, firms’ obligation to disclose information about their product cycle process and how firms manage conflict of interests. This article discusses these issues and the ways in which they affect a firm’s ability to sell, market and distribute their products to investors.
The new MiFID II framework applies to both the product development and sales process. In the delegated directive, “manufacturer is defined as investment firms that create, develop and issue the launch of new financial instruments … Whilst investment firms that offer or sell financial instruments and services to clients should be considered distributors”. However, their obligations within the framework are very different and rather complex. For example, manufacturers are required to manage conflicts of interest every time a new financial instrument is created. They also have a duty to ensure that “effective process and controls are in place during the production process of new financial instruments” On top of this, manufacturers are also required to evaluate the needs of their target market in relation to their client’s characteristics, needs and objectives. However, their duty of doing so is not as extensive like that of distributors because manufacturers generally do not have face to face contact with clients.
The responsibilities of distributors are to decide the target market for the financial instrument, regularly review financial instruments against their target market to ensure that they are “fit for purpose” and obtain relevant information from manufacturers. Firms that work with others are required to share information with other firms within the product cycle chain. But it is difficult for some investment firms to conclude on what side of the product cycle chain they fall into. For example, questions are raised as to whether firms that provide products and services within the secondary market, such as an execution only business, will be classified as distributor or manufacturer. This is because, with such business, the consumer would have requested specific investment without advice.
In one of JWG’s MIG meetings, which is one of our special interest groups, it was agreed that, in most cases, firms that provide such products on secondary markets will not be manufacturers. This may be because firms that operate on the secondary market do not actively create new products to be sold onto consumers and, as a result, such firms will not necessarily fall within the definition of a ‘manufacturer’ under the new product governance framework. Nevertheless, there are times where a firm may act as a distributor and manufacturer. In such cases, firms will have to comply with all the obligations set out for both manufacturers and distributors within the MiFID II product governance framework.
Conflict of interest
This presents more issues because, in instances where a firm is acting as both the manufacturer and the distributor of an investment product, it may be difficult to adhere to the obligation to avoid a conflict of interest in the design or creation process every time a new financial instrument is created. This is because when a firm is manufacturing and distributing the product at the same time, there is a potential to become biased with regards to their own financial instruments, irrespective of whether the product meets the clients’ characteristics or needs. This is highly likely to cause a conflict of interest for such firms and may challenge them to fulfil all the obligations of manufacturers and distributors. Their ability to be impartial may also be compromised and this may affect the way in which they can efficiently act in the best interests of their clients.
It seems that the regulator has provided some guidance for firms who may be at risk of breaching market integrity. Within the delegated directive, potential conflicts of interest must be analysed each time a financial instrument is manufactured. So, for firms acting as a manufacturer and distributor, this means that, each time they create a new financial instrument, they will have to analyse whether there is a risk that it conflicts with their position as a distributor of that product and how it may adversely impact their potential clients. In one of our MIG meetings, it was decided that firms would not only have to amend their conflict of interest policies but would also have to document evidence of mitigation and update disclosures to explain when a specific conflict of interest cannot be mitigated. In this way, it may make it easier for firms that operate both as manufacturers and distributors of investment products to effectively explain why the conflict is there and explain why such a conflict of interest may be difficult to mitigate in the production process.
Liability under Co-manufacturing
Another issue with the MiFID II product governance framework is the question of who is liable when an investment product does not comply with the MiFID II product governance framework, especially in instances where firms collaborate with others to co-manufacture an investment product. Is the manufacturer liable or the distributor?
As MiFID II is a European market based regulation, third party investment firms from third countries are unlikely to be willing to disclose certain information in relation to the creation and specification of their investment product due to competition issues. Firms are concerned about this especially in instances where a distribution firm, which is based in the EU, has sold an investment product manufactured by a third-party firm which is not based in the EU. It is highly likely that the distribution firm based in the EU would be held liable for selling a product that does not comply with the MiFID II product governance framework.
During one of our MIG meetings, it was discussed that, in situations where this is the case, firms should outline their mutual responsibilities in a written agreement. However, to ensure that all the necessary information is being shared between manufacturers and distributors, a strict set of criteria should be issued to allow standardisation within the industry. Nevertheless, there is still uncertainty as to whether agreements will be standardised or whether a centralised store will be implemented.
Is ‘target market’ ill defined?
How information will be shared between EU based firms and international firms is not the only issue concerning investment firms – the definition of “target market” under the framework has also caused a lot of debate within the industry.
According to ESMA’s Final Report guidelines on MiFID II, “target market” is one of the cornerstones of the product governance framework, yet it has not been granularly defined in ESMA’s report.
The industry has been presented with six core principles which firms will need to take into consideration when they are assessing the approximate distribution channel which is proportionate to their ‘target market’:
- The type of clients at whom the product is targeted.
- The knowledge and experience of the investors.
- The financial situation of the investors and their ability to bear losses as a result.
- The ability of the target market to bear losses and take more risks.
- The financial objective of the investor.
- The client’s need for the investment product.
ESMA has pointed out that, as manufacturers do not usually have direct client contact, the six categories can be used as “examples for orientation purposes”. On the other hand, distributors will have to provide much more detail to ensure that the means they use to distribute their products is proportionate to their target market. In one of our MIG meetings, it was discussed that, in instances where firms provide more complicated products, more granular detail should be used to identify the target market, but when products are less complex, less detail may be necessary. What is evident under the new framework is that there will have to be an increased level of coordination between manufacturers and distributors to ensure that, at both ends of the product cycle, there is a consensus on the definition of ‘product target market’ when investment products are being marketed to investors.
Are there similarities between MiFID II and the existing PRIIPs KID requirements?
Despite the issues firms may have implementing the new MiFID II product governance framework, there are some similarities between the framework and the existing PRIIPs regulation which currently covers packaged retail investment products and insurance based investment products. For example, under the MiFID II product governance framework, firms are required to provide information to investors about all the associated risks involved in investing in a financial instrument. Similarly, under the PRIIPs regulation, manufacturers are required to provide a brief description of the risk reward profile.
The way in which firms are required to take a scenario analysis is also similar. Under MiFID II, investment firms are required to undertake scenario analysis of how their financial instrument would perform in adverse conditions, for example, if the market environment deteriorated or if the manufacturer or the third party involved in manufacturing the product experienced financial difficulties. Similarly, in Article 8 (3) under PRIIPs, the KID firms are required to provide investors with scenarios of how financial instruments would perform in adverse conditions. What differs between the MiFID II product governance framework and the KID is that, these scenarios under PRIIPs Article 8 (3) are broken down into three sub-categories: unfavourable scenarios, moderate scenarios and favourable conditions. The similarities show that there is a crossover of obligations between MiFID II and the PRIIPs regulation and, as a result, for firms that sell PRIIPs products, implementing this part of the MiFID II product governance framework may merely be an enhancement to procedures which already exist.
There is still uncertainty as to how firms will be able to leverage scenario analysis used under the PRIIPs regulation for MiFID II retail clients, professional clients and ECPS. This is mainly due to product complexity and the levels of skill and experience professional clients will have in comparison to retail clients. As a result, it has been suggested that the proportionality principle could be applied. However, for firms to do so, they would require validation of this approach from the regulator. In addition to this, the way in which the scenario analysis is undertaken under PRIIPS differs from what is required under MiFID II. There was a general agreement in one of our MIG meetings that only the worst-case scenario under PRIIPs could be used to meet the MiFID II product governance requirements. In this way, it will help firms to simplify the way in which they approach product scenario analysis and ensure compliance with the new MiFID II product governance framework.
Will product scenario analysis need to be disclosed to distributors?
During one of our MIG meetings, it was also questioned whether manufacturers will have to disclose to distributors the results of their product scenario analysis. Participants concluded that it would be part of the product approval process based on the EC Commission Delegated Directive of MiFID II. Perhaps this is because the distributors are required to define the events that could materially affect the potential risk to their target market. Thus, by manufacturers disclosing the results of their scenario analysis, it may help distributors to effectively communicate to their specified target market the risks associated with investing in a financial instrument. This, in turn, may also help firms to comply with the requirement to ensure that the financial instrument meets the characteristics and needs of the clients.
What about costs and charges disclosure?
There also is a crossover between the PRIIPS regulation and MiFID II product governance framework in relation to the disclosure of costs and charges. Under PRIIPS, a calculation methodology is used which allows firms to capture all the costs and charges incurred by firms, such as one-off costs, ongoing costs and incidental costs. In addition, this data is calculated on an annual basis meaning that firms can provide clients with all relevant information in relation to the costs of investing in financial instruments. In ESMA’s recent Q&A it was suggested that this data should be used by firms to fulfil their obligations for MiFID II ex-ante costs and charges. In Article 50(a)MiFID II firms are required to use incurred costs as a proxy for the expected costs and charges and, in instances where this information is not available, firms are required to use reasonable estimations of the expected costs and charges. If firms adopt the methodology used to calculate the costs and charges under PRIIPS regulation, it may make it easier to make estimations of the costs associated with their instrument when their actual costs are unavailable.
The pending MiFID II product governance framework will have a significant impact on the way in which investment products will be sold to clients, but the complexity of investment products has arguably not been fully recognised. Whether MiFID II product governance requirements will improve investor protection within the industry may only become clear after the implementation of MiFID II on 3 January 2018.
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