Opinion: Elisabeth Roegele on product governance

"Product oversight and governance" (POG) is a collective term applied to a raft of new regulations affecting almost the entire financial sector. By implementing POG, European legislators have brought about a paradigm shift, because in the past customer-related organisational requirements and investor protection arrangements were primarily focused on the distribution process and the timing of providing a service to the customer. The new standards track the entire lifecycle of the financial products concerned, from the cradle to the grave: from product manufacture through product observation after distribution to the end of the product's life, for example when it is redeemed or matures.

The POG issue has received the most comprehensive treatment so far in securities regulation, namely in MiFID II¹, the revised version of the Markets in Financial Instruments Directive, which will have to be applied as from 3 January 2018. MiFID II, where the term has been shortened to product governance, contains a large number of requirements for financial instruments and structured deposits.

Commitment to greater investor protection

By including the product governance requirements in Article 16(3) and Article 24(2) of MiFID II, European legislators have committed themselves to a significant boost in investor protection. German legislators had already anticipated some of these requirements in the German Retail Investor Protection Act (Kleinanlegerschutzgesetz) of July 2015. The entire package of European regulations will now – to the extent required – be transposed into German law by way of the German Second Financial Markets Amendment Act (Zweites Finanzmarktnovellierungsgesetz). Manufacturers and distributors of financial products will have to implement the relevant processes in future.

Customer interests as a benchmark

MiFID II makes customer interests a key benchmark by which a product and the accompanying distribution strategy will have to be measured in future. Whether customer interests are satisfied will, however, depend on many different, sometimes variable, factors, such as the target group and the current market situation. What is more, customer interests can only be comprehensively safeguarded if they are taken into account during both manufacturing and distribution of the product and if manufacturing and distribution are coordinated and dovetail into each other. This means that not only the product approval process at the manufacturer, but also the equivalent process for including the product in the product universe of a distributor will have to feature a large number of process steps that can help to ensure that customer interests are safeguarded and the product is suitable for the needs of the respective customer group. Additional requirements are an observation process to keep continuous track of the development of the product as well as a review process that can be used subsequently to adjust products and distribution strategies, if necessary.

Product approval process

Specifically, the product governance requirements mean that manufacturers under the scope of MiFID II will in future have to set up a product approval process, which will have to be regularly reviewed. Products must not be approved for distribution without having passed through this process. Another objective of the process is to ensure that the manufacturers adequately understand and take account of the features and risks of the products they manufacture and their significance for the end customer. In addition, the product approval process is aimed at making management take greater responsibility for their firms' own products. This is made possible, for example, by reserving key decisions within the process for executive management.

Identifying the target market

The core element of the product approval process is to identify a target market for the product before distributing it to end customers. To this end, the end customers' investment objectives and their ability to bear potential losses are among the factors to be taken into account. Moreover, all the relevant risks associated with the product must be assessed, especially the risk of loss or default and the risk of fluctuations in value. The investment firm also has to ensure that the planned distribution strategy is suitable for the target market. The requirement to identify the target market is intended to make manufacturers and distributors rethink some of their approaches. It also goes without saying that both manufacturers and distributors want to generate profit, and quite legitimately so. However, the purpose of making them focus on the target market is to prevent these interests from dominating the product manufacturing process to such an extent that they lose sight of the interests of end customers. Since the customers for whom the product is intended will in future have to be specified at the beginning of the manufacturing process, their needs will be given special weight.

Convergence in Europe

In order to guarantee Europe-wide convergence in the application of these requirements, the European Securities and Markets Authority (ESMA) issued draft product governance guidelines in October 2016², providing more detailed information on the set of obligations manufacturers and distributors face with regard to the target market. According to these guidelines, manufacturers have to assess the target market at least on the basis of the following six categories, although the level of detail of the assessment may vary, depending on the complexity of the product and the planned channel of distribution: The categories to be included are the type of client – retail client, professional client or eligible counterparty –, knowledge and experience, the client's financial situation and their ability to bear potential losses. In view of the risk/reward profile of the product, the target client's risk tolerance must also be determined. Finally, the minimum criteria also include the end client's investment objectives and needs. A possible example would be an investor wanting to arrange their retirement provision using ethical investment products.

Identifying the distributor's target market

In order to achieve the required integration between product manufacturing and distribution, manufacturers will in future be obliged to provide information gained during their product approval process – especially on the target market – to the distributors. Distribution firms will be expected to critically examine the target market specified by the manufacturer, define it on a more concrete level on the basis of their customer base, and then implement it in practice. This means that, apart from specifically justified exceptional cases, they will be expected to market a product only to customers identified as target customers. In addition to the suitability assessment required at the investment advice stage or the appropriateness test that is necessary for more complex products in the non-advised business, the distributor will therefore have to establish for its client whether they belong to the target market identified.

The identification of the target market as a core element of product governance was so important to European legislators that they have extended it to products that are not subject to the manufacturer requirements of MiFID II. For these cases, legislators have assigned a kind of fall-back responsibility to distributors that cannot access information from the manufacturer's approval process in those instances: if a distributor wants to offer products for which the manufacturer has not specified a target market, because the manufacturer is not subject to the provisions of MiFID II or the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG), the distributor is required to determine the target market independently. If a third-country manufacturer fails to provide the necessary information, it could, for example, be obtained from reliable, publicly accessible sources, such as the securities prospectus. This could be a conceivable solution in the case of shares or corporate bonds issued in a third country that are to be traded in Europe in an execution only transaction.

Product monitoring obligations during the entire lifecycle

The new product governance rules entail monitoring obligations for manufacturers and distributors for the entire lifecycle of a product. This means that responsibility for the product does not end at the point of sale, but will in future extend to any consequences for investors and the financial system that arise from manufacturers and distributors having jointly launched a product. The aim of the monitoring obligations is to allow companies to detect at an early stage if product features in their market and customer environment develop counter to clients' interests.

Since effective monitoring is only possible with the requisite information about the product, another focus of the new requirements is on the communication processes between manufacturer and distributor. This means on the one hand that distributors receive the manufacturer's information from the product approval process. On the other, they send information suitable for product monitoring back to the manufacturer (e.g. experience made with the product, any complaints received, extent to which target market has been reached). If this exchange of information or the manufacturer's or distributor's own analyses give rise to relevant changes that could have a negative impact on products, appropriate measures will have to be taken. These could include, for example, passing information to customers or adjusting the distribution strategy.

BaFin's role

BaFin is actively involved in shaping ESMA's work centred on the European legislative process and the establishment of a uniform European administrative practice. For example, it conducts a large number of bilateral and multilateral discussions with association representatives and consumer protection bodies and gives public presentations on the product governance concept in MiFID II. In its supervision, BaFin will be closely involved in the organisational implementation of the product governance rules in the investment firm and – with a sense of proportion – ensure that the key objective of these amendments are realised, i.e. that conflicts with clients' interests are avoided at the earliest opportunity. Desired side effects include that the risks to companies are reduced and the European and German financial markets and their participants are strengthened.

Conclusion

The new product governance requirements, especially the rules on the target market and the newly required close cooperation between manufacturers and distributors, complement the existing conduct of business rules and will thus strengthen collective consumer protection. In addition, the product governance requirements will complement BaFin's product intervention powers, which apply already because they have been anticipated by the Retail Investor Protection Act: if – as an internal control measure – manufacturers and distributors identify the target market accurately and correctly, this can help ensure that financial instruments are only marketed to the appropriate target groups.

Information requirements and cost transparency

Communication on an equal footing between investment firms and clients is what investor protection aims to achieve by applying conduct of business rules – without depriving consumers of their right to be consulted. Both national and European regulation continues to be based on the concept of well-informed consumers who act under their own responsibility. In addition, other aspects, such as behavioural factors, are increasingly gaining importance. This is the reason why the information requirements to which the companies are subject under MiFID II have been expanded, in some cases significantly so. One focus of the new requirements is on the transparency of the costs associated with an investment service.

The current Securities Trading Act³ already requires detailed cost disclosure in accordance with MiFID I. However, this applies to the overall price the customer has to pay, rather than recurring and non-recurring costs, which have so far not been a particular focus. This is set to change. Another point is that many providers have in the past spread information on prices and fees across a large number of documents (for example the list of prices and services, the key information document or the client advice agreement) and only linked them with cross-references, which has made them all the more difficult to understand.

Disclosure of total amount

Pursuant to Article 24(4c) of MiFID II, all costs and charges of the product and investment service will in future have to be aggregated into a total amount – a requirement welcomed by consumer protection bodies. This total amount will be disclosed both before the respective service is provided (ex ante) and – where necessary – subsequently (ex post). Ex ante disclosures that cannot be accurately determined may be estimated as accurately as possible or based on calculation models. Ex post disclosures must refer to the costs actually incurred. To allow clients to keep an eye on the overall result, the effect that the costs will have on the return will also have to be explained, in addition to the ex ante and ex post disclosures.

Presentation more complex

Overall, the presentation of costs, with detailed information on intricate cost structures even within products and services, scenarios and diagrams, will become more transparent, but also more complex as a result. This manifests itself especially when analysing how this interacts with the way costs are presented in accordance with the PRIIPs Regulation, the Regulation on key information documents for packaged retail and insurance-based investment products. Together with other supervisory authorities, including the European Securities and Markets Authority, BaFin is working to ensure that the disclosures under the two sets of rules remain workable and comprehensible, although this is hardly likely to result in complete convergence. The main reason is that some aspects are not covered by the PRIIPs Regulation, but the provisions of MiFID II require them to be part of the cost transparency arrangements. One such example is the cost of service provision.

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