A financial instrument that suits all investors is more likely to be a top seller than one with a small target market. Before financial products are sold, the manufacturers must identify the target market, i.e. the potential investors, for their products. Distributors such as banks are required to have their own product approval process for third-party products, but they are also permitted to make use of the target market identified by the manufacturer – provided they critically review it (see info box “Product Governance in Securities Trading”). Does this work?

As part of its survey on the distribution of structured notes, BaFin discovered that almost two thirds of the distributors surveyed (see info box “Structure of the market survey") use the target market specified by the manufacturers without making any changes. If the target market is too broad, however, this could result in investors being offered structured notes that do not meet their needs.

Common minimum standard

Since 2017, a voluntary “common minimum standard for the identification of a target market” has become established in practice; this minimum standard was drawn up by the German Banking Industry Committee (Deutsche Kreditwirtschaft – DK), the German Investment Funds Association (Bundesverband Investment und Asset Management – BVI) and the Deutscher Derivate Verband (German Derivatives Association, DDV).

The minimum standard facilitates communication between manufacturers and distributors on the basis of uniform target market criteria, both before and after a financial product has been placed on the market.

Delegation of responsibility

The market survey revealed that 65% of distributors used the manufacturers’ target market without any changes. This is not always wrong; distributors can reach the same conclusion as manufacturers. But if distributors simply use the target market without conducting their own assessment, they delegate their share of responsibility to the manufacturers. By virtue of their proximity to the clients, however, it is the distributors themselves who know their clients’ needs best. In contrast, 35% of distributors changed the target market in some cases – usually by further narrowing its scope. They sometimes also corrected the manufacturers’ classifications where these were not plausible in light of the minimum standard.

Broad-brush results

Although most of the manufacturers complied with the agreed minimum standard, in some cases, this standard was applied without careful consideration. For example, manufacturers sometimes identified clients with only basic knowledge and limited experience as target clients for more complex tracker certificates. For 6% of the structured notes included in the survey, the distributors should have adjusted the target market categories but failed to do so. By defining uniform target markets for groups of structured notes that differ greatly in terms of their complexity and risk content, the manufacturers thus treated different products in the same way.

Conversely, some manufacturers sometimes defined different target groups for similar structured notes. They classified structured notes based on leveraged indices differently from factor certificates, which themselves have a leverage effect with regard to an index. Here, the distributors should have realised that the manufacturers were treating the same thing in different ways.

BaFin emphasises due diligence obligations of distributors

Against the backdrop of its market survey, BaFin is drawing the attention of all distributors, not just the 40 included in the survey, to their obligations. Under the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG), distributors are subject to extensive obligations as part of the product approval process. These obligations are further specified under section 12 of the Investment Services Rules of Conduct Regulation (Wertpapierdienstleistungs-Verhaltens- und Organisationsverordnung – WpDVerOV) and under the special section (BT) 5 of the Minimum Requirements for the Compliance Function and Additional Requirements Governing Rules of Conduct, Organisation and Transparency for investment firms (Mindestanforderungen an die Compliance-Funktion und die weiteren Verhaltens-, Organisations- und Transparenzpflichten – MaComp).

This means that, even if manufacturers and distributors make use of the same standards, distributors are by no means exempt from their due diligence obligations. In addition, the target market standard set out by the DK, BVI and DDV is only a minimum standard.

If this standard does not provide conclusive results, it may be necessary to further refine the target market. Blindly trusting this minimum standard does not guarantee compliance with regulatory obligations in all cases.
Under the proportionality principle, the product governance obligations increase in stringency according to certain characteristics, such as how risky, complex and illiquid the financial instruments are. It is therefore essential that distributors critically question the target market identified by the manufacturer.

Conclusion

German companies have achieved a high degree of standardisation in product governance. The common minimum standard set out by the DK, BVI and DDV provides a foundation for distributors to include financial instruments in the range of products they offer. BaFin expressly welcomes the establishment of this standard, and has requested market participants to further develop it.

The DK, BVI and DDV have already indicated that the results of the market survey are to be used to improve and further clarify the common understanding of the criteria for target market identification. They are also developing proposals on how to improve the assessment of target markets.

BaFin’s market survey has shown that, in order to effectively correct errors in the product governance process, distributors need to follow the steps for target market identification independently and impartially. BaFin will publish further questions and answers on matters of interpretation with regard to distributors’ obligations and will ensure, as part of its operational supervision, that distributors comply with these obligations.