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Erscheinung:30.11.2022 Product governance: a lack of precision

A BaFin survey shows that the institutions that manufacture financial products and the investment firms that distribute them do not always adequately meet their product governance obligations. Shortcomings have been found in the cost-fee structure, for instance, which must be suitable for the potential investors.

Under the rules of product governance (see info box), financial products must be responsibly manufactured and distributed. But how do things look in real life? Do providers adhere to the requirements by informing, advising and protecting their customers as effectively as possible?

As part of an international market survey conducted by the European Securities and Markets Authority (ESMA), BaFin examined last year how 14 supervised institutions implement the requirements under the product governance regime. BaFin’s survey addressed:

  • four investment firms,
  • six private and foreign banks and
  • four savings banks/cooperative banks.

How did the institutions develop and distribute their financial products on the German market? The results show that in some areas there is clearly room for improvement.

At a glance

ESMA surveys

The European Securities and Markets Authority (ESMA) has conducted annual market surveys (common supervisory actions – CSAs) since 2019, and BaFin has regularly participated in these surveys. The aim is to bring the implementation of various European requirements into alignment – such as the investor protection rules set out in the Markets in Financial Instruments Directive (MiFID). In Germany, these rules have been transposed into the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG).

BaFin survey

Last year, BaFin surveyed 14 institutions to check on their implementation of the product governance requirements – specifically, to find out how they deal with these requirements in day-to-day business. Of the institutions surveyed, two are only manufacturers of financial products while seven are only distributors; five of the institutions are both. Manufacturers create, develop, issue or redesign financial products. Distributors sell, distribute, recommend, market or provide such products.

Target market identification and proportionality

Manufacturers of financial products and distributors, such as banks and investment firms, are required to identify the potential investors for each financial instrument – the clients for whom they have created it or to whom they intend to distribute it. The more complex a product is, the more detail they must use in defining this target market. Conversely: the less complex a product is, the less detailed the target market identification can be. This is what the proportionality principle says.

The survey shows there is room for improvement particularly with regard to the identification of the target market and the implementation of the proportionality principle. Neither manufacturers nor distributors always adequately fulfil their product governance obligations in these two respects.

Not only do manufacturers have to identify the target market for their products, they also have to ensure that the cost and fee structure of a product is a good fit for the potential investors. There were cases where this requirement was not adequately implemented either.

Manufacturers of financial products

When manufacturers customise their products to meet the needs of the group of potential investors, they are required to make use of specific features. For instance, they must ask the following with regard to a particular product:

  • What knowledge and experience with financial products should potential investors have if they intend to purchase this product?
  • What possible losses should they be able to absorb?

The answers they give will form the basis for defining the features to be used to create the product appropriate for these clients. Thus, for example, a product with a short-term maturity and multifaceted product characteristics is aimed at investors who have specific market expectations and some experience investing in securities. In contrast, the target market for such a product would not include inexperienced investors or those who wish to grow their assets in the long term. A product with a short-term maturity and multifaceted product characteristics is therefore usually aimed at a smaller, more specialised target client group than standard products, which are also known as “plain vanilla” products. Bonds and options often fall within this standard category.

The more complex a product is, the more comprehensive and in-depth the description of the individual features of the potential target clients need to be. If a product is designed in such a way that the repayment of the investment amount depends on the price development of a share or another underlying, for example, it must be specifically determined whether the product is also appropriate for retail clients and what experience and knowledge they would need in order to understand the product and be able to reach a well-informed decision.

BaFin pointed this out in a survey connected with the introduction of the European Markets in Financial Instruments Directive II (MiFID II) (see expert article on the BaFin website dated 1 April 2019).

Proportionate target market identification

As part of the BaFin survey, some of the participating manufacturers indicated that they did not distinguish between more complex and less complex financial products when identifying the target market. There are different reasons for this: two out of seven manufacturers identified the target market for all their financial products in exactly the same manner. Though three others made distinctions when identifying the potential investor group, they did not apply product complexity as a criterion.

Determining costs and fees

The cost and fee structure of a financial product must also suit the needs of the potential target clients. Manufacturers must ensure, for example, that financial products involving high initial costs are not made available to investors seeking a short-term investment. They would be unable to recover such costs due to the short investment period. As a rule, the costs should not absorb the expected returns – manufacturers must adhere to this principle in their calculations and assessments when identifying the target client group.

BaFin’s survey shows that three out of seven manufacturers only identify cost caps for their products. But this means they cannot ensure that a product design adequately reflects distinctions for the target client group with regard to costs and fees.

Distributors

The institutions acting as distributors are also, for their part, required to identify target clients for the products by reviewing the target market identified by the manufacturer and narrowing it down if necessary. While manufacturers identify the group of potential investors at an abstract level, distributors analyse their specific client base and – if need be – even more specifically define the investor group identified by the manufacturer.

Identification of the specific target market: precise and proportionate

As a rule, distributors specify the target market for the product once they receive the abstract target market identification from the manufacturer. Nevertheless, manufacturers and distributors are generally permitted to jointly identify the group of potential investors. Even in such cases, distributors are still responsible for reviewing and, as necessary, further refining the target market.

BaFin’s survey shows, however, that four out of 12 distributors simply accept the target market as identified by the manufacturer, without reviewing it, and do not identify a specific target market of their own.

A survey conducted by BaFin in 2020 on the distribution of structured notes (Zertifikate) had yielded similar findings (see expert article on the BaFin website dated 8 December 2020): even back then, most of the distributors surveyed uncritically accepted the identified target market without making any changes whatsoever.

BaFin subsequently published questions and answers on matters of interpretation, aiming to strengthen consumer protection by specifying the product governance requirements. This is also why BaFin wanted its present survey to clarify whether the shortcomings described in the past still exist today. The results show that the institutions have dealt with the past findings at a basic level, but not comprehensively.

Finally, the distributor must likewise adhere to the principle of proportionality when determining the specific target market. This means that the more complex the distributed product is, the more detailed the features must be that the distributor uses to identify the specific target client group. However, only three out of 12 distributors surveyed indicated that the level of detail with which they identified target markets for more complex financial products corresponded with BaFin’s expectations.

Common minimum standard for better exchange of information

Since 2017, a voluntary “common minimum standard for the identification of a target market” has become established in Germany – initiated by the German Banking Industry Committee (Deutsche Kreditwirtschaft – DK), the German Investment Funds Association (Bundesverband Investment und Asset ManagementBVI) and the German Derivatives Association (Deutscher Derivate Verband – DDV). There is a similar initiative at the European level: FinDatEx. This joint structure provides European market participants with standard templates designed to simplify the exchange of information.

The minimum standard helps manufacturers and distributors by setting out uniform target market criteria and features and facilitating the exchange of information between the two parties. The industry is thus significantly helping to ensure the variety of products available. It is only when target market criteria and characteristics are standardised that institutions will also distribute third-party products, giving clients access to a wider range of products through the distributors.

At the same time, the standardisation must not adversely affect the informative value of the target market identification or cause manufacturers and distributors to become less conscientious in how they treat certain product features.

Not to be overlooked is the fact that even if manufacturers and distributors make use of a standard, distributors are still responsible for determining the specific target market. The use of the standard does not lessen their duty to exercise diligence. All of the supervisory requirements mentioned above remain unaffected.

Next steps

BaFin conducted its survey as part of an international market survey carried out by ESMA. The findings identified at the European level, published in July 2022, show that there is also room for improvement in other European countries when it comes to implementing the product governance requirements.

ESMA is currently amending its guidelines for product governance in Europe. Although the amendments primarily address aspects of sustainable finance, the guidelines – open for consultation until 7 October 2022 – will incorporate the findings of the market survey from last year. These findings are thus expected to give rise to the tightening of several requirements regarding target market identification.

The institutions that drew BaFin’s attention in the course of the survey have been called on by the supervisors to remedy the shortcomings. BaFin will also continue to monitor developments in relation to the product governance regime and its implementation on the market. The same applies to the ESMA guidelines mentioned above.

At a glance:Product governance for more consumer protection

The concept of product governance – named after the term corporate governance – calls for a responsible and sustainable manufacturing and distribution process for financial products. This process focuses less on maximising a company’s profits and more on the interests of its clients. Even in the development stages of a financial product, a manufacturer is expected to define potential investors and thus ensure that the product meets their needs and can be manufactured for them. The cost and fee structure of the product must also be suited to the potential investor group’s requirements. In practice, this means that different – and sometimes very complex – financial products should not be made available to professional or retail clients at the same time.

The product governance regime affects the entire lifecycle of the product. Both product manufacturers and distributors have various obligations in this respect – they must identify a target market, for example, to be able to manufacture and distribute products. In addition, manufacturers and distributors must monitor the product on an ongoing basis and extensively exchange information.

Additional information can be found in an expert article on the BaFin website dated 8 November 2018.

Author

Kerstin Yoo
Division WA 41
Policy Issues Relating to Investment Firms Supervision and Supervision of Investment Firms

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