Revised ESMA Guidelines on MiFID II Product Governance Requirements

On 27 March 2023, ESMA published the final Guidelines on MiFID II product governance requirements. They are being currently translated into the official languages of the EU and will become applicable two months after the date of the publication on ESMA’s website in all EU official languages.

Background

The product governance requirements introduced by MiFID II are one of the key elements of the investor protection framework, which aims to ensure that the financial products are manufactured and/or distributed in the best interests of the client. Therefore, firms manufacturing products for sales to clients or distributing products to clients shall meet certain product governance obligations such the identification and periodical review of the target market for each product and the development of a distribution strategy which is consistent with the target market.

On 8 July 2022, ESMA launched a public consultation on the Guidelines and collected feedback until 7 October 2022. The review of the Guidelines which was published in 2017 was needed in order to consider i) the amendments introduced by the Capital Markets Recovery Package and subsequent MiFID II Amending Directive; ii) the sustainability-related amendments to the MiFID II Delegated Directive; iii) the recommendation by ESMA’s Advisory Committee on Proportionality (ACP) and iv) the shortcomings evaluated in the Common Supervisory Action (CSA) on product governance.

The revised Guidelines aimt to:

• reduce the risks of mis-selling and related financial consequences and therefore the risks of complaints, litigation costs, fines as well as negative impact on reputation;
• reduce the risks of regulatory and supervisory arbitrage and achieving positive effects from increased harmonisation and standardisation for investment firms and competent authorities;
• reduce the risks of greenwashing in the manufacturing and distribution of products.

Key concepts of the ESMA Guidelines

The most important amendments to the Guidelines concern the following topics.

Specification of any sustainability-related objectives a product is compatible with

Following the public consultation, ESMA has decided not to significantly amend its initial proposal. Therefore, the revised Guidelines stipulate that firms should specify any sustainability-related objectives the product is compatible with within the category “clients’ objectives and needs”. However, ESMA allows firms to choose whether or not to match the target market with respect to the sustainability objectives with the definition of sustainability preferences under suitability. 

Additionally, ESMA took the decision not to further amend the specific point at this stage on whether a manufacturer should specify the sustainability-related objectives of a product by referencing sustainability data of either the issuer of the product or of the product itself. This decision was made to avoid being too prescriptive and to enable companies to take a flexible approach.

The revised Guidelines specify that for products which consider sustainability factors, a negative target market assessment should always be performed with respect to the five target market categories (i.e. client type, knowledge and experience, financial situation, risk tolerance and objectives and needs), but the sustainability-related objectives of these products should not be considered when performing such a negative target market assessment. Consequently, the products with sustainability factors can be made available to clients with and without sustainability preferences.

Practice of identifying a target market per cluster of products instead of per individual product (“clustering approach”)

The Guidelines confirm that firms may decide to define the target market by adopting a common approach for products with comparable features (i.e. clustering approach). Firms should use a sufficient level of granularity to ensure that only products with sufficient comparable characteristics are clustered together. ESMA outlines that firms should use a non-exhaustive list of key factors (e.g. risk factors, liquidity, capital protection clauses, charging structure, currency, etc) to define the appropriate clusters, and should document accordingly why each specific product belongs to a specific cluster. 

Furthermore, ESMA confirms that the target market assessment for complex and risky products such as Contracts for Difference (CFD) should be conducted very carefully and should lead to a very narrow target market, which is confined to high-risk seeking clients.

In the final Guidelines, ESMA deleted the reference to certain Over-the-Counter (OTC) derivatives and structured products to clarify that there is no exemption to the use of a clustering approach for these. Nevertheless, it is stressed that the more complex the underlying products of a cluster become, the more granular the clustering should be.

Determination of a compatible distribution strategy where a distributor considers that a more complex product can be distributed under non-advised sales 

The Guidelines outline that distributors should identify additional measures when more complex products are considered to be distributed under non-advised services to ensure that the distribution strategy is compatible with the product’s target market. For example, distributors could decide to only make the more complex product only available when requested by the client and not actively market such a product. ESMA specify that the products should not be distributed under non-advised services.

Periodic review of products, including the clarification of the proportionality principle

Manufacturers and distributors should review on a regular basis whether products and services are reaching the target market. In general, all products are subject to periodic review, however, the frequency and the depth of the reviews depend on the nature of the product. For example, for certain simpler products distributed under the execution-only exemption, product reviews can be less frequent and in-depth. 

Considering the feedback received during the public consultation, ESMA confirms that distributors should proactively inform the manufacturer whenever they have relevant information that could support reviews by MiFID II manufacturers.

In addition, in the final Guidelines ESMA outlines the responsibility for distributors to determine, on an ex-ante basis, what information is necessary to evaluate whether products are reaching their intended target market. Furthermore, the Guidelines state that firms must review their distribution strategy for more complex products that are distributed through non-advised sales in some cases (e.g. the review shows that such products are distributed too often outside the positive target market). Following the consultation, ESMA has chosen to eliminate the example of using a questionnaire to gather additional information about their clients. Nonetheless, it is emphasised that the general clarification that firms need sufficient information to carry out a product review still applies. 

Impact on Swiss financial service providers

Swiss-based firms manufacturing or distributing financial products to EU/EEA clients will be impacted by the revised Guidelines. Therefore, these firms are advised to reassess the existing product governance policies and processes in light of the new requirements. 

How can we support you?

Would you like to understand better the impact of the new Guidelines on your business, or do you need support in the implementation of the new regulatory requirements? Please do not hesitate to contact us.