At the start of February 2021, the European Securities and Markets Authority (“ESMA”) announced the launch of a common supervisory action (“CSA”) with national competent authorities (“NCAs”) on the application of product governance rules (“PROD”) under the MiFID II Directive (2014/65/EU) across the European Union (“EU”).
In the announcement, ESMA stated that its guidelines on the topic in 2017 and its published series of Q&As (which are updated from time to time) (the “ESMA Q&A”), will be considered for the CSA, to be conducted later this year. The CSA will aid the analysis of:
- how manufacturers ensure that the costs and charges of financial products are compatible with the needs, objectives and characteristics of their target market and do not undermine the financial instrument’s return expectations;
- how manufacturers and distributors identify and periodically review the target market and distribution strategy of financial products; and
- what information is exchanged between manufacturers and distributors, and how frequently this is done.
ESMA believes that the CSA and the related sharing of practices across NCAs, will help ensure consistent implementation and application of EU rules and enhance the protection of investors in line with its objectives. For the purposes of this article, we have focused on the feedback by ESMA in their Q&A on points 1 and 2 above, whereas point 3 will be covered in more detail once the CSA is published.
WHAT THIS MEANS FOR FIRMS
The introduction of PROD was formalised in 2014 and the FCA Handbook regarding PROD subsequently transposed the requirements of MiFID II into UK legislation. PROD applies to all MiFID investment firms, amongst other categories of covered entities. Such firms in the UK are no doubt waiting (together with their European counterparts) with bated breath to see how countries and firms are coping with the implementation of the PROD rules. Whilst the CSA is looming, it is a good reminder to firms to revisit their PROD set-ups and ensure alignment as much as possible with the ESMA guidelines, which set out comprehensively, the PROD framework expected of firms.
Additionally, we highlight to firms the following from ESMA’s Q&A which directly relate to the first and third areas of analysis (stated above) by ESMA to be the focus of the CSA.
Area 1: How manufacturers ensure that the costs and charges of financial products are compatible with the needs, objectives and characteristics of their target market and do not undermine the financial instrument’s return expectations.
Section 16 (Product Governance) of ESMA’s Q&A sets out the following points addressed by ESMA:
- as part of the product approval process, firms should have clear and robust policies and procedures to identify and quantify all product related costs and charges and this would encompass all implicit and explicit product costs as well as service costs likely to be incurred by the client (e.g. inducements);
- firms should assess if and how the costs identified are compatible with the envisaged target market of the product and whether adjustments are needed, and should substantiate how cost structures and components are compatible with the characteristics of the target market. For example, firms should ensure that a financial instrument with significant up-front costs should not have in its target market clients with investment horizons that are too short for possibly retrieving the costs from expected returns over time;
- during the product design phase the manufacturing firm shall undertake a scenario analysis of their financial instruments and, in this context, simulate product returns taking into account all costs of the instruments (implicit and explicit);
- in order to ensure that charges do not undermine the financial instrument’s return expectations, firms could, for example, assess the consistency between costs and return of a complex product through the Monte Carlo methods. Alternatively, or additionally, firms could, for example, undertake a scenario analysis to assess whether the costs of the product (implicit and explicit) are inferior to the expected return. Firms could also assess whether the expected net return is consistent with those expected for similar products available on the market. The methodologies (and other methods are permitted) should in any case be robust and well documented, with a clear identification of roles and responsibilities in the process;
- manufacturers can also calculate the fair value of a product and compare this value with the (expected) price of the product vis-à-vis the end client and assess if the result is consistent with the current practices for similar products available on the market;
- manufacturers should also include the typical taxes end-clients would have to pay (e.g. capital gains taxes) when calculating whether the costs and charges could undermine the financial instruments return expectations;
- target clients should be able to access and choose the product(s) that best serve their needs, objectives and characteristics by assessing all relevant costs and benefits of the product(s). Therefore, during the product design phase the firm should ensure that the charging structure of the product is not opaque, hard to assess or designed to mislead clients and to exploit behavioural biases;
- ESMA expects firms to:
- ensure that artificially low initial rates/costs are not used to attract and mislead unsophisticated clients;
- avoid the use of unnecessarily complex formulas for the determination of costs;
- avoid too many cost components or unnecessarily splitting cost components in too many elements if this reduces clarity;
- consider, in cases where the cost structure is particularly complex, the possibility of some form of testing of the cost disclosures to ensure that these are not too complex to understand based on the characteristics of the target clients; and
- assess whether there is no duplication of costs (e.g. the same type of fee is not included in two different cost categories) and ensure that costs are properly separated and accounted for.
Area 3: What information is exchanged between manufacturers and distributors, and how frequently this is done.
The Q&A mentioned that firms should bear in mind that Article 9(13) of the MiFID II Delegated Directive requires manufacturers to provide to distributors all information necessary to understand and recommend or sell the financial instrument properly. In ESMA’s view, this also includes information about the product-related costs and charges, which also enables distributors to provide ex-ante and ex-post cost transparency to clients according to Article 24 (4) MiFID II.
FCA’s PRODUCT GOVERNANCE REVIEW
Helpfully, in the UK, the FCA published the results of its “MiFID II: product governance review” on 26 February 2021, which might give some indication of how UK firms are faring (based on a limited representation sample) and what to work on, although a full review against PROD and the ESMA guidelines would of course provide a better picture on a firm-by-firm basis. We will summarise the key findings of that review in due course.
We think it’s safe to say that the PROD regulatory arena is one that would well deserve the tagline of, “Watch This Space”, given the ongoing CSA and FCA’s indication in its review, that part of the FCA’s work would be to consider whether it needs to make further changes to product governance rules and guidance, for both asset managers/manufacturers and distributors and whether these changes will better address the key sources of harm throughout the product lifecycle.
For more information, and any guidance or advice on PROD, Cleveland & Co External in-house counselTM, your specialist outsourced legal team, are here to help.