MiFID II: Product Governance
The revised Markets in Financial Instruments Directive (2014/65/EU) (MiFID II) that is due to take effect from 3rd January 2018 is set to usher in a wide range of new and sweeping reforms that are aimed at improving the competitiveness of financial markets and increasing the degree of harmonised protection for investors throughout the European Union (EU). As part of these reforms, the new ‘Product Governance’ requirements are aimed at putting in place a strong and robust framework for the way financial services firms (including discretionary investment managers) manufacture and distribute products.
MiFID II Product Governance Rules
Article 16(3) of MiFID II specifies that Investment Firms that are manufacturing Financial Instruments for sale to clients must maintain, operate, and review a process for the approval of each Financial Instrument, as well as significant adaptations of existing Financial Instruments, prior to them being marketed or distributed to clients. This product approval process must not only specify an identified target market of end clients within the relevant category of clients for each Financial Instrument, but it must also ensure that all relevant risks to this identified target market of end clients are assessed, and that the intended distribution strategy is consistent with the identified target market.
Investment Firms must also put in place review procedures so that they can regularly review Financial Instruments to ensure that they take into account any event that could materially affect the potential risk to the identified target market, and also to assess whether their Financial Instruments remain consistent with the needs of the identified target market. This includes an assessment of whether the intended distribution strategy of the Investment Firm remains appropriate. If an Investment Firm is manufacturing Financial Instruments it must make available to all distributors all appropriate information on each Financial Instrument and the product approval process, including the identified target market of the Financial Instrument.
Under Article 24(2) of MiFID II Investment Firms that are manufacturing Financial Instruments intended for sale to clients must also ensure that those Financial Instruments are designed to meet the needs of an identified target market of end clients within the relevant category of clients. These Investment Firms must ensure that they understand the Financial Instruments they offer or recommend, they assess the compatibility of the Financial Instruments with the needs of the clients to whom they provide Investment Services, and they also take account of the identified target market of end clients.
One of the objectives of the new product governance rules is that Investment Firms only offer or recommend Financial Instruments that are in the interest of the client. This new product governance framework for Investment Firms will certainly require widescale changes to existing internal systems in order to ensure that those systems can effectively identify target markets and ensure compatibility with a client’s investment profile. However, in light of numerous mis-selling scandals (e.g. Endowment Mortgages, Payment Protection Insurance, Over-the-Counter Derivatives) the new product governance rules are a welcome new addition to the financial investor protection framework in the EU.
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