UNITED KINGDOM: MiFID II: product governance review

Monday March 1 2021

On 26^th February 2021, the Financial Conduct Authority (FCA) published its MiFID II product governance review and its key findings in 4 main areas: product design, product testing, distributors and governance & oversight.

This review looked at product governance in a sample of 8 asset management firms. It examined how these firms, as product providers (manufacturers), take MiFID II’s product governance rules into account, particularly the interests of the end clients, throughout the product lifecycle.

Key findings by area

The FCA  group its key observations into 4 main areas: product design, product testing, distributors and governance & oversight.

Product design

The FCA observations here focused on how well firms assess the negative target market and conflicts of interest.

Negative target market

Of the firms in the review, only 1 manufacturer appeared to have considered the ‘negative target market’ concept, but it could not identify the specific group of consumers that would be a ‘negative target market’ for its UCITS and NURS products. The FCA also heard of a negative target market that overlapped with an existing investor-base. In this case, the negative target market was defined as investors who wished to hold the investment for longer than 5 years, yet the firm recognised that some investors could remain invested beyond that timeframe.

Conflicts of interest

All firms in their sample had a framework for managing conflicts of interest, but not all appeared to be effective.

The FCA expect firms to identify, manage and mitigate potential conflicts while providing a service. They should consider whether there are certain product characteristics, such as charges, objectives or its general operation, that could benefit the firm at the expense of the end investor. They should also consider whether there are conflicts which may create incentives to favour one set of investors over another. It is important to manage any potential conflicts in such cases while considering information involving the target market and distribution strategy. Simply having a framework in place is not enough; the ultimate outcomes are fundamental. Failing to undertake these activities may damage the interests of a client and also risks breaching rules in SYSC 10 and PRIN 8 (conflicts of interest).

Product testing

The FCA observations here focused on scenario and stress testing, as well as how the firms disclosed costs.

Scenario and stress testing

To protect investors, PROD asks certain firms to carry out scenario analysis to assess the risk of poor outcomes to consumers and the circumstances in which they may occur. This includes assessing resilience in volatile market conditions and scenarios that may affect how an individual product performs (outlined in PROD 3.2.13R). Stress tests should cover adverse market conditions, including the firm’s own financial strength, asset-specific stresses and any risks from a highly concentrated consumer base. They would expect firms to consider such activities in order to comply with other rules, such as BIPRU 12.4.1R, COLL 6.12 or FUND 3.7.

Costs disclosures

Most of the firms assessed also appeared to leave out certain charges, particularly portfolio transaction costs, from their cost disclosures. The FCA expect manufacturers to disclose costs and charges in a way that is clear, fair and not misleading and that complies with relevant regulatory requirements. The information firms provide to customers in wider marketing material should reflect the underlying characteristics of a product and give a fair and clear account of charges, including portfolio transaction costs. Failure to do this risks breaching PRIN 7 (communications with clients).

Distributors

The FCA observations here focus around firms’ due diligence, the information they sought from distributors and their use of management information (MI).

Due diligence

The quality of due diligence over distributors was variable. Some firms assessed a distributor’s arrangements more robustly than others.

Information from distributors

All asset managers faced challenges in getting end-client data from distributors – even when they specifically asked for this information. Some asked for feedback through meetings rather than with detailed questionnaires. A recurrent theme was that asset managers feel unable to influence distributors because of the commercial sensitivity of the data request. The asset manager’s size was also sometimes described as a factor in this. The most problematic area involved pooled nominee accounts for execution-only clients where asset managers rely on distributors for end-investor information.

Management information

The systems and procedures for monitoring data internally varied, as did how firms use management information (MI).

Governance & oversight

Nearly all firms carried out a formal product assessment or review every year. However, different firms showed varying levels of oversight and challenge across these governance channels.

Second line of defence and committees

All asset managers had product governance committees, but some fell short expectations. The role of the second line of defence was often poorly defined, meaning the potential for meaningful challenge was limited.

Authorised Fund Manager (AFM) Board

While firms were aware of the AFM Board’s product governance obligations and the need for oversight of the relevant committees’ work or their second-line functions, there was variation in the quality of contribution from the independent Non-Executive Directors.

Record keeping

The inability to evidence robust challenge and oversight should raise concern for those individuals accountable for this activity (the focus of the new Senior Management and Certification Regime) as it leaves firms and those accountable unable to evidence challenge and oversight, potentially in breach of SYSC 9.1.1R.

Training

Asset managers should have effective control over their product governance processes to ensure the right investment service reaches the respective target market. To achieve this, it is important that staff are sufficiently experienced on the characteristics of its financial instruments, the investment services provided and the needs, characteristics and objectives of the identified target market.

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