As forewarned in the October 2020 edition, ESMA has launched a common supervisory action (CSA) on how MiFID II product governance requirements have been implemented around the EU. Firms also need to prepare for new requirements to incorporate consideration of sustainability factors into their product governance arrangements by early 2022, and the wider MiFID II review may herald further changes to product governance requirements. Meanwhile, firms need to consider the impact of the pandemic on the investments in their portfolios, and what that means for individual funds and fund investors.
The overall messages from regulators and supervisors are that firms should ensure their product governance arrangements are fit-for-purpose, are aligned to changing regulatory requirements and evolving supervisory expectations, and stand up to robust and objective challenge. Products should deliver good customer outcomes (value of money) and firms should be able to evidence this.
Questions for CEOs
Are we proactively and regularly revisiting the stress testing of our funds and service offerings to consider the impact of the pandemic on the underlying assets?
Are we challenging ourselves on the level of costs and charges in our funds and on value for investors?
Are we receiving and analysing information from distributors about how are funds are viewed and used?
Are we robustly and objectively assessing and reviewing the target market for each fund?
Does the compliance function play an active part in our product governance arrangements?
Are we preparing for the incorporation of sustainability factors throughout our product governance arrangements?
ESMA's expectations and questions
In June 2020, ESMA published guidance (PDF395 KB) designed to provide clarification for the compliance function. This guidance included confirmation that compliance should be formally involved in the development and maintenance of a firm's product governance framework, policies and processes. Further, ESMA expects the compliance function to play a part in each product or service approval, whether relating to manufacturing or distribution.
It has now launched a CSA with national competent authorities (NCAs) on the application of MiFID II product governance rules across the EU. The CSA will be conducted during 2021 and its aim is to ensure consistent implementation and application of EU rules and to enhance the protection of investors. ESMA and the NCAs will assess progress made by manufacturers and distributors of financial products, including:
- How manufacturers ensure that the costs and charges within financial products are compatible with the needs, objectives and characteristics of their target market and do not undermine the product's return expectations
- How manufacturers and distributors identify and periodically review the target market and distribution strategy of financial products
- What information is exchanged between manufacturers and distributors and how frequently this is done
These points were much debated within the funds industry when MiFID II was implemented. Fund managers, whether of UCITS of alternative investment funds (AIFs), are not subject to MiFID II, but fund distributors are. Therefore, in order to ensure their funds are distributed, managers have to provide target market information on their funds, which is generally done via an industry-agreed template. Similarly, fund managers are not required by EU law to request information from distributors about how their funds are being used in practice, but if they do not consider such information, there is a risk that their funds will become out of line with the target market expectations of distributors. In addition, some NCAs expect asset managers to play a part in the product governance arrangements of funds whose assets they manage.
Fund managers should pay close attention to how this work progresses and ESMA's findings and recommendations.
MiFID II review
In December 2020, the EU co-legislators provisionally agreed the final form of the Capital Markets Recovery Package proposed by the Commission in July 2020. (See KPMG's Regulatory Horizons, February 2021.) The package was billed as adjusting the legislation to allow capital markets to assist in the recovery of the European economy from the impact of the pandemic. The product governance regime has been simplified, with all financial instruments exclusively distributed to eligible counterparties now excluded from the requirements.
The co-legislators debated whether to define non-structured UCITS as “simple” products and exempt them from the product governance requirements. This option did make the final text. The final change was only that, for both professional and retail clients, certain product governance requirements will no longer apply to corporate bonds with “make-whole clauses”.
It is possible that the position of non-structured UCITS will be debated again as part of the fuller review. Also on the table is the introduction of a new category of “semi-professional” investors, which might have access to a wider set of funds.
The amendments proposed by the European Commission to Level 2 rules on the integration of sustainability factors, under UCITS, AIFMD and MiFID II, require firms to consider clients' ESG preferences in suitability assessments and to embed consideration of ESG (environmental, social, governance) factors into their product governance and risk management processes.
In its advice to the Commission on the Level 2 amendments, ESMA noted that asset managers will have to set up new controls and potentially hire more staff, so that firms have “sufficient human and technical resources for the assessment of sustainability risks”.
The final rules are expected to be issued soon, with an implementation deadline of 12 months. Firms will need to refer to the Taxonomy Regulation - the compulsory dictionary of “E”. The draft Level 2 rules under the Taxonomy Regulation, in relation to climate change mitigation and adaptation are detailed and total 500 pages. For more on ESG regulation, see our new reality paper, “Delivering sustainable finance” (PDF 1.8 MB).
Firms need to start the implementation process now. They need to clarify their strategy and amend processes, policies and documentation, not only initially but on an ongoing basis as part of their product governance arrangements.
Funds have been subject to stress throughout the pandemic due to market volatility and impacts on portfolio companies and other underlying assets. Scenario testing needs to be revisited and on an ongoing basis. Firms also need to ensure that product development and distribution methods are genuinely aligned to investors' best interests. They need to manage the entire product lifecycle from the investors' perspective, and to ensure their product assessments are robust and objective, in order to generate customer outcomes that are acceptable to supervisors and the market.