European Union : SMSG Advice - Response to ESMA’s Consultation Paper on MiFID II product governance

Securities and Markets Stakeholder Group

Date: 16 December 2016 ESMA/2016/SMSG/024

ADVICE TO ESMA

Response to ESMA's Consultation Paper on MiFID II product governance

1. Executive summary

   The SMSG's overall view of these guidelines is positive. The guidelines provide guidance and establish a framework to define the target market for investment products under MiFID II and in doing so, reduce the risk of miss-selling. At the same time, they are not overly complicated.

   Nevertheless, the SMSG has some focused remarks. A major issue refers to the respective role of distribu- tor and manufacturer and the communication between both. We are concerned that some of the guidelines are feasible within the context of a small market where "everyone knows one another" (distributors and manufacturers), but are more difficult to implement in the context of a large market. This would be most regrettable, as the guidelines should facilitate a European Capital Market Union, rather than provide bar- riers for it. Several of our remarks, in particular with regard to distributors and manufacturers, reflect this concern.

   A second remark refers to assets which after an initial public offering, trade only on a secondary market (example: stocks). The SMSG considers that it would be very helpful if the guidelines provided clear guid- ance on the responsibilities and treatment of such instruments and illustrate this with a clear example. In doing so, differentiation between products could be needed (stocks, ETF's…). It should also be specified how long the responsibility lasts (only at stage of initial public offering?).

   More generally, the SMSG proposes that ESMA rephrases its guidelines to make sure that execution-only and execution under appropriateness remain workable. In this context, the SMSG refers in particular to the position of brokers. Also, it expresses the concern that the guidelines should not have as unintended side-effect that the potential for corporates and SME's to raise capital on the public equity markets be- comes more burdensome. In the context of execution-only and execution under appropriateness, a guiding principle could be that the target market guidelines should not have more restrictive consequences than the existing "know your client' requirements.

   A fourth remark refers to the dichotomy of product approach versus portfolio approach. The members of the SMSG share the concern that a portfolio approach should remain possible. However, at the same time they share the concern that the degrees of freedom provided to enable this portfolio diversification should not be abused to facilitate miss-selling. The SMSG proposes: (i) that the final guidelines are clear with regard to the perspective expected from the manufacturer: should the manufacturer define the target mar- ket from a single-product perspective or from a portfolio perspective; (ii) that the guidelines on the extent of selling outside the target market correlate to this perspective. The SMSG also discusses different possible approaches that could be envisaged.

   The SMSG also points at the fact that many asset managers, "manufacturers" of UCITS and AIF's, fall outside the scope of MiFiD II and hence are not subject to these guidelines. The SMSG proposes that this is remedied once it comes to an update of level 1 legislation (UCITS, AIFMS). However, as this is unlikely to

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   occur in the timespan available for the implementation of these guidelines, the SMSG proposes that ESMA looks at possible mitigating approaches: (i) encourage manufacturers outside the scope of MiFiD II to determine the target market as a service to their distributor; (ii) use the target market description on the PRIIPs-KID as a starting point within which the distributor further narrows the target market.

   Finally, with regard to implementation costs, we consider a critical issue to be the requirements on how distributor and manufacturers are to communicate. This is also related to how compliance with the guide- lines will be monitored. If a common cross-border ICT platform is to be established, encompassing distrib- utors and manufacturers, the ICT costs would be huge. While there will also be training costs, in particular for sales and advice staff, we do not believe these to be disproportionate, as the proposed criteria are not overly complicated. Nevertheless, there is a risk of a peak load coming together as MiFID II approaches implementation. For this reason, it would be good that the final guidelines are in place as soon as possible.

   With regard to implementation, we would also like to point at a possible source of confusion. The PRIIPs- KID requires a definition of target market as well. However, the format of the PRIIPs-KID does not allow the target market to be defined with similar granularity as the MiFID II product governance guidelines require. To remove all possible misunderstandings, we would suggest that the ESMA guidelines are more explicit on the alignment of (i) product governance target market definition and (ii) requirements to indi- cate target market on publicly available information, in particular PRIIPs-KID, taking into account the need of compactness of the PRIIPs-KID.

   Apart from the remarks above, we also have suggestions regarding the clarity of the language.

2. Background

3. On 5 October 2016, ESMA published a consultation paper on "Draft guidelines on MiFiD II product governance requirements", pursuant to the product governance requirements laid down in Articles 16(3) and 24(2) of MiFiD II, as well as in Articles 9 and 10 of the MiFiD II Delegated Directive. These draft guidelines mainly addressed the target market assessment, as this aspect was identified as the most important one for ensuring the common, uniform and consistent application of the above-men- tioned rule. Within the SMSG, a working group was established to comment on these guidelines. This advice reflects the discussions of the working group as well as the issues raised in the plenary session of 10 - 11 November 2016.

4. Comments on the different questions in the consultation
5. Q1: Do you agree with the list of categories that manufacturers should use as a basis for defining the target market for their products? If not, please explain what changes should be made to the list and why.

6. Irrespective of the categories as such, the SMSG points at the need to avoid misinterpretations and misunderstandings. Differences in national or local usages may result in concepts being interpreted differently (see also point 5 of this advice). For these reasons, it is important that the concepts used by the manufacturer in defining the target market are clearly defined. On the long term, it would be good that ESMA considers establishing a common conceptual framework and common definitions. However, this seems to be an endeavour, which realistically speaking, cannot be achieved on the short term. We therefore suggest, that for the time being, the guidelines state the need for the man- ufacturer to clearly define the concepts that are being used.

7. One of the categories is "risk tolerance and compatibility of the risk/reward profile of the product with the target market." This category mixes different concepts. First of all, there is the element of "risk tolerance" of the client. This surely is a relevant element in defining the target market. Related to that,

   but not the same, are the "risk/reward expectations". This is equally important, but it is different from "risk tolerance" as it also includes a reference to the potential reward. Thirdly, there is the "risk/re- ward profile of the product", which is one of the relevant characteristics of the product (alongside other characteristics, such as complexity). It is obvious that the product characteristics and target market should be aligned. However, from a semantic point of view, we suggest that this alignment is done after the six categories are considered in their wholeness, possibly balanced off against one- another, and not isolated for one of the six categories as is done by the wording: "risk tolerance and compatibility of the risk/reward profile of the product with the target market." We suggest that the wording "risk/reward profile of the product" is deleted under the heading "risk toler- ance" and the wording "risk/reward expectations of the client" is referred to under "cli- ent objectives" instead.

8. The distinction between "clients' objectives" and "clients' needs" should be better explained. The text suggests that 'objectives' refers to the 'wider financial goals of target clients', whereas 'needs' refers to other goals (such as ethical investment, green investment'). However, this distinction is far from clear and not consistent throughout the text. For example: the inclusion of 'currency protection' under "clients' needs', clearly refers to financial goals. The example on p 38 refers to "six years' investment horizon" under "clients' needs", whereas Annex III, page 23, includes investment horizon under cli- ents' objectives. We suggest to clearly describe what is the difference between clients' ob- jectives and clients' needs and to ensure consistency with those definitions in the ex- amples.

9. With regard to the 'type of clients to whom the product is targeted', the SMSG notes that the more refined the description, the greater the risk that concepts are only properly understood in the home market of the manufacturer and interpreted differently cross-border. Also, concepts such as "defen- sive" / "conservative" / "aggressive" / "speculative" to describe a type of clients may be understood differently between manufacturers and distributors. Hence, the SMSG reiterates that there is a need to define clearly the concepts that are being used. The SMSG would also suggest not to mix categories. For example: why is "sophisticated clients" mentioned among "type of clients", whereas it refers to elements that are captured under "knowledge and experience"

   Q2: Do you agree with the approach proposed in paragraphs 18-20 of the draft guidelines on how to take the products' nature into account? If not, please ex- plain what changes should be made and why.

10. It is not clear from the description what the respective responsibilities are in case of instruments that are generally traded on secondary market. For example: who is the manufacturer in case of shares? And how long does the responsibility to define the target market last (suggestion: only at time of in- troduction)? Who is to be considered as the 'distributor' (what with actors who merely act as inter- mediaries: see in this respect also points 10-11)? And what are the distributor's responsibilities in case of non-EU instruments (example: IBM shares). The SMSG would like to have more clarity with regard to instruments traded on the secondary market, with possible differentiation among the type of in- struments (ranging from shares, bonds… to ETF's). The SMSG considers that it would be very helpful if the guidelines provided clear guidance on the responsibilities and treatment of such instruments.

11. The SMSG also suggests to include in Annex IV an illustrative example of "shares" and "UCITS" as these are the products most widely sold to retail investors. Q3: Do you agree with the proposed method for the identification of the target mar- ket by the distributor?

12. The respective responsibilities of manufacturer and distributor are feasible within a small market where "everyone knows one another". However, there is a concern that it could be much more difficult in a large market with a large number of market participants to communicate with each other. For example: "19…. a manufacturer should determine the extent of clients' information available to the distributor". How far-going is this meant to be? What is the depth of this requirement? How much is to be done? We would suggest that ESMA adds examples to show what this means and how this can be done in a pragmatic way.

13. "20. … if the product is deemed appropriate for a sale without advice, the firm should also specify the preferred acquisition channel (face-to-face, via telephone, online etc.) and, if relevant, specific design features of the acquisition channel". This guideline is extremely far-reaching with regard to the re- sponsibility of the manufacturer. Here, the manufacturer is put in a role where he is almost required to micromanage the distribution process. This is even more difficult as the techniques and technology are constantly changing. We would suggest that it is the responsibility of the distributor to determine the appropriate acquisition channel, within the target market definition given by the manufacturer.

14. The draft guidelines require distributors to "36…. pay particular attention to situations where they might not be able to conduct a thorough market assessment": (i) execution services under appropri- ateness and (ii) execution-only. A footnote is added stating that "even firms providing investment services under appropriateness or execution-only regime, could be in the position to conduct a more thorough assessment of the target market." In this respect, the SMSG voices several concerns. In particular, it draws the attention on the position of brokers. They act on "execution-only" basis and have under level 1 legislation no obligation to collect information on their clients. It would not be workable, and counter to level 1 legislation, that they are forced by these guidelines, to adhere to the obligations for distributors provided for by these guidelines.

15. There is also a concern that the guidelines could act as a barrier for companies, in particular SME's, to raise capital on the public markets. In this case, this would run counter to the Commission's in- tention to support SME funding via all channels and particular public equity markets. We suggest that ESMA rephrases its guidelines to ensure that execution-only and execution under appropriateness remain workable.

16. In defining the distributors' responsibilities in the specific context where "execution-only" or execu- tion under appropriateness" is possible, a guiding principle could be that the target market guidelines should not have more restrictive consequences than the "know your client" requirements. In a context of "execution-only" this would mean that the absence of "know your client" requirements takes precedence over the target market requirements. In the context of "ap- propriateness", this would mean the appropriateness test passed by the client, is deemed to be a suf- ficient condition regarding knowledge and experience to allow the sale of the product, without the distributor being required to verify the other target market criteria described by the manufacturer.

    Q4: Do you agree with the suggested approach on hedging and portfolio diversifica- tion aspects? If not, please explain what changes should be made and why.

17. The members of the SMSG share the concern that a portfolio approach should remain possible be- cause of the benefits it provides to the investor in terms of risk diversification. However, at the same time they share the concern that the degrees of freedom provided to enable this portfolio diversifica- tion should not be abused to facilitate miss-selling. The issue of selling and advising outside the target market requires balancing these considerations.