MiFID II: Helping you hit the target (market)

25 May 2017

Diagram 1

Following on from our introduction to MiFID II Product Governance in the last blog post, this blog considers how you define and agree a target market when creating and distributing a financial product.

What is a target market?

The term ‘target market’ is used widely in general marketing theory, and recommends that the target market segment and customer is considered before a product is developed and distributed. MiFID II Product Governance is about applying this concept to financial products and markets, with the ultimate aim of protecting the investor who is buying the product/service.

In the past, the seller of a product added disclosures and the buyer took the decision and the risk that the product was right for their needs. With MiFID II Product Governance, the tables have turned, the seller of the product (the ‘manufacturer’ and the ‘distributor’) takes the responsibility, and must prove through the new product approval process and throughout the ongoing product lifecycle that the investor’s interests are considered. The rules require the manufacturer to determine who is suitable for the product, and how it is to be distributed. The distributor of the product must do the same before it can be sold to the investor.

Challenges arise in the design, implementation and business as usual application. Markets are highly intermediated and financial organisations are complex, many parties can be involved in the manufacture and distribution of a product. How do you ensure all participants are talking the same ‘target market language’, and doing so seamlessly to allow the normal functioning of the market with minimal disruption?

These questions need to be answered in the next three months if financial institutions are to implement and operationalise the enhanced processes and controls by the MiFID II 3rd January 2018 deadline.

So how do you define a ‘target market’?

When a product is created, the manufacturer and distributor need to agree on the appropriate target market and channel before the product can be sold. There is no guidance in the regulatory text on the specific criteria so it is at the discretion of participants to define and agree.

Manufacturers and distributors must approach this from different angles. The manufacturer can set out the product profile (risk and reward, liquidity) in detail, but can only define high level, theoretical attributes of the suitable investor. The distributor, who is closer to the end user, can define these in more detail based on practical knowledge of their client relationships. It is essential therefore that both parties agree the criteria and process for ‘matching’ (see Diagram 1 below).

Diagram 2
Diagram 1: matching the target market criteria (click on image to enlarge)

As a part of the ‘matching’, it is important to consider ‘Level 1’ versus ‘Level 2 (detailed)’ criteria. Level 1 criteria examples are in the central column of the diagram (‘client type’ or ‘product risk/reward’). These will need to be agreed first across industry. The most recent European Securities and Markets Authority (ESMA) consultation papers (5th October 2016) proposed six Level 1 criteria. However, even these are generating debate and disagreement across the industry (see Diagram 2 below).

Level 2 criteria are much more challenging. Something like ‘client type’ is straightforward; in our experience, the industry is leaning towards use of the MiFID II counterparty types (retail, professional, eligible). By contrast, ‘client objectives’ is more contentious as there are no standardised terms to fall back on - for example what does ‘ethical’ mean?

Diagram 3
Diagram 2 - industry body responses to ESMA (click on image to enlarge)

What can firms do now?

All firms should be taking a house position on what target market framework would work in their organisation. This will need to be in collaboration with front office sales and trading, risk, compliance, operations, and finance. This will form one of the core components of the Product Governance framework that will need to be implemented.

Firstly, firms need to be involved in industry consultations in order to get their view across and understand what others in the industry are thinking. This is a market-wide challenge.

Secondly, think through how to simplify these issues. Target market selection could be a ‘waterfall’ process in which, for example, selecting a professional or eligible counterparty will automatically align the other criteria without the need for further detail. Equally, trading on an execution-only basis could ‘close off’ certain product types by default.

Thirdly, open a dialogue with manufacturers and distributors now as agreements and working arrangements will be vital. Discuss how to leverage existing product taxonomies and client segmentations used by both parties, and how selecting and matching criteria can work in practice.

The next blog: risk assessments

We shall consider how products can be risk assessed during manufacture and monitored after distribution.

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