Product governance requirements under MiFID II and the Investment Services and Activities and Regulated Markets Law of 2017

The Cyprus Securities and Exchange Commission (“CySEC”) has issued a circular (number 236 dated 15 September 2017) to Cyprus Investment Firms (“CIFs”), UCITS Management Companies (“UCITS MCs”) and Alternative Investment Fund Managers (“AIFMs”) that it regulates advising them of their obligations regarding product governance requirements under MiFID II and the Investment Services and Activities and Regulated Markets Law 87(I)/2017 (“the IS Law”), which implements MiFID II in Cyprus. These requirements will apply from 3 January 2018, when the IS Law enters into force.

The objective of product governance requirements is to increase investor protection by regulating all stages of the life-cycle of products or services in order to ensure that firms which create and market financial instruments and structured deposits act in the clients’ best interests.

Under the MiFID II nomenclature, investment firms which create, develop, issue or design financial instruments, including advising corporate issuers on the launch of new financial instruments, are “manufacturers”, and investment firms which offer or sell financial instruments and services to clients are “distributors”. Some product governance requirements under MiFID II and the IS Law apply specifically to manufacturers or distributors, and some apply to both.

The product governance requirements under MiFID II are set out in articles 17(3) and 25(2) of the IS Law, chapter III of Commission Delegated Directive (EU) 2017/593  and the ESMA guidelines document ESMA35-43/620. Investment firms are required to comply with the product governance requirements in a way that is appropriate and proportionate, taking into account the nature of the financial instrument, the investment service and the target market for the product.

The main requirements for investment firms manufacturing financial instruments are as follows:

  • Appropriate procedures must be in place for approval of all new financial instruments or significant adaptations of existing financial instruments before they are marketed or distributed, ensuring that the target market is clearly identified, relevant risks are assessed and that the intended distribution strategy is consistent with the identified target market.
  • Appropriate procedures must be in place to manage conflicts of interest, including
  • An analysis of potential conflicts of interests must be carried out each time a financial instrument is developed.
  • Before a financial instrument is launched, an assessment must be made of whether it may represent a threat to the orderly functioning or to the stability of financial markets.
  • Staff involved in the development of financial instruments must possess the requisite expertise to understand the characteristics and risks of the financial instruments concerned.
  • The board of directors must have effective control over the firm’s product governance process and there should be effective monitoring by the compliance function.
  • When products are developed in collaboration with others, the responsibilities of each participant in the process must be adequately and clearly recorded.
  • The target market for the proposed financial instrument must be identified and an assessment must be made of whether the financial instrument meets the identified needs, characteristics and objectives of the target market. Specific types of clients for whom the proposed financial instrument is appropriate, and the groups for which it is inappropriate, must be identified.
  • Investment firms must undertake a scenario analysis of their financial instruments assessing the risks of poor outcomes for end clients posed by the product and in which circumstances these outcomes may occur.
  • Due consideration should be given to the proposed charging structure.
  • Adequate and accurate information must be provided to distributors of the financial instrument (including information about the appropriate channels for distribution of the financial instrument, the product approval process and the target market assessment) to enable them to understand and recommend or sell the financial instrument properly.
  • The review process does not finish with the launch of the financial instrument: financial instruments must be subject to continuous review to ensure that they remain consistent with the needs, characteristics and objectives of the target market and that they are only reaching clients with whose needs, characteristics and objectives they are compatible.
  • A fresh review must be carried out prior to any further issue or re-launch if any event occurs that could materially affect the potential risk to investors.

The main requirements for investment firms distributing financial instruments are as follows:

  • Before distributing a product, investment firms must determine the target market for the respective financial instrument, even if the target market was not defined by the manufacturer.
  • Firms must have in place adequate product governance arrangements to ensure that the products and services they intend to offer or recommend are compatible with the needs, characteristics, and objectives of the identified target market and that the intended distribution strategy is consistent with the identified target market. They should identify any groups of clients for whose needs, characteristics and objectives the product or service is not appropriate.
  • Investment firms distributing products should obtain information from the manufacturer so that they have the necessary understanding and knowledge of the products they intend to recommend or sell to ensure that they will be distributed in accordance with the needs, characteristics and objectives of the identified target market. If the manufacturer of the product is not subject to MiFID II, the distributor must have adequate and reliable information to ensure that products will be distributed in accordance with the characteristics, objectives and needs of the target market.
  • Investment firms must use the manufacturer’s information about the product and information on their own clients to identify the target market and distribution strategy.
  • Investment firms must have in place effective procedures to ensure compliance with all requirements of the IS Law, including those relating to disclosure, assessment of suitability or appropriateness, inducements and proper management of conflicts of interest.
  • Investment firms must periodically review and update their product governance arrangements, and take action when necessary in order to ensure that they remain effective.
  • Regular reviews should be undertaken of the investment products the firm offers or recommends and the services it provides, taking into account any event that could materially affect the potential risk of the identified target market, to ensure that the product or service remains consistent with the needs, characteristics and objectives of the identified target market and that the intended distribution strategy remains appropriate.
  • The investment firm’s board of directors must exercise effective control over the product governance process and its compliance function must exercise oversight of product governance arrangements in order to ensure they are effective and to identify possible risks and failures.
  • Investment firms must ensure that their staff possesses the necessary expertise to understand the characteristics and risks of the products and services they intend to offer or recommend and the needs, characteristics and objectives of the identified target market.
  • Distributors of financial instruments should provide their manufacturers with information on sales and any other information required to facilitate product reviews carried out by the manufacturer.

While stressing that product governance requirements apply to all products sold on primary and secondary markets, irrespective of the type of product or service provided and of the requirements applicable at point of sale, the circular allows for the rules to be applied in a proportionate manner, depending on the complexity of the product and the degree to which publicly available information can be obtained, taking into account the nature of the instrument, the investment  service and the target market. For example, much simpler arrangements could be sufficient for straightforward products distributed on an execution-only basis in the mass retail market.

While products manufactured and distributed prior to 3 January 2018 are exempt from the product governance requirements, certain actions may nevertheless need to be taken, such as target market identification, stress testing of existing products and review of the fee structure and of the existing relationships and documentation between manufacturer and distributor. For products developed before 3 January 2018 but not yet distributed by then, distributors will be required to comply with the product governance requirements applicable to them, treating the manufacturer as if it were a non-MiFID entity. Both the manufacturer and the distributor will have to comply with the regulatory requirements in any product review process cycle after 3 January 2018.

The circular advises Cyprus investment firms to understand the product governance requirements, review their existing procedures and arrangements and take any action necessary to ensure that they comply fully with the new requirements from 3 January 2018. No later than 31 December 2017 they must provide CySEC with a declaration from their board of directors that they have taken all appropriate measures to comply with the law with effect from 3 January 2018.

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