Product development

An investment firm that manufactures investment products to be sold to clients (the manufacturer) must have a process in place for the development, approval and revision of investment products. For each investment product, the manufacturer must identify the target group and tailor the distribution strategy accordingly to ensure that products are distributed to the target group and not outside it. The investment product should meet the needs, characteristics and objectives of the target group. This is tested by inter alia an assessment of the risk/return profile of the product. Also, it must be ensured that the investment product has characteristics that are in the client's interest.

In addition, the investment firm must ensure that all relevant risks for the target group are evaluated. To this end, the investment firm must inter alia perform scenario analyses. The cost structure must also be assessed.

Before the investment firm markets the product, it must check whether the investment product may pose a threat to the orderly functioning or the stability of financial markets.

Investment firms must review investment products on a regular basis, taking into account any event that could materially affect the potential risks for the target group. In addition, the investment firm must assess whether the investment product remains consistent with the needs of the target group sufficiently and whether the distribution strategy remains appropriate.

Notification of crucial events

Commission Delegated Directive supplementing Directive 2014/65/EU (MiFID II), Article 9(15), provides that investment firms shall review whether the financial instruments that they issue, manufacture or put together and place on the market, prior to any further issue or launch, function as intended, if they are aware of any event that could materially affect the potential risk to investors (crucial events).

This can include, for example, the crossing of a threshold that will affect the return profile, or any change in the solvency of certain issuers whose securities or guarantees may impact the performance of the financial instrument or structured deposit. When such events occur, the investment firm must take appropriate action, such as filing a notification with the AFM.

What information should you provide?

Examples include information about the event or outcomes of the review, such as:
• the impact of the event on the functioning of the product
• the target group or groups to whom the product was sold
• the implications for that target group or those target groups
• the implications for the distribution strategy, and
• the measures taken or to be taken

When selecting investment products and services, the investment firm must satisfy the following requirements:

• The investment firm has an adequate process. This process ensures that the products and services that they wish to offer meet the needs, characteristics and objectives of the identified target group (the target group).

• The distribution strategy is consistent with the target group.

• The investment firm uses the information of the manufacturer and combines this with its own information on its clients. Based on the needs, characteristics and objectives of its clients, the investment firm determines to whom it will offer the investment product or service. The distributor must therefore identify a target group itself and determine how the distribution is to take place.

• If the investment product has not been developed/manufactured by a manufacturer that falls under the scope of MiFID II, the distributor must make all reasonable efforts to ensure that the product information from that manufacturer is reliable and adequate.

• The distributor must regularly evaluate the selection process of investment products and determine whether the product or investment service meets the needs of the target group. It must also assess whether the distribution strategy remains appropriate. The distributor must inform the manufacturer about this and about the sale of the investment product. The manufacturer needs this information to review its investment products.

The ESMA Guidelines on MIFID II product governance requirements have been updated as of 3 October 2023. These guidelines apply to investment firms. The AFM applies these guidelines in its supervision of the product governance standards. ESMA has also prepared Q&As for this topic, which can be found in the document ESMA Q&As Investor Protection (Chapter 16).

Key additions: 

Defining the target market

• Article 32b of the Decree on Conduct of Business Supervision of Financial Undertakings under the Wft (BGfo) now adds that financial instruments must also comply with sustainability objectives. Guideline 25 further elaborates on this subject. According to Article 32b(2) BGfo, there is no need to define a negative target market with regard to sustainability objectives for financial instruments with sustainability factors. (Please note that target market categories other than sustainability must always be defined for the negative target market.) The AFM explains that this exception only applies to financial instruments with sustainability factors. It does not apply to financial instruments with no sustainability factors. The rationale behind this is that financial instruments with sustainability factors remain available to clients who do not have sustainability objectives. This exception therefore does not apply to financial instruments with no sustainability factors. This means that financial instruments devoid of sustainability factors are unlikely to appeal to clients having sustainability objectives.

Distribution strategy

• If distributors intend to make use of nudging and digital engagement activities such as gamification techniques, they should carefully consider the extent to which the actual use of such techniques is in their clients’ best interests as early as the decision-making phase. Some gamification techniques, such as those inducing clients or potential clients to maximise the number of transactions, will never be in the clients’ best interests. See Guideline 44.
• In the context of defining the distribution strategy, Guideline 64 illustrates the importance of properly setting up the online choice environment in non-advised services. The Guideline lists examples of measures that may contribute in preventing distribution of financial instruments outside the target market. Distributors may, for example, refrain from the use of nudging and/or gamification techniques and ‘finfluencers’ in offering more complicated financial instruments via execution-only services (EO).

Evaluation

• Both developers and distributors need to perform the product evaluation based on both quantitative and qualitative criteria. This can be done proportionately and depends on the level of a product’s complexity. Examples of criteria mentioned include the number of sales outside the target market and the results of client surveys. Distributors need to check whether they have distributed financial instruments outside the target market. This requires distributors to draw reliable conclusions based on the right information (Guidelines 73 and 77).

Case study

• Different case studies are included to show what is expected in terms of substantiation and explanation when defining the target market and distribution strategy. One case study, for example, features options (Case study 6). It explains how options can be used in a variety of ways and how this results in the definition of different target markets. There is always a limited target market and the proposed distribution strategy is tailored accordingly. In short, the preferred method of distribution is not through EO. If the distributor is nevertheless convinced of being able to offer options through EO without selling outside the target market, they will need to build in several safeguards. The case study offers examples of safeguards that can be built in.