29 th September MiFID II Sally Rigg KPMG. Product Governance. Sally Rigg KPMG

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1 @uktisa Sally Rigg KPMG Governance Sally Rigg KPMG 1

2 TCF to MiFID II The journey so far. TCF RPPD MiFID II 37 The six TCF outcomes TCF Outcome Number TCF Outcome 1 Consumers can be confident that they are dealing with firms where the fair treatment of customers is central to the corporate culture 2 s and services marketed and sold in the retail market are designed to meet the needs of identified consumer groups and are targeted accordingly 3 Consumers are provided with clear information and are kept appropriately informed before, during and after the point of sale Where consumers receive advice, the advice is suitable and takes account of their circumstances Consumers are provided with products that perform* as firms have led them to expect, and the associated service is of an acceptable standard and as they have been led to expect Consumers do not face unreasonable post-sale barriers imposed by firms to change product, switch provider, submit a claim or make a complaint * The term perform does not solely relate to product performance it also encompasses the operation of the product so could read consumers are provided with products that operate as firms have led them to expect, and the associated service is of an acceptable standard and as they have been led to expect 38 2

3 RPPD aims and objectives RPPD Customer experience Provider responsibilities Distributor responsibilities Design Target market Distribution channel suitability Information transparency and clarity Suitability of advice Good customer outcomes 39 Definitions manufacturer those firms manufacturing investment products (financial instruments and structured deposits) i.e. those firms that create, develop, issue and/or design investment products (ESMA Final Report December 201 We use provider to include persons who offer services such as portfolio management (through distributors or otherwise) as well as those who develop, manage or package products such as life insurance, general insurance or investment products or who develop or enter into home finance transactions (i.e. mortgages, home reversion plans and home purchase plans). (FCA RPPD 1.12) Recognised that there may be more than one manufacturer in the distribution chain. distributor investment firms that decide the range of products (financial instruments and structured deposits) issued by itself of other investment firms and services they intend to offer to clients. MiFID II also applies to distributors selling investment products issued by entities that do not fall under the scope of MiFID (ESMA Final Report December 201) We use distributor to mean those persons who then make up the rest of the supply chain taking the product or service to the customer. This could include, for example, financial advisers, third party administrators, appointed representatives, banks, building societies, and those who sell insurance as a secondary part of their business. (FCA RPPD 1.13) Recognised there may be more than one distributor in the distribution chain. 0 3

4 MiFID II brings in new requirements TCF+ Management Information & Reporting & Distribution strategies Distributor oversight Governance requirements On-going product assessments Governance Target market end client Costs & charges disclosure Risk identification Selection of distribution channel Conflicts of interest Stress testing & scenario analysis 1 Business Models The FCA has said that there are eight key areas of product development and governance: approval procedures; Identification of target market and generation of product ideas; Design and development of product features; Stress-testing and modelling; Selection and monitoring of distribution channels; Information to distributors; Information to consumers; and Post-sales responsibility (FSA Finalised Guidance - Retail Development and Governance Structured Review, March 2012) 2

5 lifecycle reviews Ongoing target market compatibility Identification of crucial events that may change expected outcomes s are operating in line with stated objectives and risk profile Changes to products are in the customers interests Feedback loops lessons learned Post sales analysis Provision of adequate information to distributors Taking reasonable steps to ensure financial instruments are distributed to the identified target market Distributor training Distributor selection, oversight and MI reporting Taking action to address discrepancies Sales/ Distribution Ongoing assessment Customer The Lifecycle Governance and controls Design Approval Governance and Oversight, as well as Board engagement Client best interests Maintain and operate effective organisational and administrative arrangements clearly defining roles and responsibilities Effective inclusion of control functions such as Compliance in oversight arrangements Identification of target market Conflicts of interest management Scenario analysis Identification of customer interests and needs usage Establish and review effective policies and procedures approval process, including matching of needs to target market and distribution strategy Risks, stress testing and scenarios Pricing and Value Clear, fair and not misleading information Complex/ Non complex Consumer understanding Incentives and remuneration costs and charges Costs are compatible with the product objectives Avoidance of conflicts of interest Transparency 3 MiFID II Governance 1. Governance and Controls Member States shall ensure that the management body of an investment firm defines, oversees and is accountable for the implementation of the governance arrangements that ensure effective and prudent management of the investment firm including segregation of duties in the investment firm and the prevention of conflicts of interest, and in a manner that promotes the integrity of the market and the interests of clients (Art 9 (3)) Sales/ Distributio n Custome r Ongoing Assessme nt 7 The Lifecycle Governanc e and Controls 1 2 Design 3 Approval Pricing and Value A firm shall ensure that the management body has effective control over the firm s product governance process Where investment firms collaborate, including with an investment firm in a non-eea Member State or a non-mifid firm, to create, develop, issue and/or design a product, they shall outline their mutual responsibilities in a written agreement. Investment firms shall ensure that the management body has effective control over the firm s product governance process to determine the range of investment products that will be distributed and the services provided to the respective target markets. (ESMA Final Report December 201)

6 Governance role of Compliance and second line of defence New requirements for Compliance proposed by ESMA for both product manufacturers and product distributors: Information about the products a firm manufactures and its distribution strategy shall be systematically included in compliance reports to the management body and made available to National Competent Authorities on request Requirements for investment firms compliance functions to oversee the development and periodic review of product governance arrangements in order to detect any risk of failure by manufacturers to comply with their obligations Requirements for investment firms compliance functions to oversee the development and periodic review of product governance arrangements in order to detect any risk of failure by distributors to comply with their obligations Information about the products a firm distributes and the services provided shall be systematically included in compliance reports to the management body and made available to National Competent Authorities on request Many firms already include Compliance and Risk in product approval forums as good practice MiFID II Governance 2. Design The product approval process shall specify an identified target market of end clients within the relevant category of clients for each financial instrument and shall ensure that all relevant risks to such an identified target market are assessed and that the intended distribution strategy is consistent with the identified target market (Art 1 (3)) Sales/ Distributio n Ongoing Assessme nt 7 The Lifecycle Governanc e and Controls 1 2 Design Custome r 3 Approval Pricing and Value When manufacturing products, the firm shall identify the potential target market for each product and be able to specify the type(s) of client for whose needs, characteristics and objectives the product is compatible. As part of this process, the firm shall identify any groups of investors for whose needs, characteristics and objectives the product is not compatible. Where investment firms work together to manufacture a product, only one target market assessment is required The target market must be identified at a sufficiently granular level to avoid the inclusion of any groups of investors for whose needs, characteristics and objectives the product is not compatible. Manufacturers designing products that are distributed through other investment firms have to ascertain the needs and characteristics of clients for whom the product is compatible based on their theoretical knowledge and past experience of the product, the financial markets and the needs, characteristics and objectives of potential investors (ESMA Final Report December 201)

7 FCA expectations When undertaking product design we would typically expect a firm to identify a target market. However, the way this should be done, and the level of detail that should be gone into, will depend on the nature of the product and its general risk profile. The onus is on the firm (not us) to determine the appropriate way to identify the target market. The provider may be able to meet this standard by identifying for whom the product is not suitable. It may also, where appropriate, be able to identify a range of alternative target markets, an extremely broad target market, or a hypothetical market. There may be circumstances in which a firm could identify the whole market as its target market, although firms should be wary of using this as an alternative to giving due consideration to the issue of the target market. FCA Roles and Responsibilities of Providers and Distributors Firms should recognise that the identification of a target market or audience is crucial, not only for generating ideas for products, but for avoiding failures later in the value chain, whether or not an intermediated model is used consideration of the target market should permeate all aspects of the product development and distribution throughout the product s lifecycle FSA Retail Development and Governance Structured Review March Current challenges and pitfalls in identifying target market Many would like to undertake customer research but find it provides little benefit high yield, low risk please Focus on competitor analysis and potential profit me too pre launch analysis Viewing the distributor as the client not the end-investor Many retail customers don t know what it is that they want or what would fulfil their needs Relying on feedback from intermediaries to generate ideas based on which products are most likely to sell 8 7

8 Identifying a target market some common approaches Typically, firms approach the identification of a target market through building either a product profile of an investor profile: Build a product profile: Extent to which it is considered likely customers will need advice in order to invest in a product, for example, if risk profiling tools are required or if the investment has a particularly complex strategy or uses complex investment techniques; Likely investor usage (core, component etc); Risk characteristics; Likely time horizon; Investment minimums and pricing; Likely investor sophistication and understanding; Levels of risk or volatility; Liquidity; Regulatory regime; Specific institutional needs the product is designed to address; Dealing frequency; Onshore/offshore considerations; Segregated mandates and bespoke strategies Build an investor profile: Investment objective (e.g. income, growth, income & growth, capital preservation); Risk (e.g. low, medium, high taking into account for example, SSRI) Investment time horizon; Usage; complexity; Plain English summary SUITABLE* FOR NOT SUITABLE* FOR TARGET MARKET * MiFID II uses the term compatible 9 9 design product usage potential solution Solution Component Core 0 8

9 Target market potential definitions Target Market complexity Consumer Investment Objectives Risk Profile Demographic characteristics Investment timeframe Customer understandi ng/sophistic ation Portfolio use Return Profile Market Exposure Capital risks Liquidity risks A.N. Other Fund Professional & Institutional Complex Component Growth Equity/ Bond etc Volatility Early exit penalties Tax status Short term < yrs Professional Qualified Non Complex Core Income Territory Credit exposure Market liquidity Proximity to retirement Medium 10 years Experienced Wealth Manager/ Private Bank Solution Income & Growth Currency Compensation scheme coverage Guarantees Defined by customer need/ grouping e.g. mortgage holders Long term > 10 years Educated / Informed Financial Planner Absolute Return Gearing Spreads/ value discounts Dealing Frequency Non-retirement lifestage e.g. students Mass Retail Non-advised/ Execution only Derivatives Domicile/ Regulatory regime Investment minimums 1 Can we use target market definitions to Build an end investor profile? Target Market Professional investor Qualified investor Wealth Manager/ Private Bank Financial Planner - Only compatible with a target market that meets the MiFID professional investor criteria - Distinction between Per se and Elective? - Compatible with a target market that meets FCA Qualified investor criteria e.g. Professional Investors, Eligible Counterparties (MiFID definition) Certified High Net Worth, Certified Sophisticated investors etc - Distinction between ECPs, Elective Professionals, Certified High Net Worth etc? - Compatible with target market that receives advice and has investible assets of greater than x? - Part of wider portfolio? - Sophisticated/ more savvy investors than typical mass market retail? - HNW, UHNW, MA - Typically less wealthy clients that Wealth Manager/Private Bank - Client base typically investible assets of xk - xk Non advised / XO - Investors with less than xk to invest - Mass market retail? - Appropriateness test may help with complex products 2 9

10 Stress testing, scenario analysis and crucial events Scenarios that could lead to poor investor outcomes Mitigating actions or triggers for future action Why do it? Ensure all relevant risks are identified and assessed both on an initial and on-going basis Establish how the product will perform under a variety of conditions, including possible failures of design features Understand the inter-actions of different product characteristics and assumptions built into the product design process Model potential product outcomes from an investor/customer perspective Can help to inform approach to use of risk warnings Make decisions that better integrate risk management Improve contingency planning and develop appropriate mitigating actions before events crystallise Can help prevent liquidity and/or capacity constraints Inform stress testing framework Scenario analysis and identification of crucial events required under MiFID II 2011 KPMG LLP, a UK Limited Liability Partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ("KPMG International"), a Swiss entity. 3 Stress testing, crucial events and customer outcomes Could stress testing/crucial events help to define target market? - e.g. Capacity for risk/loss? 10

11 Selecting appropriate distribution channels Distributor due diligence Initial due diligence Could include an assessment of: Any risks posed to the fulfilment of the firm s legal and regulatory responsibilities (AML/KYC) Regulatory status Financial capability (and any likely training needs) Distributor s target market (end investor)/customer base Distributor s distribution strategy FSCS and other alternative coverage Governance and contact points Business Continuity/Disaster Recovery arrangements Training and Competence arrangements (where applicable) How marketing material provided will be used and by whom Financial stability Continuing due diligence Could include an annual assessment of: Ability to meet on-going assessment criteria Capture any material changes Confirmation that products are being sold in line with the identified target market with exceptions based reporting Regular reporting Provision of regular Management Information to support product manufacturer oversight Ad hoc oversight Exceptions based reporting What can we learn from other industries? 11

12 Information flows product manufacturers and distributors On-going Assessment On-going Assessment Distributor Oversight Advised/ Non Advised Manufacturer MI & Reporting Distributor Information Information Target Market Target Market 7 MiFID II Governance 3. Approval The product approval process shall specify an identified target market of end clients within the relevant category of clients for each financial instrument and shall ensure that all relevant risks to such an identified target market are assessed and that the intended distribution strategy is consistent with the identified target market (Art 1 (3)) Sales/ Distributio n Ongoing Assessme nt 7 The Lifecycle Governanc e and Controls 1 2 Design An investment firm which manufactures financial instruments for sale to clients shall maintain, operate and review a process for the approval of each financial instrument and significant adaptations of existing financial instruments before it is marketed or distributed to clients (Art 1 (3)) Custome r Pricing and Value 3 Approval We expect firms to have transparent and auditable product approval frameworks which: Have clear roles and responsibilities for those operating them; Incorporate effective scrutiny and challenge; Embed the delivery of fair outcomes for customers; Manage any conflicts between the firm and the customer properly; Have clear criteria for when an abridged or light process may be used and for what constitutes a new product; Take account of changes in the external environment; and Have a review mechanism to prevent product creep. (FCA Finalised Guidance Retail Development and Governance Structured Review, March 2012)

13 MiFID II Governance. Pricing and Value Investment firms shall consider whether the product meets the identified needs, characteristics and objectives of the target market, checking for example that: design is driven by features that benefit the client and not by a business model that is dependent on poor client outcomes (ESMA Final Report Dec 201) Sales/ Distributio n Custome r Ongoing Assessme nt 7 The Lifecycle Governanc e and Controls 1 2 Design 3 Approval Pricing and Value Investment firms shall consider the charging structure proposed for the product, checking for example that (the following list is not exhaustive): i. costs and other charges are compatible with the needs, objectives and characteristics of the target market; ii. Charges do not undermine the return expectations of the product. For example, it is unlikely to be appropriate for a tax advantaged financial product to have costs or charges that equal, or exceed, the expected tax benefit for investors. It is important, during the product design process, that the firm ensures that the fees do not remove almost all of the tax advantages; and iii. The charging structure of the product is appropriately transparent for the target market (e.g. it shall not be too complex to understand or disguise charges). (ESMA Final Report December 201) 9 9 Pricing Business Model Analysis All firms need to have adequate controls around the development and marketing of their products. However, where a firm s business model relies significantly on a particular product or class of product, the firm s controls over the risks associated with the development and marketing of those products should be particularly robust in order to reflect that reliance. While we recognise that they must operate on a commercially sound basis, firms should strike a balance with pricing and market pressures to ensure that fair customer outcomes are delivered. FSA Retail Development and Governance Structured Review Firms must put consumers at the heart of their business model. That means it is important to make comparing costs as easy as possible. As part of the overall relationship between firms and consumers, firms need to manage the costs with as much tenacity as they produce returns, and make the costs they charge clear. Firms have a duty to act in the best interest of investors. For this matter, this means structuring and disclosing charges so that they are clear to investors, particularly retail investors. FCA Thematic Review 1/7 Clarity of fund charges March

14 MiFID II Governance. Customer Member States shall require that, when providing investment services, or where appropriate, ancillary services to clients, an investment firm act honestly, fairly and professionally in accordance with the best interests of its clients and comply, in particular with the principles set out in this Article and in Article 2 (Article 2 (1)) All information, including marketing materials addressed by the investment firm to clients or potential clients shall be clear, fair and not misleading. Marketing communications shall be clearly identifiable as such. (Article 2 (3)) Sales/ Distributio n Custome r Ongoing Assessme nt 7 The Lifecycle Pricing and Value Governanc e and Controls 1 2 Design 3 Approval An investment firm shall understand the financial instruments they offer or recommend, assess the compatibility of the financial instruments with the needs of the clients to whom it provides investment services, also taking account of the identified target market or end clients as referred to in Article 1(3), and ensure that financial instruments are offered or recommended only when this is in the interest of the client. (Article 2 (2)) Appropriate information shall be provided in good time to clients or potential clients with regard to the investment firm and its services, the financial instruments and proposed investment strategies, execution venues and all costs and related charges. (Article 2 ()) The information referred to in paragraphs and 9 shall be provided in a comprehensible form in such a manner that clients or potential clients are reasonably able to understand the nature and risks of the investment service and of the specific type of financial instrument that is being offered and, consequently, to take investment decisions on an informed basis. Member States may allow that information to be provided in a standardised format (Article 2 ()) 1 1 Say what? Leverage Risk: The use of derivatives to increase the exposure of the Fund to the market through either long or short positions will make the value of the Fund s investments more volatile than those of an un-leveraged fund Emerging markets & frontier risk: Emerging markets, and especially frontier markets, generally carry greater political, legal counterparty and operational risk Writing (selling) call options: In exchange for up-front cash at the time of selling the call option, the Portfolio may be limited to profit from an increase in the market value of stocks. In a rising market, the Portfolio could significantly underperform the market, and the Portfolio s options strategies may not fully protect it against declines in the value of the market The use of FDI involves additional risks: (i) FDI may be highly sensitive to price movements of the asset on which they are based; (ii) a counterparty to a non-exchange traded FDI may not meet its payment obligations in the event of default; (iii) the use of FDI may result in increased leverage. These risks may lead to significant losses Derivatives risk: A derivative may not perform as expected, and may create losses greater than the cost of the derivative Real estate risk: The Portfolio primarily invests in a very specific sector of the economy which can be particularly exposed to a downturn in macro economic conditions or particular conditions affecting the property market Use of mathematical formulae: The Investment Adviser expects to use mathematical formulae to implement the Strategy. The use of such formulae may be subject to a number of limitations and may result in the Strategy performing differently than expected as a result of the design of the formulae, inputs into the formulae or other factors 2 1

15 Transparency and clarity are paramount 3 MiFID II Governance. Sales/Distribution An investment firm which manufactures financial instruments shall make available to any distributor all appropriate information on the financial instrument and the product approval process, including the identified target market of the financial instrument When an investment firm offers or recommends financial instruments which it does not manufacture, it shall have in place adequate arrangements to obtain the information referred to in the fifth subparagraph and to understand the characteristics and identified target market of each financial instrument Sales/ Distributio n Custome r Ongoing Assessme nt 7 The Lifecycle Pricing and Value Governanc e and Controls 1 2 Design 3 Approval Investment firms shall ensure that the provision of information and details about an investment product to distributors is of an adequate standard to enable distributors to understand and sell the product properly. This shall include information about the appropriate sales channel for the product, the product approval process and the target market assessment. Firms that distribute remain subject to the overarching disclosure requirements in Article 2 of MiFID II (ESMA Final Report Dec 201) When investment products are manufactured by investment firms that fall under the MiFID scope, distributors shall obtain information to gain the necessary understanding and knowledge of the products they intend to offer in order to ensure that these products will be distributed in accordance with the needs, characteristics and objectives of the identified target market. When the manufacturer is an investment firm under MiFID, this obligation shall be considered as complementary to the duty of manufacturers of making information on products available to distributors (ESMA Final Report December 201) 1

16 MiFID II Governance 7. Ongoing Assessment The management body shall monitor and periodically assess the adequacy and the implementation of the firm s strategic objectives in the provision of investment services and activities and ancillary services, the effectiveness of the investment firm s governance arrangements and the adequacy of the policies relating to the provision of services to clients and take appropriate steps to address any deficiencies Members of the management body shall have adequate access to information and documents which are needed to oversee and monitor management decisionmaking. (Art 9 (3)) Sales/ Distributio n Custome r Ongoing Assessme nt 7 The Lifecycle Pricing and Value Governanc e and Controls 1 2 Design 3 Approval An investment firm shall regularly review financial instruments it offers or markets, taking into account any event that could materially affect the potential risk to the identified target market, to assess at least whether the financial instrument remains consistent with the needs of the identified target market and whether the intended distribution strategy remains appropriate Article 1(3) Investment firms which manufactures financial instruments for sale to clients shall ensure that those financial instruments are designed to meet the needs of an identified target market of end clients within the relevant category of clients, the strategy for distribution of the financial instruments is compatible with the identified target market, and the investment firm takes reasonable steps to ensure that the financial instrument is distributed to the identified target market Article 2(2) Distributors shall provide the manufacturer with sales information and, if necessary, information on their own reviews of the investment products they distribute and the services they provide to support product reviews carried out by manufacturers ESMA Final Report December 201 Management Information and Reporting 1

17 Management Information joining the dots Much of the Management Information will not be new. It is more about joining the dots and in some cases, thinking about things differently 2 nd and 3 rd line of defence activities Risk Management Customer feedback MI performance Sales activities Complaints And making sure that customer interests and needs are consistently evidenced... 7 Example MI Target Market s and services are designed to meet the needs of an identified target market (end investors) and are targeted accordingly Standards and Risks 1. Our products and marketing initiatives take account of our expertise, knowledge and experience and are tailored to appropriate investor segments i. Risk 1 Real end investor needs which the product/service is designed to fulfil are not identified ii. Risk 2 Staff/Distributors receive inadequate training on our products and services iii. Risk 3 - Investors are sold and/or buy products and/or services which were not designed for them Current outcome status Amber Monthly status trend Oct Nov Dec Jan Feb Mar 2. The firm deals with providers and distributors who can demonstrate the design of their products and services for both new and existing customers is compatible with the needs of the identified target market of end investor i. Risk The firm deals with providers and/or distributors who design and/or distributes products and/or services that are incompatible with the identified target market Key metrics and management commentary 1. s and services are designed to meet the real needs of an identified target market of end investors and are targeted accordingly Metric measured Rating Management commentary Consumer testing demonstrates that >90% of products sold are within the intended target market 100% of new s launched in the period have been tested successfully for end investor focus Cancellation rate within x months is less than % of total sales >90% of planned intermediary visits/ training sessions completed on time sales are within forecasted levels/tolerances for each product 8 17

18 The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. 201 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. 18