In January 2018, the European Union's second Markets in Financial Instruments Directive or MiFID II introduced the product governance regime (PROD) for firms that design and distribute financial instruments.
The new regime drew heavily on the British Financial Conduct Authority’s RPPD guidance, “The Responsibilities of Providers and Distributors for the Fair Treatment of Customers,” which it aimed at all the firms that it regulates that provide products and services to retail clients.
Both still co-exist in the regulatory ether. PROD, though, seems to be emerging as the dominant one because it consists of FCA rules. PROD tells firm what they must do. The RPPD, on the other hand, is guidance in the FCA's rulebook as 'guidance' and not 'rules.'
With an unusually low-key fanfare, the FCA has published its findings from a multi-firm review of a small sample of British collective investment scheme asset management firms whose group assets under management range from £2 billion to more than £100 billion. The review concentrated on product providers (manufacturers) and the ways in which they took PROD into account, but it paid particular attention to the interests of the end-clients throughout the lifecycle of every product.
The FCA has published its findings in detail. Our summary below highlights some relatively unsurprising problems that the regulator found to support its conclusion that there is significant room for asset managers to improve their product governance arrangements.
The FCA found the asset management firms were not giving enough consideration to the target market and distribution strategy. It also said that products’ negative target market definitions overlapped. It thought that firms' arrangements to deal with conflicts of interest were ineffective, calling for better ways of working out whether a product benefits the firm rather than the investor as a result of fund charges, objectives or its general operation.
The FCA found that manufacturers' approach to scenario testing and stress testing varied. It wanted to remind firms that scenario analysis should include an assessment of resilience in volatile market conditions and scenarios that may affect the way in which an individual product performs. Buy resilience we mean the ability of the product to do the job it was designed to do (and sold to do) even in fluctuating market conditions, in other words its way of coping with volatility. Stress tests should cover adverse market conditions, including the firm’s own financial strength, asset-specific stresses and risks that flow from a highly-concentrated consumer base.
Firms need to improve the consistency of their disclosures in all communications to investors and intermediaries, not least in marketing and regulatory documents such as prospecti and the UCITS Key Investor Information Document. These also take in materials required by regulators. Previously raised as a concern in another FCA multi-firm review (February 2019), it appears that firms are still not getting this right, with firms omitting portfolio transaction costs from their cost disclosures.
The quality of how diligently asset managers checked out distributors was variable; some asset managers thought that it added little value. The FCA thinks otherwise: 'due diligence' helps asset managers to establish whether distributors are fit-for-purpose in the client onboarding process. It also ensures that the product in question is reaching its intended target market.
At the core of PROD is information exchange between manufacturers and distributors, which is proving to be a headache for asset managers. The FCA noted that this is not happening, with commercial arrangements cited as a hindrance, perhaps due to the dominance of some distributor platforms, perhaps as a result of a disinclination of asset managers to insist on gathering end-client data trends from their distributors.
Governance and oversight
The FCA has identified a number of ways of improving governance that asset managers may want to consider.
- Improvements in management information. The FCA refers asset managers back to its 2015 guide entitled "Treating customers fairly – guide to management information" (which was in fact published by the FSA in 2007), which it says “remains relevant.”
- Defining the role of the second line of defence more clearly.
- Improving the quality of 'challenge' offered by non-executive directors on Authorised Fund Manager (AFM) boards.
- Improving recordkeeping to do with the robust challenge and oversight that may or may be happening.
- Ensuring that the training process tackles the characteristics of the financial instruments and services being provided, the needs, characteristics and objectives of the identified target market and results for the end-investor.
The FCA’s assessment is that there is significant scope for improvements to be made. The FCA will continue to focus on product governance and consider the value of further changes to PROD rules and guidance. It threatens to open investigations “or other appropriate measures” wherever it identifies the likelihood of people breaking its rules.
What should asset managers do?
Do not take false comfort from the FCA restricting the scope of its review to some of the largest asset managers, i.e. those who are most likely to have (and commit) resources to make structured product governance arrangements. If the FCA has found fault here, then smaller asset managers must also consider how their arrangements will pass muster. This should be relevant to anyone who has been charged with individual accountability for Product Governance under the Senior Managers and Certification Regime or SM&CR.
Nor should any asset manager draw comfort from the FCA’s focus on UK-authorised funds. Product governance arrangements apply to the manufacture of ginancial instruments in general. They apply to product design, product testing, distribution, governance and oversight.
Asset managers should consider the effectiveness of their product governance arrangements throughout their product ranges, particularly with respect to higher-risk products that they ought not to distribute to the mass market.
That way, firms will be more likely to meet the FCA’s principal expectation: that manufacturers will act in the best interests of the funds that they manage and of those who invest in those funds.
* Jonathan Wilson can be reached on +44 (0)20 3146 1869 or at email@example.com