Financial Services

ESMA publishes 2023 Guidelines on MiFID II product governance requirements

Written by

Dr. Michael Huertas

RegCORE Client Alert | Capital Markets Union

QuickTake and key points

Defining product governance and thus both product manufacturers’ and distributors’ obligations has been a central part of the legislative and regulatory framework set out in MiFID II as well as the work of the European Securities and Markets Authority (ESMA). ESMA acts as both the gatekeeper of this chapter of the EU’s Single Rulebook on financial services and the driver of supervisory convergence amongst the EU’s national competent authorities (NCAs) on how product governance and other related standards are supervised. The product governance requirements introduced by MiFID II have proven to be one key element of the MiFID II investor protection framework, aiming at ensuring that financial instruments Excluding bonds with no other embedded derivative than a make-whole clause in accordance with the exemption in Article 16a of MiFID II.Show Footnote and structured deposits (collectively “products”) are manufactured and/or distributed when this is in the best interest of clients.

On 3 August 2023, ESMA published guidelines on MiFID II product governance requirements (the 2023 Guidelines). Available hereShow Footnote The 2023 Guidelines replace the previous version of the guidelines issued by ESMA, which began to apply from 3 January 2018 See hereShow Footnote and take account of recent regulatory and supervisory developments. The 2023 Guidelines are expected to be supplemented by supervisory Q&A publications. Firms are reminded that the 2023 Guidelines (like its predecessor) are relevant to dealings with retail clients but also to professional clients and eligible counterparties and with respective of the latter with the end-client in mind. A professional client and/or eligible counterparty that has the intention to on-sell products to other clients that acts only as a link in the intermediation chain is not considered an end-client but is considered a distributor.

The objectives of the 2023 Guidelines are to establish consistent, efficient and effective supervisory practice within the European System of Financial Supervision (ESFS) The ESFS is comprised of the ESAs, the NCAs and the European Systemic Risk Board and thus covers macro-prudential supervision (oversight of the financial system as a whole) and micro-prudential supervision (of individual regulated firms).Show Footnote and to ensure the common, uniform and consistent application of the MiFID II requirements on product governance. The 2023 Guidelines will be translated into the official languages of the EU and published on ESMA’s website. They will enter into effect two months after being translated and published on ESMA’s website. The 2023 Guidelines were previously published as a final report on 27 March 2023 setting out the rules in draft form along with a feedback statement See details hereShow Footnote summarising the responses received plus highlighting the amendments and clarifications received by ESMA during the consultation period. The main amendments to the 2018 version introduced into the 2023 Guidelines concern the:

  • specification of any sustainability-related objectives a product is compatible with;
  • practice of identifying a target market per cluster of products instead of per individual product (“clustering approach”);
  • determination of a compatible distribution strategy where a distributor considers that a more complex product can be distributed under non-advised sales; and
  • periodic review of products, including the application of the proportionality principle on depth and frequency of reviews.

This Client Alert looks at some of the key legal and regulatory points regulated firms may want to consider in light of the 2023 Guidelines. Accordingly, regulated firms may want to forward-plan for increased supervisory scrutiny by the NCAs coordinated by the ESMA or other European Supervisory Authorities (ESAs) (including in the European Banking Authority – EBA and the European Insurance and Occupational and Pensions Authority – EIOPA) may make use of in future supervisory cycles in 2024 and the years ahead. Equally, the 2023 Guidelines should be read in conjunction with our coverage in Client Alerts focusing on the ESA’s (in particular ESMA’s) reforms of product governance and distribution standards as well the EU’s overarching reforms in its recent Retail Investor Strategy that affects much more than “retail clients”.

The 2023 Guidelines’ requirements in detail

The 2023 Guidelines apply to regulated firms (in terms of their compliance obligations) and competent authorities in the ESFS (as supervisors). As with the preceding version, the 2023 Guidelines, state that “competent authorities and financial market participants must make every effort to comply with these guidelines.” Importantly, the term financial market participants is conceptually broader than the defined term of “firm” i.e. a regulated firm as used in other parts of the 2023 Guidelines.

The 2023 Guidelines are equally quite clear (perhaps more so than in the previous version they replace) that “competent authorities” are directed to implement the 2023 Guidelines into their national legal and/or supervisory frameworks, as appropriate, including where particular measures are direct primarily at financial market participants and that they comply with the 2023 Guidelines. However, in keeping with established processes, within two months of the 2023 Guidelines being made available in all official EU languages, NCAs are required to notify ESMA whether they (i) comply, (ii) do not comply, but intend to comply, or (iii) do not comply and do not intend to comply with the 2023 Guidelines. The compliance table for the 2018 Guidelines for example showed all NCAs complying and it is expected that the 2023 Guidelines will also see that level of compliance.Show Footnote It should be noted that some EU NCAs have included supervisory expectations and guidance on product governance requirements that may go beyond the pan-EU harmonised measures and firms will want to remain cognisant of jurisdictional differences where these exist.

The 2023 Guidelines distinguish between:

  • manufacturers: firms that manufacture a product, including the creation, development, issuance or design of that product, including when advising corporate issuers on the launch of a new product; and
  • distributors: firms that offer, recommend or sell a product and service to a client.

Firms may act, depending on product and/or target market, at any time as (i) manufacturer; (ii) distributor; or (iii) both.  Manufacturers will need to therefore ensure they meet standards expected of them but also that the distributor meets standards relevant to it and vice versa. Where third party distributors are involved, any distribution agreements and any sub-distribution agreements should include obligations on such distributors to contractually cater for respective compliance obligations.

While the 2023 Guidelines are drafted with “traditional” financial services in mind, the advent of the EU’s Markets in Crypto-Assets Regulation (MiCAR), See hereShow Footnote which also means certain crypto-assets will be regulated under MiFID II as financial instruments and others under MiCAR, will be of interest to (existing and new) regulated firms with a crypto-asset focus. The 2023 Guidelines does not refer to nor does it exclude MiCAR or crypto-assets that, pursuant to MiCAR, may become categorised as MiFID II relevant financial instruments or structured deposits and thus become, for purposes of the 2023 Guidelines, “products”.

The Guidelines are divided into the following sections, which can be summarised as follows:

  • Guidelines for manufacturers: requirements that apply only to product manufacturers. They cover the following topics:
    • Identification of the potential target market by the manufacturer (categories): manufacturers should consider the potential target market of their product by using quantitative and qualitative considerations. Manufacturers should consider the type of clients to whom the product is targeted, their knowledge and experience, their financial situation and their ability to sustain losses, their risk tolerance and their overall needs and objectives. Within, what ESMA acknowledges is a “broad category of clients’ objectives and needs”, the firm should also specify any sustainability-related objectives the product is compatible with and sets out certain criteria to be considered by the firm. ESMA also notes that services for the mass market, may require automation of processes and this automation is usually based on formulas or algorithmic methodologies that process quantitative criteria for products and clients. Such numerical data is usually generated through scoring systems (for example, by using product features like volatility of financial instruments, ratings of issuers, etc. or through “conversion” of factual data into numerical systems).
    • Identification of the potential target market (differentiation based on the nature of the product): The identification of the potential target market should be done for all products, in an appropriate and proportionate manner, considering the nature of the product. This means that the target market identification should consider the characteristics of the product including its complexity (including costs and charges structure), risk-reward profile or liquidity, or its innovative character. ESMA reminds firms that manufacturers should conduct a very comprehensive target market evaluation for certain extremely complex and risky products, such as contracts for difference (CFDs) and other products with similar qualities, resulting in a drastically decreased target market or no compatible target market at all. If a manufacturer believes that a CFD or product with similar features does not have a compatible target market, the product should not be distributed. If a manufacturer believes that a CFD, or a product with similar features, is compatible with a target market whose needs, characteristics, and objectives a CFD, or a product with similar features, is compatible with, such a target market should in any case be limited to high-risk seeking clients who understand the risks involved and who are able and willing to lose money on average with their investment and who are seeking speculative investments with only a small chance of earning positive returns.
    • Adopting a clustering approach: Manufacturers may also choose to define the target market for some items by using a common strategy if the product attributes are sufficiently comparable (i.e. the “clustering approach”). Manufacturers should use a sufficient level of granularity when using a clustering approach to ensure that only products with sufficiently comparable characteristics and risk features are grouped together (i.e., clusters should be homogeneous within themselves but heterogeneous towards other clusters). Firms should pay special attention to the amount of complexity of products while identifying homogeneous clusters, which means that the more complex the underlying items of a cluster become, the more granular the grouping should be. In general, it is assumed that a clustering strategy will not be effective for certain more complicated items, and that enterprises should specify the target market at the particular product level. When clustering products, manufacturers should consider several key factors, including: risk factors (such as market, credit, and liquidity risk); charging structure (cost level and type); optionality elements (in the case of derivatives or products with embedded derivatives); financial leverage; bail-in eligibility; subordination clauses; observability of the underlying (e.g. the use of unfamiliar or opaque indices); guarantees of principal repayment or capital protection. When utilising a clustering approach, the manufacturer should always examine and document whether a certain product belongs to a specific cluster and, as a result, whether the target market specified for this cluster may be assigned to this product. Clear criteria should be stated under each cluster for this purpose. In any event, while utilising a clustering strategy, producers should take into account the results of each product's charging structure and scenario analysis. In all circumstances, especially when utilising a clustering strategy, the target market must be determined at a sufficiently granular level to avoid incorporating any groups of investors with which the product is incompatible in terms of needs, characteristics, and aims.
    • Articulation between the distribution strategy of the manufacturer and its definition of the target market: The manufacturer must ensure that the distribution strategy it intends to use is compatible with the chosen target market. Similarly, the manufacturer must take reasonable steps to guarantee that the product reaches the intended target market. The manufacturer should develop its distribution strategy such that it favours the selling of each product to its target market. This includes making best efforts, when the manufacturer has the ability to choose the distributors of its products, to select distributors whose type of clients and services offered are compatible with the product's target market. A manufacturer should evaluate the level of client information required by the distributor to effectively analyse the target market for its product while developing the distribution strategy. As a result, the manufacturer should recommend the type of investment service that the targeted clients should or may use to obtain the financial instrument. If the product is deemed suitable for sale without advice, the firm may also identify the preferred acquisition channel.
    • Charging structures: Manufacturers must consider whether the proposed charging structure (where applicable) for the product is clear to target investors, whether the charges will undermine product return expectations, and whether they are compatible with the needs, objectives, and characteristics of the target market.
    • Product testing: Manufacturers must conduct product testing to analyse the risk of, and circumstances that may lead to, undesirable outcomes for end clients posed by the product, as well as to evaluate their product in adverse situations, such as a deteriorating market.
    • Periodic reviews: Manufacturers must analyse if the products offered or sold remain commensurate with the needs of that market and whether the distribution strategy is acceptable. The frequency of review will be determined by considerations such as the products' complexity or innovative character. Distributors will be obliged to provide information on sales (including sales made outside the target market or distribution plan) and post-sales reviews to support the manufacturer's product review.
    • Potential conflicts of interest: Manufacturers must implement procedures to ensure that their products conform with the standards for adequate conflict of interest management, including remuneration. Manufacturers must examine potential conflicts of interest each time a product is made and guarantee that the design of products does not harm end users or undermine market integrity.
  • Guidelines for distributors: requirements that apply only to product distributors. They cover the following topics:
    • Timing and relationship of target market assessment of the distributor with other product governance processes: The distributor’s target market identification (i.e., the identification of the ‘actual’ target market for that product) should be conducted as part of the general decision-making process about the range of services and products the distributor is going to distribute.  The identification of the target market of products intended for distribution, in particular, should ensure that the decisions made to define the distributor's product assortment are based on the characteristics, aims, and demands of the distributor's client base. Distributors should decide which products are going to be recommended (also through the provision of portfolio management) or offered or actively marketed to certain group of clients (characterised by common features in terms of knowledge, experience, financial situation, etc.). Distributors should also decide which products will be made available to (existing or prospective) clients at their own initiative through execution services without active marketing, considering that in such situations the level of client information available may be very limited. Accordingly, distributors should consider what distribution strategies should be used for the different client groups, including the way in which products will be marketed. In particular, where firms intend to use nudging and digital engagement practices such as gamification ESMA explains that it views gamification techniques as those that “add games or game-like competitive elements to non-game contexts such as financial services. Examples of game-like elements are earning of points or badges; keeping score or leader boards; showing performance graphs; by using meaningful stories or avatars to engage users; or introducing teammates to either induce conflict, cooperation, or competition. Gamification is a type of digital engagement practice that can be used; in turn, digital engagement practices refer to how actively users interact with a software application or platform.”Show Footnote techniques for the distribution of certain products, distributors should carefully assess whether using such techniques would be in the best interests of the client group for which such strategies would be used. See also our coverage on recent supervisory expectations on finfluencers (available here)Show Footnote
    • Relation between the product governance requirements and the assessment of suitability or appropriateness: a distributor must identify the actual target market and to ensure that a product is distributed in accordance with the actual target market is not substituted by an assessment of suitability or appropriateness and has to be conducted in addition to, and before such an assessment.
    • Identification of the target market by the distributor (categories): Distributors should use the same list of categories used by manufacturers as a basis for defining the target market for their products. However, distributors should define the target market on a more concrete level and should take into account the type of clients they provide investment services to, the nature of the products and the type of investment services they provide and the level of detail of information gathered from clients.  Distributors should verify that the concepts used to define the actual target markets for products are linked with the concepts used in the context of the suitability and appropriateness arrangements. For example, in relation to the manufacturer's target market category of knowledge and experience, which may broadly refer to “basic”, “average”, or “advanced” investors, the distributor should adopt a more granular classification consistent with its suitability or appropriateness arrangements, where appropriate given the features of the products; another example would be a distributor who, in relation to the category clients' risk tolerance, specifies clients' willingness to accept risk. Importantly, distributors should use consistent phrases and definitions when defining the actual target market for products, and they should ensure consistency between the actual target markets indicated for items with homogeneous product attributes.
    • Identification of the potential target market (differentiation based on the nature of the product): Distributors should consider the same factors as provided for manufacturers.
    • Identification and assessment of the target market by the distributor (interaction with investment services): distributors are required to identify and assess the circumstances and needs of the group of clients to whom they will offer or recommend a product. Distributors are reminded that investment advice and portfolio management services allow for a higher degree of investor protection, compared to other services provided under the appropriateness regime or under execution-only.
    • Distribution strategy of the distributor: The distributor should take the distribution strategy identified by the manufacturer into account and review it with a critical look including as to how it compares to the distributors own distribution strategy and/or other strategies of manufacturers using the same distributor.
    • Portfolio management, portfolio approach, hedging and diversification: When providing investment advice, adopting a portfolio approach, and portfolio management to the client, the distributor can use products for diversification and hedging purposes. In this context, products can be sold outside of the product target market, if the portfolio as a whole or the combination of a financial instrument with its hedge is suitable for the client.
    • Regular review by the manufacturer and distributor to respectively assess whether products and services are reaching the target market: Firms should use both quantitative and qualitative criteria to review products, relating to the product’s characteristics (e.g., changes in the product’s risk factors, investment strategy, cost structure (e.g., level and types of costs)), market conditions (e.g., adverse market conditions, regulatory developments) and distribution (e.g., client complaints, sales outside the target market, results from client surveys, online client trading behaviour). Distributors must at the very least evaluate whether the product or investment service continues to be consistent with the demands, characteristics, and objectives of the target market, as well as whether the distribution strategy is acceptable. If it determines that the target market is incorrect or that the product or investment service does not match the target market's circumstances, it must take necessary action, such as rethinking the target market.
    • Distribution of products manufactured by entities not subject to MiFID II product governance requirements: Firms that distribute products, that have not been manufactured by entities subject to the MiFID II product governance requirements, are expected to perform the necessary due diligence so as to provide an appropriate level of service and security to their clients compared to a situation where the product had been designed in accordance with the MiFID II product governance requirements.
    • Application of product governance requirements to the distribution of products manufactured before the date of application of MIFID II: products that were manufactured before the entry into force of MIFID II and are still being distributed will fall under the scope of the product governance requirements.
  • Guidelines on issues applicable to both manufacturers and distributors: guidelines that apply to both product manufacturers and distributors. They cover the following topics:
    • Identification of the “negative” target market and sales outside the positive target market: The firm needs to consider whether the product would be incompatible with certain target clients (“negative” target market), by considering the categories in the identification of target markets previously mentioned.
    • Application of the target market requirements to firms dealing in wholesale markets (i.e. with professional clients and eligible counterparties): a firm does not need to specify a target market for other firms (professional clients and eligible counterparties) within the intermediation chain, but rather it needs to design the target market with the end-client in mind (the final market in the intermediation chain).

For certain simpler products distributed under the execution-only exemption, product reviews can be less frequent and require less depth, and ad-hoc reviews can in such cases to a large extent be driven by client complaints and/or market events that significantly affect the product’s risk-return profile. A manufacturer that has advised a corporate issuer on the launch of a new product, may also apply the review obligation for that product in a proportionate manner, irrespective of whether it concerns a simpler or more complex product.

Outlook and next steps

The Guidelines are a logical conclusion of ESMA’s updates to this core policy document setting out (welcome) clarifications to legislative and regulatory requirements along with supervisory expectations. They will require EU regulated firms, both as product manufacturers as well as product distributors to review their own product governance policies and procedures as well as updating client-facing and legal documentation. This is particularly the case given that both the ESAs and individual NCAs are making greater use of “mystery shopping” to review whether firms are adequately meeting their product governance obligations. See details hereShow Footnote

Further considerations may apply to firms operating in third countries where their products are distributed and/or made available into the EU. This includes notably UK headquartered firms and their EU operations and questions on how to align ESMA’s revised supervisory expectations with the UK’s new Consumer Duty See details hereShow Footnote as well as Swiss headquartered firms and their EU operations. See coverage hereShow Footnote

Given the above, firms will want to revisit their own product governance policies and procedures as well as those persons that they rely upon throughout the product lifecycle and the intermediation chain across various channels. Given the increased supervisory scrutiny in the EU but also in other third countries on product governance compliance and client facing disclosures, some firms may also want to, in support of internal reviews and gap analysis exercises, to conduct their own mystery shopping exercises to ensure that is designed and reflected in a product governance policy, product terms as well as in a distribution agreement is actually followed in practice.

About us

PwC Legal is assisting a number of financial services firms and market participants in forward planning for changes stemming from relevant related developments. We have assembled a multi-disciplinary and multijurisdictional team of sector experts to support clients navigate challenges and seize opportunities as well as to proactively engage with their market stakeholders and regulators.

Moreover, we have developed a number of RegTech and SupTech tools for supervised firms, including PwC Legal’s Rule Scanner tool, backed by a trusted set of managed solutions from PwC Legal Business Solutions, allowing for horizon scanning and risk mapping of all legislative and regulatory developments as well as sanctions and fines from more than 750 legislative and regulatory policymakers and other industry voices in over 170 jurisdictions impacting financial services firms and their business.

Moreover, in leveraging our Rule Scanner technology, we offer a further solution for clients to digitise financial services firms’ relevant internal policies and procedures, create a comprehensive documentation inventory with an established documentation hierarchy and embedded glossary that has version control over a defined backward plus forward looking timeline to be able to ensure changes in one policy are carried through over to other policy and procedure documents, critical path dependencies are mapped and legislative and regulatory developments are flagged where these may require actions to be taken in such policies and procedures.

If you would like to discuss any of the developments mentioned above, or how they may affect your business more generally, please contact any of our key contacts or PwC Legal’s RegCORE Team via or our website.