PROD – negative target market

All the PROD governance rules can be summarised as identifying the type of investor that a particular product was designed for – otherwise known as the ‘target market’. Most readers will probably know that manufacturers are obliged to declare, against a number of investor attributes, the target market for the product. These investor attributes include whether the investor is a retail or professional investor, level of knowledge/experience, risk tolerance and ability to bear losses. Target market is also affected by such aspects as how the product will be distributed, for example on an advised or non-advised basis. All of this is usually documented in a standard template, the European MiFID Template (EMT).

So far, so good. But, if the concept of target market is intended to be clear and unambiguous, you might wonder what the following disclaimer on the EMT refers to:

“The target market specifications of this template apply for stand-alone proposals of products and do not need to be taken into consideration in case of providing investment advice adopting a portfolio approach and/or portfolio management for diversification and/or hedging purpose. In this latter case, the criteria to be considered should be at least “Investor type” & ‘knowledge & experience’.”

We were recently asked whether this means that firms only need to consider “Investor type” & ‘knowledge & experience’ in designing portfolios?

 The answer is yes … and no!

Negative target market
The statement is to do with what MiFIDII refers to as the negative target market. (Best not to think about how many Eurocrats and meetings it took to come up with that label!) 

Anyway, in a nutshell, this is the opposite of positive target market, the latter being, as described above, the categories of investor to whom a product or financial instrument is aimed (as identified by the manufacturer).

The negative target market comprises those categories of investor for whom the product or financial instrument has been identified as incompatible for some reason connected with its nature or design. PROD requires both manufacturers and distributors to identify such investors equally as much as the positive target market. 

PROD focuses exclusively on financial instruments for manufacturers but brings in investment services (which includes portfolio management) for distributors. PROD recognises that in the case of a portfolio of instruments there may well be a good reason to include a specific instrument that, on its own, would be incompatible with the investor but as part of a broad portfolio, to achieve diversification or hedging, could well be suitable. 

In those circumstances, advisers or portfolio managers are not  bound by the lowest denominator of the incompatible investment and would be able to consider a narrower range of EMT criteria. There is a certain logic to this. For example, using a hedge fund as part of a portfolio would be more likely to be suitable for an investor with reasonable knowledge and/or a professional client say, which are the two minimum criteria that are contained within the EMT disclaimer. Of course, it could well be prudent to consider a wider, yet still not full, set of criteria. It depends on the circumstances of the client. Hence, yes … and no!

ESMA guidelines
You can read about this in the ESMA guidelines document. The relevant sections are 52-55 and 67-74. These are replicated below.

The key item to note is 54 which indicates that firms can use products for clients outside of the target market provided that this is done as part of a portfolio for the purpose of diversification, and the overall portfolio is otherwise suitable for the client.


Portfolio management, portfolio approach, hedging and diversification

52. 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.

53. The identification of a target market by the distributor is without prejudice to the assessment of suitability. This means that, in certain cases, permissible deviations between the target market identification and the individual eligibility of the client may occur if the recommendation or sale of the product fulfils the suitability requirements conducted with a portfolio view as well as all other applicable legal requirements (including those relating to disclosure, identification and management of conflicts of interest, remuneration and inducements).

54. The distributor is not required to report sales outside of the positive target market to the manufacturer if these sales are for diversification and hedging purposes and if these sales are still suitable given the client’s total portfolio or the risk being hedged.

55. Sales of products into the negative target market should always be reported to the manufacturer and disclosed to the client, even if those sales are for diversification or hedging purposes. Moreover, even if for diversification purposes, sales into the negative target market should be a rare occurrence (see also paragraphs 67-74).

 

Identification of the ‘negative’ target market and sales outside the positive target market

67. The firm needs to consider whether the product would be incompatible with certain target clients (“negative” target market). When doing so, the firm should apply the same categories and principles as stated above in paragraphs 13-20 and 34-40. In line with the approach followed for the identification of the ‘positive’ target market, the manufacturer, who does not have a direct relationship with end-clients, will be able to identify the negative target market on a theoretical basis, i.e. with a more general view on how the specificities of a given product would not be compatible with certain groups of investors; the distributor, taking into account the manufacturer’s more general negative target market as well as information on its own client base, will be in the position to identify more concretely the group of clients to whom it should not distribute that specific product. In addition, the distributor is also required to identify any group(s) of clients for whose needs, characteristics and objectives, a service related to the distribution of a certain product would not be compatible.

68. Some of the target market characteristics used in the positive target market assessment by manufacturers and distributors will automatically lead to opposing characteristics for investors for whom the product is not compatible (for example, if a product is made for the investment objective “speculation” it will at the same time not be suitable for “low risk” objectives). In this case, a firm could define the negative target market by stating that the product or service is incompatible for any client outside the positive target market.

69. Again, it is important to take account of the principle of proportionality. When assessing a potential negative target market, the number and detail of factors and criteria will depend on the nature, especially the complexity or the risk-reward profile, of the product (i.e. a plain vanilla product is likely to have a smaller group of possible investors for whom it is incompatible, while the group of clients for whom the financial instrument is not compatible might be large for a more complex product).

70. There might be situations where products could, under certain circumstances and where all other legal requirements are met (including those relating to disclosure, suitability or appropriateness, identification and management of conflicts of interest), be sold outside the positive target market. However, these instances should be justified by the individual facts of the case, the reason for the deviation should be clearly documented and, where provided, included in the suitability report.

71. As the negative target market is an explicit indication of those clients for whose needs, characteristics and objectives the product is not compatible and to whom the product should not be distributed, the sale to investors within this group should be a rare occurrence, the justification for the deviation should be accordingly significant and is generally expected to be more substantiated than a justification for a sale outside the positive target market.

72. For example, the sale of products outside the target market could occur as a result of non-advised sales (i.e. where clients approach a firm to purchase a certain product without any active marketing by the firm or having been influenced in any way by that firm), where the firm does not have all the necessary information to conduct a thorough assessment of whether the client falls within the target market, which might be the case, for instance, for execution platforms that only operate under the appropriateness regime. It is expected that in the context of product governance arrangements, firms analyse ex-ante situations such as the one described, and make a responsible decision on how they are going to address them should they occur, and that client-facing employees are informed of the approach defined at management body level, so that they can comply with it. Firms should also take into consideration the nature of the products included in the range of those they intend to offer to clients (for example, in terms of complexity/risk) and the existence of any conflicts of interest with clients (such as in the case of self-placement), as well as their business model. Some firms could, for example, consider the possibility of not allowing clients to operate if they fall within the negative target market, while letting other clients transact on a financial product that is in the ‘grey’ area, i.e. between the positive and negative target markets.

73. It is important that if the distributor becomes aware, for example, through the analysis of clients’ complaints or other sources and data, that the sale of a certain product outside the target market identified ex-ante has become a significant phenomenon (for instance, in terms of number of clients involved), such input will be taken into due consideration in the course of its periodic review of the products and related services offered. In such cases, the distributor may, for example, come to the conclusion that the target market originally identified was not correct and that it needs to be reviewed or that the related distribution strategy was not appropriate for the product and has to be reconsidered.

74. Deviations from the target market (outside the positive or within the negative) which may be relevant for the product governance process of the manufacturer (especially those that are recurrent) should be reported to the manufacturer taking into account the exceptions as noted in paragraph 54.

Important Note: ATEB news is intended to provide general information ONLY. The content, including any views expressed or guidance provided, does not replace the need to comply fully with FCA Rules and Guidance. Unless you have discussed news article content with ATEB, and specifically how it relates to your circumstances, then ATEB disclaims all liability and responsibility and actions arising from any reliance placed upon it. For the avoidance of doubt therefore, any reliance you place on such information without our consultation is at your own risk.

ATEB Compliance offers compliance and regulatory advice.

ATEB Suitability provides report writing software for the financial services market.

Our View

Firms should have a documented and robust investment process that defines how investment solutions are matched with clients for whom those solutions are demonstrably suitable. The client falling within the definition of a product’s PROD ‘target market’ should be an integral part of the investment process considerations. It is noteworthy that the PROD criteria do not refer at all to the size of the client’s portfolio, so firms that still segment their clients and investment propositions according to how much money the client has to invest (you know who you are!) are probably in need of a CIP update.

It is probably more usual than not that recommended solutions are not single product solutions but a number of products combined to create a portfolio of products that work together to achieve diversification or hedging intended to aid overall management of investment risk. The ESMA guidelines aim to clarify that a portfolio might contain products that are potentially ‘incompatible’ with the investor if used on a standalone basis but which are entirely suitable when used in conjunction with the other elements of the portfolio.

Action Required By You

  • Consider whether your investment process genuinely factors in the PROD target market criteria;
  • Make sure you identify categories of client for whom your ‘standard’ propositions are not intended;
  • Define what you do for those clients – bespoke solutions perhaps?
  • Contact your usual ATEB Consultant for assistance with PROD and investment process;
  • Or contact ATEB directly. 
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About the Author

Technical Manager - Often referred to as the Oracle or the Sage, Alistair has a wealth of financial services experience. He is our go-to Technical Manager and enjoys nothing more than a complicated conundrum. Feel free to test his renowned knowledge by getting in touch.

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