PROD 3.2 Manufacture of products

General

PROD 3.2.1R

1A manufacturer must:

  1. (1)

    ensure that the financial instruments it manufactures are designed to meet the needs of an identified target market of end clients within the relevant category of clients (see COBS 3 for client categories);

  2. (2)

    ensure that the strategy for distribution of the financial instruments is compatible with the identified target market; and

  3. (3)

    take reasonable steps to ensure that the financial instrument is distributed to the identified target market.

[Note: article 24(2) of MiFID]

PROD 3.2.2G

Consideration of target market factors should permeate all aspects of product development and distribution, as well as ensuring the selection of appropriate distribution channels and the promotion of the financial instruments are accompanied by sufficient and correct information.

Product governance arrangements

PROD 3.2.3R

A manufacturer must maintain, operate and review a process for the approval of:

  1. (1)

    each financial instrument, and

  2. (2)

    significant adaptations of existing financial instruments,

in each case before they are marketed or distributed to clients.

[Note: article 16(3) of MiFID]

PROD 3.2.4R

For each financial instrument the product approval process must:

  1. (1)

    specify an identified target market of end clients within the relevant category of clients (see COBS 3 for client categories);

  2. (2)

    ensure that all relevant risks to the identified target market are assessed; and

  3. (3)

    ensure that the intended distribution strategy is consistent with the identified target market.

[Note: article 16(3) of MiFID]

PROD 3.2.5G

When designing financial instruments, a firm should have in place systems and controls to manage adequately the risks posed by financial instrument design.

Manufacture by more than one firm

PROD 3.2.6R

Where firms collaborate to manufacture a financial instrument, only one target market needs to be identified.

[Note: article 9(9) of the MiFID Delegated Directive]

PROD 3.2.7R

Where firms collaborate, including with entities which are not authorised and supervised in accordance with MiFID or third country investment firms, to create, develop, issue and/or design a financial instrument, they must outline their mutual responsibilities in a written agreement.

[Note: article 9(8) of the MiFID Delegated Directive]

Target market

PROD 3.2.8R

Manufacturers must identify the potential target market for each financial instrument at a sufficiently granular level and must:

  1. (1)

    specify the type or types of client for whose needs, characteristics and objectives the financial instrument is compatible; and

  2. (2)

    identify any group or groups of client for whose needs, characteristics and objectives the financial instrument is not compatible.

[Note: article 9(9) of the MiFID Delegated Directive]

PROD 3.2.9G

The level of granularity of the target market and the criteria used to define the target market and determine the appropriate distribution strategy should be relevant for the financial instrument and should make it possible to assess which clients fall within the target market. For simpler, more common financial instruments, the target market could be identified with less detail while for more complicated financial instruments such as bail-inable instruments or less common financial instruments, the target market should be identified with more detail.

[Note: recital 19 of the MiFID Delegated Directive]

PROD 3.2.10R

Manufacturers must determine for each financial instrument they manufacture, whether it meets the identified needs, characteristics and objectives of the target market, and in doing so must include an examination of the following elements:

  1. (1)

    whether the financial instrument’s risk/reward profile is consistent with the target market; and

  2. (2)

    whether the design of the financial instrument is driven by features that benefit the client and not by a business model which relies on poor client outcomes to be profitable.

[Note: article 9(11) of the MiFID Delegated Directive]

PROD 3.2.11R

Manufacturers of financial instruments that are distributed through other firms must determine the needs and characteristics of the clients for whom the product is compatible based on:

  1. (1)

    their theoretical knowledge of, and past experience with, the financial instrument or similar financial instruments;

  2. (2)

    the financial markets, and

  3. (3)

    the needs, characteristics and objectives of potential end clients.

[Note: article 9(9) of the MiFID Delegated Directive]

Product testing

PROD 3.2.12R

Manufacturers must undertake a scenario analysis of their financial instruments to assess:

  1. (1)

    the risks of poor outcomes for end clients posed by the financial instrument; and

  2. (2)

    in which circumstances those poor outcomes may occur.

[Note: article 9(10) MiFID Delegated Directive]

PROD 3.2.13R

In conducting the scenario analysis manufacturers must assess their financial instruments under negative conditions covering what would happen if, for example:

  1. (1)

    the market environment deteriorated; or

  2. (2)

    the manufacturer or a third party involved in manufacturing and/or the functioning of the financial instrument experiences financial difficulties or other counterparty risk materialises; or

  3. (3)

    the financial instrument fails to become commercially viable; or

  4. (4)

    demand for the financial instrument is much higher than anticipated, putting a strain on the firm’s resources and/or on the market of the underlying financial instrument.

[Note: article 9(10) MiFID Delegated Directive]

PROD 3.2.14R

Manufacturers must consider the charging structure proposed for each financial instrument, including examination of the following:

  1. (1)

    whether the financial instrument’s costs and charges are compatible with the needs, objectives and characteristics of the target market;

  2. (2)

    whether the charges undermine the financial instrument’s return expectations, such as where the costs or charges equal, exceed or remove almost all the expected tax advantages linked to a financial instrument; and

  3. (3)

    whether the charging structure of the financial instrument is appropriately transparent for the target market, such as that it does not disguise charges or is too complex to understand.

[Note: article 9(12) of the MiFID Delegated Directive]

PROD 3.2.15R

Manufacturers must consider whether the financial instrument may represent a threat to the orderly functioning, or to the stability, of financial markets before deciding to proceed with the launch of the financial instrument.

[Note: article 9(4) of the MiFID Delegated Directive]

Information disclosure to distributors

PROD 3.2.16R

A manufacturer must make available to any distributor of that financial instrument:

  1. (1)

    all appropriate information on the financial instrument;

  2. (2)

    all appropriate information on the product approval process;

  3. (3)

    the identified target market of the financial instrument, including information about the target market assessment undertaken;

  4. (4)

    information about the appropriate channels for distribution of the financial instrument;

and must ensure that the information is of an adequate standard to enable distributors to understand and recommend or sell the financial instrument properly.

[Note: article 16(3) of MiFID II and 9(13) of the MiFID Delegated Directive]

PROD 3.2.17G

When providing information to distributors, a manufacturer should make it clear if that information is not intended for end client use.

PROD 3.2.18G

Manufacturers may consider, for example, with regard to each distribution channel or type of distributor what information distributors of that type already have, their likely level of knowledge and understanding, their information needs and what form or medium would best meet those needs (which could include discussions, written material or training as appropriate).

Review of financial instruments

PROD 3.2.19R
  1. (1)

    A manufacturer must regularly review the financial instruments it manufactures taking into account any event that could materially affect the potential risk to the identified target market.

  2. (2)

    In doing so, a manufacturer must assess for each financial instrument at least the following:

    1. (a)

      whether the financial instrument remains consistent with the needs, characteristics and objectives of the identified target market;

    2. (b)

      whether the intended distribution strategy remains appropriate;

    3. (c)

      whether the financial instrument is being distributed to the target market; and

    4. (d)

      whether the financial instrument is reaching clients for whose needs, characteristics and objectives the financial instrument is not compatible.

[Note: article 16(3) of MiFID II and article 9(14) of the MiFID Delegated Directive]

G

In carrying out the reviews in PROD 3.2.19R manufacturers should collect and analyse appropriate management information to detect patterns in distribution as compared with the planned target market in order to assess the performance of the distribution channels through which a financial instrument is being distributed.

PROD 3.2.21G
  1. (1)

    When reviewing the financial instruments it manufactures, a firm should communicate to the end client contractual “breakpoints” such as the end of a long tie-in period that may have a material impact on the end client that the end client cannot reasonably be expected to recall or know about already.

  2. (2)

    If the manufacturer does not know the identity of the end client, it should communicate any contractual breakpoints to the distributor.

PROD 3.2.22R

Manufacturers must:

  1. (1)

    review financial instruments prior to any further issue or re-launch if they are aware of any event that could materially affect the potential risk to clients; and

  2. (2)

    identify crucial events that would affect the potential risk or return expectations of the financial instrument.

PROD 3.2.23G

Crucial events that would affect the potential risk or return expectations of the financial instrument include:

  1. (1)

    the crossing of a threshold that will affect the return profile of the financial instrument; or

  2. (2)

    the solvency of certain issuers whose securities and guarantees may impact the performance of the financial instrument.

PROD 3.2.24R

When a crucial event affecting the potential risk or return expectation of the financial instrument occurs, a manufacturer must take appropriate action, which may consist of:

  1. (1)

    the provision of any relevant information on the event and its consequences on the financial instrument to the clients or distributors of the financial instrument if the manufacturer does not offer or sell the financial instrument directly to the clients;

  2. (2)

    changing the product approval process;

  3. (3)

    stopping further issuance of the financial instrument;

  4. (4)

    changing the financial instrument to avoid unfair contract terms;

  5. (5)

    considering whether the sales channels through which the financial instrument is sold are appropriate where the manufacturer becomes aware that the financial instrument is not being sold as envisaged;

  6. (6)

    contacting the distributor to discuss a modification of the distribution process;

  7. (7)

    terminating the relationship with the distributor; or

  8. (8)

    informing the relevant competent authority.

R

Manufacturers must review financial instruments at regular intervals to assess whether they function as intended.

R

Manufacturers must determine how regularly to review their financial instruments based on relevant factors including factors linked to the complexity or the innovative nature of the investment strategies pursued.[Note: article 9(15) of the MiFID Delegated Directive]

Conflicts of interest

PROD 3.2.27R

Manufacturers must establish, implement and maintain procedures and measures to ensure the manufacture of financial instruments complies with the requirements on proper management of conflicts of interest (see SYSC 10.1.7R), including remuneration.

PROD 3.2.28R

Manufacturers must ensure that the design of each financial instrument, including its features, does not:

  1. (1)

    adversely affect end clients; or

  2. (2)

    lead to problems with market integrity by enabling the firm to mitigate and/or dispose of its own risks or exposure to the underlying assets of the product where the firm already holds the underlying assets on own account.

[Note: article 9(2) of the MiFID Delegated Directive]

PROD 3.2.29R

Each time a financial instrument is manufactured manufacturers must analyse potential conflicts of interests.

PROD 3.2.30R

In analysing potential conflicts of interest manufacturers must assess whether the financial instrument creates a situation where end clients may be adversely affected if end clients take:

  1. (1)

    an exposure opposite to the one previously held by the manufacturer itself; or

  2. (2)

    an exposure opposite to the one that the manufacturer wants to hold after the sale of the product.

[Note: article 9(3) of the MiFID Delegated Directive]

Oversight and training requirements

PROD 3.2.31R

Manufacturers must ensure that their management bodies have effective control over their product governance process.

PROD 3.2.32R

The development and periodic review of product governance arrangements must be monitored by the person allocated the compliance oversight function of a firm in order to detect any risk of failure by the manufacturer to comply with applicable provisions of PROD.

[Note: article 9(6) and article 9(7) of the MiFID Delegated Directive]

PROD 3.2.33R

All relevant staff involved in the manufacturing of financial instruments must possess the necessary expertise to understand the characteristics and risks of the financial instruments they intend to manufacture.

[Note: article 9(5) of the MiFID Delegated Directive]

PROD 3.2.34G

Firms should have regard to SYSC 5.1, and in particular SYSC 5.1.5AB R, when considering whether their relevant staff have the necessary expertise.

Compliance reports

PROD 3.2.35R

Compliance reports to the management body must include information about the financial instruments that the firm has manufactured, including information on the distribution strategy.

PROD 3.2.36R

Manufacturers must make the compliance reports available to their competent authority on request.

[Note: article 9(6) MiFID Delegated Directive]