A number of key changes have been made to the guidelines to bring them in line with changes in the wider market, including those connected with the increasing importance of sustainability as a potential investment objective.

For product manufacturers

The updated guidelines indicate that when considering a target market, manufacturers should balance quantitative with qualitative criteria. Specifically they suggest balancing scoring systems with scenario and charging structure analyses required and undertaken under MiFID II Article 9(10) and (12).

The concept of five categories utilised to identify the target market is now formally included in the guidelines. These are:

• type of client;
• knowledge and experience;
• financial situation;
• risk tolerance; and
• client objectives and needs.

The clients’ objectives and needs category now encompasses the specification of “any sustainability-related objectives a product is compatible with” including:

• the minimum proportion of environmentally sustainable investments;
• the minimum proportion of sustainable investments;
• principal adverse impact on sustainability factors considered by the product; or
• any focus on ESG criteria.

For both manufacturers and distributors there is no requirement for the identification of a negative target market (clients with whom a product would be incompatible) in connection with sustainability-related objectives, for which only the identification of a positive target market is required.

When defining a target market, a common approach for some products that have comparable product features (“clustering approach”) is permitted. However, when using this clustering approach a sufficient level of granularity must be applied, particularly in connection with complex products. The guidelines suggest that this approach will not be appropriate for the more complex products. The guidelines recommend considering multiple factors when clustering products including:

• risk;
• charging structure;
• optionality elements;
• financial leverage;
• eligibility to bail-in;
• subordination clauses;
• observability of the underlying – (eg indices);
• principal repayment guarantees;
• capital protection clauses;
• product liquidity; and

• product currency denomination.

For product distributors

The guidelines suggest that, for distributors, target market identification should occur early – “when the firm’s business policies and distribution strategies are defined by the management body”. The distributors should, in particular, seek “compatibility with the needs, characteristics, and objectives of target clients.”

The focus of the guidance here, just like with the target market identification for manufacturers, is once again the alignment between the product and the client. And distributors are expected to “refine the distribution strategy as identified by the manufacturer” to take into account the distributor’s specific client base and target market.

Distributors will need to assess more closely the application of behavioural finance and digital engagement techniques to their distribution techniques to ensure that they would be in the best interests of the client group. Like the FCA, ESMA singles out gamification techniques as potentially harmful and the guidelines suggest that “certain gamification techniques will never be in the interest of the client” highlighting trading apps that nudge users to maximise the number of trades as an example of this.

Allowing clients to operate on a non-advised basis is possible under the guidelines with an adequate warning. The decision to allow clients to operate on a non-advised basis should be made taking into consideration the product cost and features and should not be made where there are reasonable doubts about the ability to reach the identified target market.

Products and distribution strategies should be periodically reviewed by both manufacturers and distributors. Distributors should share the results of their review with manufacturers. Information gathered that suggests a wrongly identified target market is “subject to the proportionality principle” and can be aggregated.

For both manufacturers and distributors

Finally, there are new directions for firms who either manufacture or distribute products to “substantiate and document choices made” in connection with product governance, including target market identification and distribution.

The last case study in the guidelines document includes some useful information on options, including multiple leg strategies. The case study suggests that, as a result of their complex nature and the risk involved, “option strategies should only be available to very experienced investors” and preferably on an advised basis. Additional measures will be needed for any options product distributed on a non-advised basis to ensure appropriate market targeting.

The document, including the illuminating feedback received by ESMA from industry, is essential reading for those subject to MiFID II.