MiFID II Product Governance: A Complete Guide

MiFID II product governance imposes a regime of obligations on both the manufacturers of financial products and the distributors that sell them to clients — requiring that every product is designed for an identified target market and distributed only through channels appropriate to that market.

Product governance is among the most practically demanding elements of the MiFID II framework. It applies across the lifecycle of a financial product — from initial design and target market identification through ongoing monitoring and review — and creates obligations for firms that have no direct contact with the end investor. A fund manufacturer, a structured product issuer and a platform that distributes third-party products each have distinct but interconnected obligations under the regime.

The FCA’s product governance rules are set out in PROD — the Product Intervention and Product Governance sourcebook — which implements the MiFID II product governance requirements for FCA-regulated investment firms. PROD applies to both MiFID investment firms and non-MiFID firms operating in analogous markets, making its scope broader than purely MiFID-regulated activity.

Manufacturers and Distributors: The Core Distinction

PROD divides firms into two categories: manufacturers and distributors. A manufacturer is any firm that creates, develops, issues, designs, structures, packages, manages or administers a financial instrument. A distributor is any firm that offers or sells a financial instrument to clients. The same firm can be both manufacturer and distributor — for example, a vertically integrated wealth manager that creates model portfolios and sells them directly to clients — in which case the obligations of both roles apply.

The distinction matters because the obligations are different in scope and focus. Manufacturers bear the primary responsibility for designing products that meet the needs of an identified target market and for establishing the distribution conditions under which the product should be sold. Distributors are responsible for operating within those distribution conditions, for carrying out their own target market assessment on the clients they serve, and for feeding back sales data to manufacturers.

The Manufacturer’s Product Approval Process

Before a financial product is brought to market, the manufacturer must operate a product approval process that defines and documents the product’s target market, its distribution strategy, and the arrangements in place to monitor whether the product continues to meet the target market’s needs over time. The approval process must be carried out by persons with relevant expertise who are independent of the business line developing the product — in practice, this typically means compliance sign-off is required before any new product launch.

The product approval process must consider: the product’s features, including its risk-return profile, liquidity and complexity; the type of client for whom the product is and is not designed; the distribution channels appropriate for reaching that client type; and the scenarios in which the product might perform contrary to the client’s expectations. Products with unusual or complex features — structured products with capital-at-risk, products with embedded costs that are not immediately apparent, or products whose performance is highly dependent on market conditions — require a more detailed approval analysis proportionate to the risk.

Target Market Identification

Target market identification is the analytical core of the manufacturer’s product governance obligations. The manufacturer must identify, at a sufficiently granular level, the category of clients for whom the product is designed — and must specify both the positive target market (clients for whom the product is suitable) and the negative target market (clients for whom the product should not be distributed).

PROD identifies five categories for target market assessment: client type (retail, professional, eligible counterparty); knowledge and experience; financial situation and ability to bear losses; risk tolerance and reward objectives; and client needs, objectives and characteristics. For each category, the manufacturer must specify the target market in terms that are sufficiently precise to inform distributors’ own assessment of whether the product is appropriate for their clients.

Target market specifications that are either too broad — effectively describing the whole investor population — or too narrow — specifying characteristics that only a tiny subset of investors would meet — do not comply with PROD. The FCA’s expectation is that a distributor reading the manufacturer’s target market specification should be able to make a genuine assessment of whether its clients fall within the identified market, without having to make additional assumptions about the manufacturer’s intent.

Distribution Strategy and Conditions

The manufacturer’s product governance obligations include specifying the distribution strategy for each product — the channels through which it should be distributed, the types of distributor appropriate to reach the target market, and any conditions that should apply to the distribution. These specifications must be documented and communicated to distributors before distribution begins.

Where a manufacturer identifies that a product should only be distributed through advised channels — because its complexity means clients need personalised advice to assess its suitability — that condition must be explicit in the distribution strategy. Manufacturers that allow products to be distributed through execution-only platforms when their own specifications indicate that advice is required are in breach, regardless of whether the distributor is aware of the manufacturer’s specification.

The Distributor’s Obligations

Distributors must obtain all relevant information from manufacturers about each product they sell, understand the product’s features and target market, and carry out their own compatibility assessment — determining whether the product is compatible with the needs and characteristics of the clients they serve. The distributor’s target market assessment must be at least as granular as the manufacturer’s specification and must be updated periodically as the distributor’s client base or the product’s characteristics change.

Where a distributor sells a product to clients outside the manufacturer’s positive target market, or within the negative target market, it must have documented its reasons for doing so and confirmed that the sale is appropriate in the specific circumstances. Systematic distribution outside the identified target market — without adequate justification — is a product governance failure regardless of whether individual suitability assessments were carried out.

Distributors must also feed back sales information to manufacturers at agreed intervals. The feedback obligation is mutual: manufacturers rely on distributor data to carry out their periodic product review, and distributors that fail to provide the required data undermine the manufacturer’s ability to monitor whether the product continues to meet the target market’s needs.

Ongoing Product Review

Manufacturers must carry out periodic reviews of each product to assess whether it continues to perform as expected for the identified target market. The review must consider: whether the product has performed as intended since the last review; whether any events — regulatory changes, market developments, changes to the product’s features or costs — have occurred that require reassessment of the target market specification; and whether distribution data from distributors indicates that the product is being sold to clients outside the target market.

Where a product review identifies that the product is no longer meeting the target market’s needs, or is being distributed inappropriately, the manufacturer must take corrective action — which may include amending the distribution strategy, restructuring the product, or withdrawing it from sale. The SMCR means that the senior manager responsible for product governance carries personal accountability for ensuring reviews are conducted and acted upon.

Product Governance Under the Consumer Duty

The FCA’s Consumer Duty products and services outcome requires that products are designed to meet the needs, characteristics and objectives of the target retail customer group, and to deliver good outcomes. This is closely aligned with the MiFID II product governance framework but goes further in two respects: it applies to a wider range of retail financial products than MiFID II, and it applies an outcomes-based test rather than a process-based one.

Firms subject to both PROD and the Consumer Duty must demonstrate compliance with both frameworks. Where a product meets the PROD target market specification process but does not in practice deliver good outcomes for the customers who hold it — because it is priced in a way that erodes value, because its features are not well understood by customers, or because its distribution has resulted in inappropriate holding — the Consumer Duty standard is not met even if PROD compliance is satisfied.

The Compliance Function’s Role

Product governance compliance is one of the most resource-intensive areas of investment firm compliance. The compliance function must: review each new product through the approval process; assess the adequacy of target market specifications; confirm the distribution strategy is appropriate; monitor distributor sales data against target market parameters; oversee the periodic product review process; and maintain documentation adequate for FCA inspection. At larger firms with significant product ranges, these responsibilities require a specialist product governance team rather than being managed within a general compliance function.

Key References

• FCA Handbook PROD — Product Intervention and Product Governance Sourcebook
• FCA — MiFID II overview and guidance
• FCA Handbook COBS 4 — Communicating with clients