Integration of sustainability preferences into MIFIDII and IDD product governance regulation

Aligning with clients’ sustainability preferences

In order to promote responsible investment, collecting investors’ sustainability preferences becomes compulsory for investment firms in the European Union under MIFIDII (Markets in Financial Instruments Directive) and IDD (Insurance Distribution Directive) from the 2nd of August 2022.

These responsible investment preferences will have to be taken into consideration in the investment advice.

If no suitable sustainable investments are available for the investor, the investor will have to modify his or her sustainability preferences to be allowed to invest in the product.

“Sustainability preferences” refers to a product with one of the following sustainable finance characteristics:

(a) with minimum proportion of environmentally sustainable investments (Taxonomy aligned)

(b) with minimum proportion of sustainable investments (SFDR aligned)

(c) that considers Principal Adverse Impacts (PAI) on sustainability factors where qualitative or quantitative elements demonstrating that consideration are determined by the client

Information about a) and b) can be collected in percentages or by ranges or sizes.

First draft guidelines have been published by the ESMA (European Securities and Markets Authority) and the EIOPA (European Insurance and Occupational Pensions Authority) in January and April 2022 to help financial firms implement these new requirements about sustainable investing.

They will also impact the existing rules of the European Commission about product governance, investment advice and target markets.

Product governance and target markets

What are product governance and target markets?

In order to better protect the investor, the European commission adopted in 2017 guidelines about product governance requirements (Articles 16(3) and 24(2) of MiFID II and Articles 9 and 10 of the MiFID II Delegated Directive).

The purpose of product governance is to ensure that financial firms distribute financial instruments in the best interests of investors from the beginning of the life cycle of the products on regulated markets.

More precisely, asset managers should ensure that products are designed to meet the needs of an identified target market of end-investors.

The notion of target markets is very similar to the marketing concept of a client segmentation (age, objectives, financial situation…). The logics is just inverse. Contrary to marketing, product governance starts from the product, and then makes sure the investor’s profile matches the product target market.

Distributors (pension funds, insurance companies, banks…) must thus take into consideration information provided by the manufacturer about target market in their investment decisions.

Definition of target markets

Identification of the potential target market by the manufacturer.

There are six categories to be considered by the manufacturer : type of investor, knowledge and experience, financial situation, especially the ability to bear losses, risk tolerance and investment objectives and needs.

The level of granularity in the definition of these categories may be modulated according to the product’s nature. 

Identification of the target market by the distributor.

The distributor must specify the target market defined by the manufacturer on the basis of the information at its disposal on the investors.

In the case of products that have been designed by entities that are not subject to the MiFID II product governance requirements, distributors should define the target market and distribution strategy themselves.

Six categories for target market identification

  1. The type of investors to whom the product is targeted – specification should at least be made according to MiFID II client categorisation although additional descriptions may be used to redefine the clients.
  2. Knowledge and experience – the firm should specify which knowledge the target clients should have about elements such as the product type, product features and / or knowledge in thematically related areas that help to understand the product.
  3. Financial situation with a focus on the ability to bear losses – the firm should specify the amount of losses the investor is willing and able to afford.
  4. Risk tolerance
  5. Objectives – the firm should specify the investment objectives of target clients and ESMA gives the examples of references to liquidity supply, retirement provision or the number of years the investment is to be held.
  6. Clients’ needs – MiFID II introduced the concept of needs of an identified target market of end clients’ and so the firm should specify aspects of the investment and expectations of targeted clients. ESMA notes that this could range from general to specific and gives the examples of ‘currency protection’ and ‘ethical investment’.

It is important to note that, according to recital 52-53 of the ESMA Product Governance Guidelines (ESMA35-43- 620), products can be sold outside of the positive target market provided that the portfolio as a whole is suitable for the client.

Product governance and sustainability preferences

The new requirement of the ESMA to capture sustainability preferences will affect the previous regulation about product governance.

On top of elements like the type of investors, their investment objectives, their risk tolerance…, sustainability preferences will have to be integrated to the definition of target markets from November 2022.

Considering that the target market should be set at a sufficient granular level, a general statement that a financial instrument has a sustainability-related profile should not be sufficient. Investment firms manufacturing and distributing financial instruments should rather specify to which group of clients with sustainability related objectives the financial instrument is supposed to be distributed.

COMMISSION DELEGATED DIRECTIVE (EU) of 21.4.2021, European Securities and Markets Authority

Challenges about the integration of sustainability preferences into target markets

There are different challenges related to the integration of sustainability preferences into target markets.

Granularity of sustainability preferences

Today, the ESMA requires a very high level of granularity regarding the appetence of clients for sustainable investment.

Since the characteristics of target markets are already quite granular, with information about the risk appetite, the type of investors, the investment objectives… adding other elements such as the level of taxonomy alignment, SFDR alignment or principal adverse impacts may lead quickly to hundreds of potential target markets.

Available information

Sustainable finance information about investment products should be available only from 2023. It will be thus difficult to integrate clients’ sustainable investing preferences into target market before this date.

Matching between products and target markets

Another challenge is that the number of sustainable finance products is still limited on financial markets today.

As a consequence, the probability that the distributor has a product whose target market corresponds exactly to a clients sustainability preferences will be quite limited.