ESMA Opinion on Structured Retail Products—
Good Practices for Product Governance
ESMA’s 27 March 2014 opinion on good practices for product governance arrangements
for structured retail products focuses on investment firms that manufacture and
distribute retail products. The practices recommended by ESMA relate to:
The complexity of the relevant structured retail products;
The nature and range of the investment services and activities undertaken; and
The types of investors for whom certain products may be suitable.
ESMA expects national competent authorities to embed these good practices in their
supervisory approaches to structured retail products providers.
The practices ESMA recommends provide a roadmap both for firms and national competent
authorities regarding the practices they should implement or expect—as manufacturers,
distributors or supervisors—to ensure sound product governance arrangements and the
consistency of supervisory practices needed for adequate investor protection across the
European Union.COMPLIANCE ALERT
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ESMA believes these practices will bridge the gap until the MiFID 2 product governance
requirements are further developed and in place. The practices cover the following areas:
• General organization of product governance arrangements;
• Product design;
• Product testing;
• Target market;
• Distribution strategy;
• Value at the date of issuance and transparency of costs;
• Secondary market and redemption; and
• Review process.
In its July 2013 report on “retailization in the EU,” ESMA highlighted the difficulties retail
investors may face in understanding the drivers of risks and returns for structured products. If
retail investors do not properly understand the risk and reward profile, and if the sellers of the
products do not properly assess the risk appetite and risk-taking capacity of retail investors,
retail investors might be exposed to losses they do not expect. This might lead to complaints,
reputational risks for manufacturers and distributors, and a loss of confidence in the regulatory
framework and, more broadly, in financial markets.
ESMA considers sound product governance arrangements to be fundamental for investor
protection and for reducing the need for regulatory intervention. Although the good practices set
forth in the opinion focus on structured products sold to retail investors, ESMA also considers
them potentially relevant to manufacturers, financial engineers and issuers of other types of
financial instruments (such as asset-backed securities or contingent convertible bonds), as well
as to the sale of financial instruments to professional investors.
General Organization of Product Governance Arrangements
Product governance arrangements should be transparent, consistent and auditable.
Arrangements established by manufacturers or distributors should:
• Define the steps to be followed before a structured retail product (SRP) is manufactured
and/or distributed, and describe the records that must be retained about critical elements of
the product governance arrangements;
• Define the roles, powers and responsibilities of the staff involved in the product governance
• Ensure that the firm’s senior management bears responsibility for the manufacturing or
distribution of SRPs;COMPLIANCE ALERT
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• Ensure that the product governance arrangements do not rely excessively on the judgment
and discretion of a limited number of individuals, but instead effectively incorporate the
input of all relevant staff;
• Properly monitor the product governance arrangements, which may include involving other
functions, such as compliance; and
• Review and update the product governance arrangements regularly in order to ensure that
they remain robust and fit for purpose. Among other things, any such review must consider
all types of relevant business information, such as complaints or investor surveys, and give
due consideration to the customers’ best interests.
Manufacturers must meet and take into account the financial needs, investment objectives,
knowledge and experience of the target markets that they identify.
For example, the choice of underlying assets must be driven primarily by the demands of the
potential target market and not by the manufacturer’s internal needs, among which ESMA
includes the offloading of assets or liabilities from the manufacturer’s own balance sheet or
trading book. In addition, manufacturers should avoid conflicts of interest, e.g., non-competitive
internal trading and/or hedging solutions.
Manufacturers must also consider the characteristics (especially the risk characteristics) of the
SRP (such as illiquidity and riskiness of the underlying assets) and understand the model, input
parameters and assumptions built into the valuation of the SRP (e.g., the expected returns, the
payoff structure), as well as its fair value. In order to develop and document such an
understanding, manufacturers should backtest the SRP and simulate various scenarios to assess
whether the outcomes of the SRP would likely meet the investment objectives of the target
Manufacturers should appropriately identify the potential target market for the SRPs they plan
to issue, and distributors should identify and analyze the target market and distribution
methods for each SRP they intend to distribute. Furthermore, good practice requires that
distributors should establish how (in the context of the provision of each type of investment
service) and to which types of clients they will distribute the SRP. Each product must be suitable
and fit the needs of the specific client and its situation.
When assessing which investors are most appropriate for the SRP being manufactured or
distributed, firms should consider various criteria, such as the market to which the SRP provides
exposure and the investment need for which the SRP is most suited.COMPLIANCE ALERT
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When determining the target market for an SRP, firms should take into account whether the
SRP will be listed on a liquid regulated market. If not, the SRP may raise suitability questions for
certain investors and should be targeted only to those investors for which the suitability
questions can be satisfactorily resolved.
Because firms should understand in sufficient detail the target market for the SRPs they
manufacture and/or distribute, they should conduct robust research regarding investor needs,
objectives and ability to understand each SRP. An analysis of the pricing structure of each SRP
should also be conducted before manufacturing or distributing it, in order to assess whether a
less complex, costly or risky product could meet the demands and the investment objectives of
the target market.
An understanding of the target market is essential in conducting the following activities:
• Choosing the appropriate way to distribute the SRP;
• Advertising the SRP to potential investors;
• Avoiding any form of exploitation of the investors’ behavioral biases;
• Overcoming information discrepancies by providing, in the marketing materials, sufficiently
detailed information regarding the results of any scenario analysis (three financial market
scenarios should be used: performs well, offers no return and performs poorly—including
the situation in which a counterparty involved in the product fails); and
• Constructing a policy as to the appropriate actions to be undertaken if a material change
Manufacturers and distributors should put their investors’ interests first in their distribution
strategy. Manufacturers distributing their SRPs through other firms should adopt appropriate
policies and procedures regarding their relationships with those firms. Such policies and
procedures should, at the minimum, cover the following:
• Criteria and procedures governing the choice of those firms;
• Roles and responsibilities of the different parties;
• Provision to distributors of sufficiently detailed information about the SRP’s payoff
structure, the model used to create the SRP, valuation methods and the SRP’s risk-return
• Assistance to distributors in identifying conditions in which the SRP should not be
distributed to an identified target market; and
• Flagging of key risks and returns (including the expected payoff function).COMPLIANCE ALERT
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When reviewing information provided by manufacturers, distributors should:
• Consider, when providing manufacturing information to clients, whether the clients will
understand the information;
• Ask the manufacturer to supply additional information or training where that seems
necessary to understand the SRP adequately; and
• Not distribute the SRP if they do not understand it sufficiently, especially if they also intend
to provide investment advice in connection with the SRP.
Distributors should also consider the unique risk factors of the SRP when monitoring the actual
Manufacturers and distributors should also:
• Determine the training, support and disclosures needed given the nature and complexity of
the SRP to be distributed;
• Ensure that the primary purpose of training
is educational and not marketing; and
• Ensure compliance with the MiFID remuneration guidelines.
Value at the Date of Issuance and Transparency on Costs
Manufacturers should establish and directly or indirectly make available to retail investors the
value (at the date of issuance) of the SRPs they manufacture. The value should be determined
consistently with the modeling and statistical analysis used in designing and testing the SRPs, as
well as with the methodologies, models and standards used by manufacturers to value their own
Value should be established by using standards generally recognized and accepted in the
market. For example, the value of the SRP could be established according to the concept of fair
value as set out in IFRS 13, which defines that term as “the price that would be received to sell
an asset or to transfer a liability in an orderly transaction between market participants at the
This notion of fair value is based on the assumption that the elements are
valued as if they were being utilized at their highest and best use (e.g., the use that would be
made by a market participant acting in its economic best interest provided it is physically
possible, legally permissible and financially feasible to act in that fashion). Under IFRS 13,
transaction costs are considered entity-specific and are excluded when determining the fair
value of an asset. Another option would be to use the concept of “intrinsic value.” The value of
1 The content of training presentations should be sufficient, appropriate and comprehensible and should not play down the risks of
a particular SRP.
2 See ESMA’s Guidelines on Remuneration, Final Report, ESMA/2013/606, 11 June 2013.
3 All entities that publish their accounts under IFRS are subject to IFRS 13 “Fair Value Measurement” and must report accordingly
as of 1 January 2013.COMPLIANCE ALERT
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the SRP would equal the sum of the values of each of its components (e.g., known or estimated
costs and fees, the embedded derivatives and the base components), while also reflecting the
market and pricing conditions at the moment when the value is communicated to investors.
SRPs are often designed for “buy and hold” investment strategies and consequently should be
targeted to investors whose investment horizon is consistent with the maturity of the SRP. When
SRPs are not listed on a liquid secondary market, firms should offer exit opportunities to
investors who may need to sell their SRP before its maturity and disclose those opportunities
appropriately to the investors.
Exit prices of non-listed SRPs (i.e., the price at which the investor may sell its SRP before its
final maturity) should be determined using objective and predefined methodologies of which
investors are informed in advance.
When a secondary market (other than a regulated market) exists for the SRPs, firms should
adopt policies and procedures identifying and managing all relevant risks that relate to trading
on that secondary market.
When the SRP trades on a secondary market (other than a regulated market), the distributor
should disclose appropriately and in due time:
• The manner in which trading is conducted on the secondary market;
• The methods used to determine the secondary market price of the SRP;
• The means used to inform investors about the secondary market price of the SRP they hold;
• Possible costs associated with the clients’ market transactions and with the making of this
Firms should also provide appropriate information on costs that may be incurred when the SRP
is redeemed. In a timely manner, they should also announce to investors how and when the
SRPs will be repaid. In practice, such information should be provided by the distributor to its
clients using, if and when necessary, information it has obtained from the manufacturer. The
distributor should ensure it has access to such information. Such information should also be
available to competent authorities on request.
4 Once the initial offering (initial description period, initial sale or primary market) of an SRP is closed, the secondary market starts;
it typically runs until the final maturity of the particular SRP. Unlike “plain vanilla” products where secondary markets usually
provide an avenue for resale, secondary markets in SRPs can present monopolistic characteristics that may lead to a variety of
economic performance problems (such as barriers to entry or exit and price and quality issues due to informational difficulties),
creating potential conflicts of interest and a lack of liquidity.COMPLIANCE ALERT
Attorney advertising. Prior results do not guarantee a similar future outcome. The comments included in this publication do not constitute a legal opinion by Kaye Scholer or any
member of the firm. Please seek professional advice in connection with individual matters. ©2014 by Kaye Scholer LLP, 425 Park Avenue, New York, NY 10022-3598.
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At and after the close of the initial offering of an SRP, manufacturers should periodically gather
appropriate information as to the performance of the SRP in order to improve the design and
manufacture of SRPs in development, to better adapt the SRPs to the needs of the target market
and to improve their firms’ product governance arrangements.
If there is a significant difference between the actual and the expected performance of an SRP,
firms should have in place robust systems and controls that enable them to understand the
differences and, where necessary, to review their product governance arrangements. Firms
should also consider what actions should be taken to mitigate detriment to investors when an
existing SRP does not perform as expected.
In conclusion, we should note that the competent authorities are still focusing on improving and
enforcing investor protection. This ESMA opinion is just one example of how product
governance structures and arrangements should be developed and implemented by everyone
involved. It will be important to attend carefully to what MiFID 2 brings regarding investor
protection in addition to the described ESMA opinion, which is based on MiFID 1.