MiFID II Product Governance: What It Is, Why It Matters, and How It Protects Your Firm

So, what exactly is product governance? Product governance under MiFID II is the framework that ensures financial products are designed, approved, marketed, and monitored in a way that genuinely meets the needs, objectives, and risk appetite of the right target clients.

Think of it as a quality control system for financial products. It ensures that the right products reach the right people, through the right channels, at every stage of the product's life.

The product governance requirements under MiFID II (Markets in Financial Instruments Directive II) represent one of the most significant investor protection measures in European financial regulation. They apply to both manufacturers (firms that create financial products) and distributors (firms that sell or recommend those products to clients).

MiFID II is primarily designed to protect retail clients. In the UK, equivalent domestic regimes include the Financial Promotions rules and the Consumer Duty.

Whether you're new to the topic or looking for a refresher, this guide will give you the knowledge you need to stay compliant and protect your clients. Level up your understanding without spending hours reading legislation.

Let’s dive in.

Why Was Product Governance Introduced?

Let's step back for a moment.

The 2008 financial crisis didn't just crash markets. It exposed serious problems in how financial products were being designed and sold. Investors were buying products they didn't understand. Firms were selling products that didn't suit their clients' needs. And when things went wrong, it was often the customer who paid the price.

The European Securities and Markets Authority (ESMA) recognised that having conduct of business rules at the point of sale wasn't enough. If a product is poorly designed from the start, or if it's sold to the wrong people, even the best sales practices won't prevent harm.

That's where product governance comes in.

MiFID II came into force in January 2018 as the most significant overhaul of EU financial markets rules in a decade. One of its key goals was to ensure financial products are created and sold responsibly.

The rules were designed to tackle the problem at its root by ensuring that firms consider customer interests throughout the entire product lifecycle, from design and development, through distribution, and into ongoing monitoring and review.

Pretty clever, right? Instead of just policing the sales conversation, regulators decided to make sure the whole system is built with investors in mind.

The Core Concept: Target Market Identification

At the heart of MiFID II product governance is a deceptively simple concept: the target market.

Before a financial product can be launched or distributed, firms must identify exactly who that product is designed for, and just as importantly, who it's not designed for.

Think of it like a dating app for financial products and investors. You want to match the right product with the right person based on their characteristics, needs, and goals.

When identifying the target market, firms must consider several key factors:

1. Client type: Is this product suitable for retail clients, professional clients, or eligible counterparties (eligible counterparties are normally institutional clients; most retail investors are not eligible)? Each category has different levels of knowledge and protection.
2. Knowledge and experience: How much does the target client need to understand about this type of product? What kind of market experience should they have?
3. Financial situation: Can the client afford to lose money on this product? What percentage of loss would be acceptable? Could there be additional payment obligations?
4. Risk appetite: What is the client's attitude toward risk? Does the product's risk-reward profile match what the target client would be comfortable with?
5. Objectives and needs: What is the client trying to achieve? Growth? Income? Capital preservation? Does this product help them meet those goals?

Here's the key insight: manufacturers might not have direct contact with end clients. They're often working from theoretical knowledge and experience about who might buy their products. That's why the relationship between manufacturers and distributors is so crucial—more on that later.

Manufacturer Responsibilities: Getting It Right from the Start

If you work for a firm that creates financial products, whether you're designing structured securities, launching investment funds, or developing new investment strategies, you're a manufacturer under MiFID II.

Manufacturers have some heavy lifting to do. Here are the core obligations:

Product Approval Process

Every financial product needs to go through a proper approval process before it hits the market. It requires a genuine assessment of the product's design, costs, risks, and target market. Firms must maintain, operate, and regularly review these processes to ensure they remain fit for purpose.

Scenario Analysis and Stress Testing

Here's where things get interesting. Manufacturers must perform scenario analysis to understand how their products will behave in different market conditions. What happens if markets crash? What if interest rates spike? What if volatility goes through the roof?

According to ESMA guidance, these analyses may reveal that a product's value is particularly sensitive to negative market conditions. When that's the case, the firm might need to identify a narrower target market; perhaps only clients with high risk tolerance should be targeted.

Charging Structure Analysis

Costs matter. A lot. Manufacturers must analyse whether their charging structure is compatible with the identified target market. If the fees are so high that they'll eat into returns for lower-value investors, that's a problem that needs addressing—either by modifying the charges or reassessing who the product is actually suitable for.

Information Sharing

Manufacturers must provide distributors with adequate information about the product, including details about the approval process and the identified target market. Without this information, distributors can't do their job properly.

Distributor Responsibilities: The Last Line of Defence

If you work for a firm that sells, recommends, or distributes financial products to clients, you're a distributor. This includes investment advisers, wealth managers, platforms, and anyone else in the distribution chain.

Distributors have a crucial role: they're the ones who actually interact with clients and make sure products end up in the right hands. Here's what's expected:

Understanding the Manufacturer's Target Market

First things first, distributors need to obtain and understand the target market information provided by manufacturers. They can't just take this at face value, though. Distributors must review this information with a critical eye and consider whether it makes sense for their own client base.

Identifying Their Own Target Market

Distributors must define their own "actual" target market for each product they distribute. This should be done at an early stage, before going into daily business, based on the firm's policies and distribution strategies.

Why two target markets? Because the distributor knows their clients better than the manufacturer does. The manufacturer might say a product is suitable for "experienced retail investors with high risk tolerance." But the distributor needs to translate that into their specific context—what does that actually mean for the clients they serve?

Compatible Distribution Strategy

Distributors must ensure their distribution strategy is compatible with the target market. A highly complex structured product shouldn't be sold through an execution-only platform to retail clients with no experience. The sales channel must match the product's complexity and the target client's needs.

Feedback to Manufacturers

This is where the relationship becomes a two-way street. Distributors should proactively provide manufacturers with relevant information to support product reviews. If products are being sold outside the intended target market, if there are complaints, or if there are any concerns about how products are performing for clients, manufacturers need to know.

Note: The information flow between distributors and manufacturers is not as complete as the legislation hoped. Many major players cite client and data constraints as limiting factors in the feedback process.

The FCA's 2021 review of asset managers found that distributors rarely pass this information back to manufacturers. That's a problem, because without feedback, manufacturers can't effectively review and improve their products.

Speaking of which:

Real-World Example 1: The FCA's Wake-Up Call

Let's look at what happens when product governance goes wrong. Or doesn't quite hit the mark.

In February 2021, the UK's Financial Conduct Authority (FCA) published a damning review of how eight asset management firms were implementing MiFID II product governance requirements. The firms ranged from boutique managers with £2 billion under management to giants with over £100 billion.

What did they find?

The FCA concluded that some asset managers were not acting in line with PROD, which, in its view, increases the risk of investor harm, especially where products may not be appropriate for investors.

Here are the specific problems the FCA identified:

• Conflicts of interest: While all firms had conflict management frameworks, not all were actually effective at preventing or managing conflicts. Having a policy on paper isn't the same as making it work in practice.
• Scenario and stress testing: The FCA found a varied approach to testing how products would perform in difficult conditions. Some firms weren't adequately assessing what would happen to clients if markets turned against them.
• Distributor feedback: All managers struggled to get useful feedback from distributors. But here's the twist: the FCA said managers could do more to challenge their distributors for this information and should record that challenge.
• Governance and oversight: Product governance committees often had poorly defined roles and terms of reference. There was limited evidence of meaningful challenge, and record-keeping was frequently inadequate.

The FCA's conclusion? There is "significant scope for asset managers to improve their product governance arrangements." That's regulator-speak for "you need to do better."

Want another example?

Example 2: The Contracts for Difference Crackdown

Consider Contracts for Difference (CFDs). Those complex derivative products that let you speculate on price movements without owning the underlying asset.

ESMA's updated 2023 guidelines specifically call out CFDs as products requiring extra careful target market assessment. According to the guidance, CFDs are complex and risky products where the target market assessment "should be conducted very carefully and should lead to a very narrow target market, which is confined to high-risk seeking clients."

Why such strong language?

Studies have consistently shown that most retail investors lose money trading CFDs. These aren't products for casual investors looking to grow their savings; they're speculative instruments for people who understand the risks and can afford to lose their entire investment.

When regulators see evidence that certain products are causing harm, they can use the product governance framework to restrict how those products are manufactured and distributed.

The Sustainability Dimension: What Happened in 2023

Product governance isn't standing still. In August 2023, ESMA published updated guidelines that reflect recent regulatory developments, including sustainability requirements.

Here's what changed:

1. Sustainability-related objectives: Manufacturers must now specify any sustainability-related objectives that a product is compatible with. If your product claims to be green or sustainable, you need to substantiate this claim in your target market documentation.
2. Greenwashing prevention: The guidelines aim to reduce the risk of greenwashing—making misleading claims about a product's environmental credentials. Product governance now plays a role in ensuring sustainability claims are genuine.
3. Clustering approach: Firms can now identify target markets for clusters of similar products rather than doing it individually for every single product. But be careful, as the more complex the products in a cluster, the more granular the clustering should be.
4. Enhanced distributor obligations: Distributors must now proactively provide relevant information to manufacturers to support product reviews, rather than only responding to requests.

These changes reflect the broader regulatory push toward sustainable finance and the growing importance of ESG (Environmental, Social, and Governance) considerations in investment decisions.

However, it's important to note that ESG/sustainability initiatives are “on hold” at many large banks pending clear direction from the US. With anti-ESG sentiment, there is speculation that European ESG momentum could also slow if US participation drops significantly.

The Principle of Proportionality: One Size Doesn't Fit All

Here's some good news: MiFID II product governance isn't one-size-fits-all.

The rules are designed to be applied proportionately, depending on the complexity of the product and the sophistication of the client.

What does this mean in practice?

• For simple, vanilla products distributed to the mass retail market on an execution-only basis, the requirements can be relatively light-touch.
• For complex structured products with multiple risk factors, sold to retail investors through advised channels, the requirements are much more stringent.
• For products sold exclusively to eligible counterparties (sophisticated institutional investors), some of the detailed requirements may be switched off entirely.

The level of granularity in your target market assessment should match the product and the client. Don't over-engineer your approach for simple products, but don't cut corners on complex ones either.

Ongoing Review: The Work Never Stops

Product governance isn't a one-and-done exercise. Both manufacturers and distributors must review their products on a regular basis to ensure they continue to meet the needs of the target market.

The frequency and depth of these reviews should be proportionate to the nature of the product. A straightforward equity fund might need less frequent review than a complex structured note with multiple embedded derivatives.

During reviews, firms should consider:

• Has anything changed that affects the target market?
• Are products reaching their intended target market, or being sold outside it?
• Are there any complaints or negative outcomes that suggest problems?
• Does the distribution strategy remain appropriate?
• Have any significant market events affected how the product behaves?

If the review reveals problems, firms must take action. Whether that's changing the product design, adjusting the target market, modifying the distribution strategy, or even withdrawing the product from sale.

Practical Tips for Getting Product Governance Right

Ready to improve your product governance framework? Here are some practical steps to consider:

• Document everything: If you can't prove you did something, regulators will assume you didn't. Keep records of your decisions, your challenges, and your rationale.
• Make your governance committees work: Don't let product governance committees become rubber-stamp exercises. Define clear roles and terms of reference, and ensure there's genuine challenge and debate.
• Build strong manufacturer-distributor relationships: The information flow between manufacturers and distributors is critical. Establish clear processes for sharing target market information and receiving feedback.
• Train your staff: Everyone involved in product design, approval, and distribution needs to understand the requirements. Regular training keeps knowledge fresh and awareness high.
• Use technology wisely: RegTech solutions can help automate aspects of product governance, improve data quality, and ensure consistency. But technology should support good processes, not replace good judgment.

Mastering MiFID II Product Governance

MiFID II product governance is a fundamental framework for ensuring that financial products serve their intended purpose: helping investors achieve their goals without taking on inappropriate risks.

When done well, product governance protects investors, reduces mis-selling risks, strengthens market integrity, and ultimately builds trust in the financial system. When done poorly—as the FCA's review showed—it leaves investors exposed to products that don't suit their needs.

The regulatory direction is clear: ESMA and national regulators will continue to scrutinise product governance practices. Firms that invest in getting it right now will be better positioned for the future.

Understanding the theory is one thing, but applying it confidently in your day-to-day work is another. If you want to deepen your knowledge, build practical skills, and stay ahead of regulatory developments, professional training can make all the difference.

Our MiFID II Product Governance course for finance professionals will help you understand and implement these requirements. Whether you're in product development, compliance, distribution, or advisory roles, you'll gain the practical knowledge you need to protect your clients and your firm.

Don't leave your product governance knowledge to chance. Invest in yourself, advance your career, and ensure you're equipped to navigate the complexities of MiFID II with confidence.

FAQ

What is the difference between MiFID and MiFIR?

MiFID is a Directive requiring national transposition by each EU member state, covering organisational requirements and conduct rules for investment firms.

MiFIR is a Regulation directly applicable across the EU without transposition, focusing on transparency obligations and transaction reporting.

Together, they form the MiFID II framework; the key difference is implementation: Directive versus Regulation.