In early January, all eyes were focused on the implementation of MiFID II. So the Financial Conduct Authority (FCA’s) Dear CEO letter on January 10 targeted at providers and distributors of Contracts for Difference (CFDs), may well have passed under most firms’ radars.

Those that have little involvement with the CFD market may have perceived the letter as not relevant to them. But there are wider implications arising in a post MiFID II context that should be taken into account. The FCA’s approach to the distribution of CFDs gives an indication of its likely approach to product governance across the investment community - particularly towards any firm targeting investors with products or strategies that are considered higher-risk or complex.

The Dear CEO letter – What Can We Learn?

The CFD market has attracted significant attention from regulators in recent years. This scrutiny is understandable. The FCA views CFDs as high risk, complex products where many investors have already lost money. The Dear CEO letter highlighted that, during the period under review, 76% of those who bought CFDs, as part of advisory or discretionary portfolio management services, during the period under review, lost money.

The FCA is waiting for the conclusions stemming from the European Securities and Markets Authority (ESMA) discussions regarding their concerns about CFDs and binary options before confirming its final conduct rules, which were discussed in Consultation Paper 16/40. Until then, the FCA’s Dear CEO letter clearly made its views clear as far as manufacture and distribution of these products is concerned.

Many of the FCA’s concerns relate to investor suitability. Their investigation found that most CFD firms had not properly defined their target market and could not explain how CFDs fulfilled a specific investor need. Many also failed to implement proper client categorisation processes, accepting weak answers to inadequate questions regarding ‘opting up’ to elective professional status.

The investigation also highlighted more generic failings, such as the lack of proper communication and oversight between manufacturers and distributors, poor attempts at defining conflicts of interest, lack of or improper use of management information and concerns regarding corporate culture.

Parallels with MiFID II Product Governance Requirements

Many issues identified by the FCA review draw striking parallels to the matters the FCA is seeking to address with new MiFID II product governance obligations introduced into the FCA Handbook as part of its PROD rules. 

Indeed, many of the PROD requirements will resonate with firms who should already be familiar with the FCA’s guidelines on Responsibilities of Providers and Distributors for the Fair Treatment of Customers (“RPPD”).  PROD not only codifies these existing guidelines but is far greater in scope extending to all types of firms that either create, issue or design (collectively “manufacture”), or distribute financial instruments.

Firms looking to launch a new investment product or financial instrument need to clearly define their target market during the manufacturing process. They need to decide who the product is aimed at and why, who it is not aimed at, whether it is priced appropriately, and consider the product’s impact on the broader market.

Similarly, firms distributing products need to ensure that their clients are accurately categorised. That means knowing enough about their clients’ requirements to determine whether they fit the target investor profile defined by the product producer.

Ultimately, this introduces a higher bar and obligates clearer lines of communication and documentation between product manufacturers and distributors – making sure target markets are not only accurately defined but also adhered to.

What to Expect

It is clear from the FCA’s review into CFD markets that further action will be taken, with a likely tilt towards ESMA policy guidelines – particularly for firms offering CFDs as part of advisory or discretionary management services.

As those actions take shape, the FCA’s treatment of the CFD market is likely to provide precedence for how MiFID II product governance rules will be implemented and enforced across the spectrum of financial services firms and investments, but particularly in relation to high-risk, complex financial products. This notice should serve as a loud warning to all those firms involved in the manufacture and distribution of financial products; they would be wise to consider their own arrangements post MiFID II implementation.

Firms must be able to demonstrate they have adequate product governance policies and procedures in place that match the new PROD obligations and in doing so will require careful analysis and adequate internal resources. Careful thought should be given to the boundaries between MiFID and non-MiFID business, distribution activities and manufacturing. The application of rules and regulation and the customer-protective intent the FCA has in implementing these rules as guidance to non MIFID activities is noteworthy.

Although the Dear CEO letter focused on one product line, it’s view that “firms need to improve a number of oversight and control arrangements to reach standards we would consider adequate” will easily be tested on other products, as well as services, within the scope of PROD. A detailed look back over the new product governance arrangements implemented to meet the MiFID II deadline, with the findings from this notice under consideration could be a prudent step for firms take.