DISCUSSION NOTE Product Design and Distribution Emerging Regulatory Approaches for Retail Banking Products AUGUST 2019 Finance, Competitiveness & Innovation Global Practice © 2019 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. 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CONTENTS Acknowledgements iii Acronyms and abbreviations iv EXECUTIVE SUMMARY 1 1.  INTRODUCTION 3 2.  WHAT IS PDD REGULATION AND HOW DOES IT RELATE TO OTHER FCP AREAS? 3 What is PDD Regulation 3 How PDD Regulation Differs from Product-Related Measures 4 Complementary Regulatory Powers on Product Intervention 5 WHY IS THE FOCUS ON DESIGN AND DISTRIBUTION OF FINANCIAL 3.   5 PRODUCTS INCREASING? 4.  INTERNATIONAL EXAMPLES 6 Country Case Studies 6 International Commentary 9 COMMON APPROACHES IN PDD REGULATION FOR RETAIL BANKING PRODUCTS 5.  9 Focus and Objectives of PDD Regulation 9 Key Principles Relating to Scope and Coverage of PDD Regulation 10 Requirements for Product Governance Arrangements 10 Requirements for Target Market Assessments 11 Requirements for Product Testing 12 Distribution Requirements 12 Requirements for Post-Sale Product Reviews 13 6.  PRODUCT INTERVENTION POWERS 13 What Is Meant by Product Intervention Powers 13 Scope and Range of Powers 13 Timeframes and Process Requirements 14   i ii   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products AREAS OF FUTURE RESEARCH AND ANALYSIS 7.  14 ANNEX—COUNTRY CASE STUDIES 15 Australia 15 Who Must Comply 16 Affected Products 17 Key Requirements for Issuers/Manufacturers and Distributors 17 Applicable Penalties 20 Product Intervention Powers 20 European Union 21 Who Must Comply 23 Affected Products 23 Key Requirements for Issuers/Manufacturers and Distributors 23 Applicable Penalties 25 Product Intervention Powers 25 Hong Kong 26 Design and Distribution Obligations 26 Product Intervention Powers 27 South Africa 27 Who Must Comply 27 Affected Products 27 Key Requirements for Issuers/Manufacturers and Distributors 28 Applicable Penalties 30 New Conduct Standard for Banks 30 Product Intervention Powers 30 United Kingdom 31 Who Must Comply and Affected Products 32 Key Requirements for Issuers/Manufacturers and Distributors 32 Applicable Penalties 34 Product Intervention Powers 34 REFERENCES 36 ACKNOWLEDGMENTS This Discussion Note is a product of the Responsible Financial Access Team in the World Bank Group’s Finance, Competitiveness & Innovation Global Practice. The note was drafted by Gian Boeddu (Senior Financial Sector Specialist, World Bank), Ros Grady (Senior Consultant, World Bank), and Shakti Nambiar (Consultant, World Bank). The team is grateful for valuable peer-review inputs received from Jennifer Chien (Senior Finan- cial Sector Specialist, World Bank) and Ivor Istuk (Senior Financial Sector Specialist, World Bank). Mahesh Uttamchandani (Practice Manager, Finance, Competitiveness & Innovation) provided over- all guidance. The team also gratefully acknowledges design and layout assistance provided by Debra Naylor of Naylor Design, Inc., and editorial inputs provided by Charles Hagner.   iii ACRONYMS AND ABBREVIATIONS ASIC Australian Securities and Investments Commission COFI Bill Conduct of Financial Institutions Bill – consultation draft, 2018 (South Africa)  Corporations Act Corporations Act, 2001 (Cth) Cth Commonwealth of Australia DDO Act Treasury Laws Amendment (Design and Distribution Obligations and Product Intervention Power) Act, 2019 (Cth) DDO Bill Explanatory Memorandum Treasury Laws Amendment (Design and Distribution Obligations and Product Intervention Power) Bill, 2018 (Cth) Revised Explanatory Memorandum DDO Proposals Paper  ustralian Government Design and Distribution Obligations and Product A Intervention Power – Proposals Paper, 2016 Draft DDO Regulations  raft Corporations Amendment (Design and Distribution Obligations and D Product Intervention Powers) Regulations, 2018 (Cth) EBA European Banking Authority EBA Guidelines European Banking Authority Guidelines on Product Oversight and Gover- nance for Retail Banking Products, 2015 EBA Final Report EBA Guidelines: Final Report, 2015 EU European Union FCA Financial Conduct Authority (UK) FCA Glossary FCA Handbook of Rules and Guidance – Glossary FCA TCF Outcomes Guidance FCA Guidance on Fair Treatment of Customers, 2015 (UK) FCP financial consumer protection FSCA Financial Sector Conduct Authority (South Africa) FSI Final Report Financial System Inquiry: Final Report, 2014 (Australia) FSMA Financial Services and Markets Act, 2000 (UK) FSP financial service provider FSRA Financial Sector Regulation Act, 2017 (South Africa) HKMA Hong Kong Monetary Authority HKMA TCF Charter HKMA Treat Customers Fairly Charter HKMA TCF Examples HKMA Examples of Measures to Implement Treat Customers Fairly Charter, 2014 MiFID II Markets in Financial Instruments Directive 2014/65/EU iv Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products   v MiFIR Regulation (EU) No 600/2014 National Credit Act National Consumer Credit Protection Act, 2009 (Cth) PDD product design and distribution POG product oversight and governance Sourcebook FCA Product Intervention and Product Governance Sourcebook (UK) UK United Kingdom EXECUTIVE SUMMARY Regulation of product design and distribution of financial the United Kingdom, as well as from international com- products, including retail banking products, has been mentary on regulating product design and distribution increasing. Policy makers are finding that financial con- regulation. sumer protection measures implemented to date, while still important, are insufficient to protect consumers against Typical elements of product design and distribution regu- all key risks. Anticipating new or changing risks to consum- latory frameworks for retail banking products observed ers has become more difficult for regulators due to rapid from the regimes considered in this Discussion Note financial sector innovation. Technological advancements include the following, in summary: are increasing the scale of potentially adverse consumer • Policy aims: The main focus is on requiring financial issues resulting from financial products or their distribution. service providers to put in place product oversight and These issues are especially acute in environments with low governance arrangements designed to ensure that levels of financial inclusion, where consumers are likely to financial products meet the needs of consumers in tar- have limited financial capability. get markets or market segments. The long-term objec- tive of such rules is to encourage fair treatment and The aim of regulating financial service providers’ oversight trust in the financial system by reducing the number of and governance arrangements for product design and consumers being sold products that do not match their distribution is to ensure that financial products distributed needs and consequent consumer detriment. in a market are designed to meet the needs of consumers • Coverage: Product design and distribution rules tend in that market. As with other financial consumer protec- to apply to both product issuers/manufacturers and tion measures, the long-term aim is to ensure fair treat- distributors. However, there is significant variation in ment and encourage trust in the financial sector. In turn, product coverage. Some regimes apply to all or most increased trust can lead to higher levels of financial inclu- retail banking products, while others apply only to lim- sion and resultant benefits for individual consumers as ited types. Rules are generally confined to products well as the broader economy. offered to a consumer (typically individuals, sometimes also small businesses) or its equivalent concept in a This Discussion Note discusses emerging approaches for jurisdiction. regulating oversight and governance arrangements for the design and distribution of common retail banking • Requirements for governance arrangements: A core products (that is, deposit, credit, and payment products). element of such frameworks are obligations to estab- These are usually the products first acquired by financial lish and implement clear, documented product over- consumers, and significant developments in product sight and governance arrangements. These should be design and distribution regulation have recently occurred supported by measures such as clearly articulated with respect to such products. The emerging approaches internal roles and responsibilities for product design identified in this Note are drawn from existing or pro- and distribution and requirements for senior manage- posed rules in a number of jurisdictions, including Austra- ment and all relevant functional areas to be involved in lia, the European Union, Hong Kong, South Africa, and the decision-making process.   1 2   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products • Requirements for target market assessments: A core needs of the target market and to identify possible fol- element of product design and distribution regulation low-up actions. is the need for an assessment of the target market • Proportionality: While rules on product design and when a product is being developed. The target market distribution can be applied to all retail banking prod- is generally described as the group(s) of consumers for ucts (no matter how simple or complex), their applica- whom a particular product is intended by the issuer or tion should follow a proportionate, scalable approach. manufacturer. Target market assessments are typically They should be flexible enough to take into account the responsibility of the product issuer/manufacturer, the nature, scale, and complexity of the business of the but distributors may also be required to undertake an relevant institution as well as the complexity and risk of assessment in connection with their distribution. Key the product. requirements are to identify the target market and then to ensure that a product is designed so that it is Some jurisdictions also provide complementary product suitable for that target market. These requirements can intervention powers to regulators. Such powers can be be supported by explicit obligations to undertake used to impose restrictions on the marketing, distribution, product testing. or sale of specified products. These powers may be used where there is evidence that a financial product has • Distribution requirements: Distribution channels and resulted in, or will likely result in, significant detriment to distributors are required to be appropriate for consum- retail clients that cannot be remedied in any other way. ers in the target market for a product. Issuers/manufac- turers typically have a range of obligations to screen This Note discusses such emerging approaches in more and monitor their distributors and exchange informa- detail and is intended as the beginning of an ongoing dis- tion with them, to ensure appropriate distribution of cussion on trends and lessons in good practices for regulat- their products. Distributors also typically have several ing product design and distribution of retail banking key obligations, including to distribute a product con- products. Many jurisdictions are still in the process of devel- sistently with its target market assessment and instruc- oping or implementing such rules. To date, such frame- tions from its issuer/manufacturer. works have tended to be implemented in developed • Requirements for post-sale product reviews: Follow- countries, at times through complex and extensive regula- ing product launch, the issuer/manufacturer (in consul- tion. Developing countries may need to consider imple- tation with third-party distributors and other key menting more streamlined requirements, at least initially. stakeholders) may be required to review the product There is much scope for future research and analysis on and related disclosure materials periodically. The aim these topics, including concerning supervisory experiences would be to assess whether the product still meets the and challenges and impact assessments. 1. INTRODUCTION Globally, there has been an increasing trend and interest and an overview of international commentary on PDD. The in regulating product design and distribution (PDD) in the Note also takes into account lessons learned from product financial sector. Policy makers are recognizing that tradi- design requirements from other financial sectors beyond tional financial consumer protection (FCP) approaches, banking (for example, structured investment products and while still important, are not sufficient to protect consum- insurance).1 ers fully. New or changing risks for consumers due to inno- vations in the financial sector have increased the The remainder of this Discussion Note is organized into challenges faced by regulators. These issues are height- the following sections and topics: ened in environments with rapid technological develop- • Section 2: What PDD regulation is and how it relates to ments and low levels of financial capability. other types of product regulation This Discussion Note highlights emerging approaches for • Section 3: Factors driving the increasing focus on PDD regulating financial service providers’ (FSPs) oversight and regulation governance arrangements for the design and distribution • Section 4: A summary of the case studies considered of retail banking products. The emerging approaches dis- for the purposes of the Note and an overview of vari- cussed in this Note are drawn from existing or proposed ous international commentary laws or nonbinding guidance issued by regulators, • Section 5: Emerging approaches based on such case referred to in the Note as PDD regulation, regulatory studies and international commentary frameworks, or rules. • Section 6: Product intervention powers for regulators The focus of this Discussion Note is on common retail • Section 7: Suggestions for further areas of research banking products (deposit, credit, and payment prod- • Annex: Detailed case studies ucts), as these are usually the products first acquired by financial consumers and significant developments in PDD regulation have recently occurred with respect to such WHAT IS PDD REGULATION AND 2.  products. The focus is primarily on individuals who acquire HOW DOES IT RELATE TO OTHER such products for personal or business purposes, although FCP AREAS? they may also include micro or small businesses run by entities other than individuals. What is PDD Regulation This Discussion Note provides case studies of relevant PDD regulation refers to regulation of FSPs’ oversight and PDD regulation in Australia, the European Union (EU), governance arrangements for the design and distribution Hong Kong, South Africa, and the United Kingdom (UK) of financial products—in this context, core banking prod- See, for example, Securities and Futures Commission (Hong Kong) 2016, European Securities and Markets Authority 2014, International 1.  Organization of Securities Commissions 2013, European Supervisory Authorities 2013, Financial Services Authority 2012, and Australian Financial Markets Association 2012.   3 4   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products ucts aimed at the retail market. There is increasing recog- should not be considered a substitute for PDD rules. nition that PDD rules are needed for an effective FCP Unlike product suitability rules, PDD rules apply proac- framework in relation to retail banking products. Such tively and at a market-wide level, aiming to ensure in rules may also benefit industry through increasing cus- advance that products are not offered outside an appro- tomer focus and retention and strengthening internal risk priate target market. management. Rules mandating provision of basic banking products The main components of PDD regulation comprise obli- A number of jurisdictions have introduced regulatory or gations on FSPs to have internal product oversight and industry-mandated requirements for the provision of basic governance (POG) arrangements for designing products bank accounts designed in advance to meet the needs of (and making product changes) that meet the needs of low-income and unbanked consumers. For example, the consumers in an intended target market and for ensuring EU, Canada, India, and Brazil have established such that such products are then distributed consistently with requirements.2 This Discussion Note focuses on oversight the intended target market. These components are sup- and governance arrangements for the design and distri- ported by a range of supporting elements, such as bution of retail banking products, rather than specific requirements governing how product issuers and distribu- requirements for mandated products. tors interact in connection with PDD. “Privacy by Design” rules The policy aim of PDD rules is for FSPs to offer and distrib- As with PDD, this regulatory approach emphasizes the ute to consumers more appropriately designed and tar- need for entities to be proactive in preventing harm to geted products. The focus is on reducing the risk that individuals, but in this case with respect to privacy. The consumers are offered unsuitable, harmful products, focus of privacy-by-design rules is on incorporating privacy encouraging FSPs to create fair value for consumers, and considerations into all stages of building the information helping to create a more level playing field for competi- systems, business processes, and networked architecture tors based on responsible practices with regard to prod- of an entity.3 Product development may constitute one ele- uct characteristics. ment of this process, but it is not the main focus. The EU General Data Protection Regulation is a leading example of a regulatory approach requiring implementation of pri- How PDD Regulation Differs from Product-Related vacy-by-design principles.4 Under Article 25 (“Data protec- Measures tion by design and by default”), a data controller is obliged PDD regulation can be distinguished from other types of to implement appropriate technical and organizational FCP measures that relate to product regulation. This Dis- measures both when determining the means by which it cussion Note does not cover these other types of mea- will process personal data and when actually processing it, sures. However, it is important to note that they can serve to protect the rights of data subjects and minimize unnec- purposes that complement PDD regulation as part of a essary collection or processing of such data. comprehensive FCP framework. Regulatory sandboxes and policy initiatives on innovation Product suitability rules Financial regulators are increasingly using a variety of Product suitability requirements focus on interactions with means to assess and manage the benefits and risks of individual consumers. In broad terms, product suitability technological developments in financial markets. Relevant rules create an obligation for an FSP to assess whether a regulatory and policy initiatives include the use of regula- particular product meets the financial objectives, needs, tory sandboxes and innovation hubs and accelerators for and capability of an individual customer. For example, both traditional providers and newer “FinTech” entities.5 responsible lending rules are a type of product suitability Such initiatives may involve assessing products, distribu- requirement. Such rules typically apply at the product tion channels, providers, and business models as well as acquisition stage or when obtaining personal financial some elements of FCP. The objectives of such initiatives advice. Product suitability rules can serve complementary are generally to foster innovation while also managing rel- goals and be used in combination with PDD rules but evant risks, including, but not limited to, consumer risks. For an outline of these examples, see World Bank Group 2018, pages 28–31. 2.  3. Cavoukian 2011. 4. Regulation (EU) 2016/679. 5. See Jenik and Lauer 2017 and Zetzsche et al. 2017. Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products   5 Such initiatives are therefore outside the scope of this Dis- quently sold to consumers beyond that target market, cussion Note, although one of their objectives may be to many of whom could not afford them.8 facilitate the design of financial products and services to • Rules on product and advice suitability are not design- meet customer needs better. ed to address whole-of-market design or distribution issues. As noted above, product suitability rules relate Complementary Regulatory Powers on Product to the need for a provider to assess whether a product Intervention meets the financial objectives, needs, and capability of an individual customer, rather than focusing up front Product intervention powers for regulators may be on the characteristics of the whole target market. This included with or alongside PDD rules. Relevant provisions assessment is done after the product has already been may allow regulators to ban the sale of products (to all designed and introduced into the market. Further, customers or to specific sets of customers), require the such rules typically apply only when a consumer is amendment or withdrawal of marketing materials, or actively applying for a product or receiving specific require FSPs to make changes to products. This Discus- advice. In addition, it may be impractical to require sion Note provides examples of such powers. that such assessments be undertaken for every cus- tomer, especially in relation to digital financial services (such as simple payment products). WHY IS THE FOCUS ON 3.  DESIGN AND DISTRIBUTION • Technological developments are expanding the range of potential risks posed to consumers by innovative OF FINANCIAL PRODUCTS financial products and distribution channels. For exam- INCREASING? ple, technological developments such as big data, machine learning, and artificial intelligence increase Policy makers around the world are increasingly putting in the market reach of FSPs and exponentially increase place PDD rules for financial products due to a range of the speed with which FSPs can assess, offer, and sell challenges they face, including the following: products to consumers.9 As a result, many products • Disclosure of information to consumers has proven to can now be distributed to consumers via “push” mar- be insufficient in fully addressing consumer risks. Con- keting (that is, without the consumer requesting such sumer protection frameworks have traditionally relied products) and without consumers having the opportu- heavily on requiring FSPs to follow good practices in nity to obtain advice, ask questions, or take the time to terms of disclosing prices, terms and conditions, and consider the suitability of the product to their needs appropriate advice to consumers.6 Disclosure require- (for example, digital credit). Such risks cannot be fully ments can help consumers make informed decisions addressed through disclosure or market-conduct regu- regarding the products they select, increasing con- lation at the point-of-sale stage but may instead sumer welfare. However, it is increasingly recognized require the earlier-stage, more proactive intervention that disclosure is by no means a complete solution— that PDD rules provide. for example: “disclosure can be ineffective for a num- • The above issues are likely to be exacerbated in envi- ber of reasons, including consumer disengagement, ronments with low financial capability. complexity of documents and products, behavioural biases, misaligned interests and low financial literacy.”7 These challenges have led policy makers to focus on pro- • In the absence of regulation, industry participants’ vider behavior before the point of sale in order to protect POG arrangements are frequently inadequate. For consumers more proactively and comprehensively. The example, when consulting on the then proposed PDD focus becomes preventing consumers from being expos- rules for the EU on retail banking products, the Euro- ed to consumer risks, rather than arming consumers with pean Banking Authority (EBA) described a number of information to avoid such risks. This change in focus shifts conduct issues identified by Member States, such as the responsibility from consumers being better informed distribution of specific types of mortgages originally to protect themselves; instead, PDD rules place a greater targeted at a niche group of borrowers but subse- onus on providers. See, for example, Organisation for Economic Co-operation and Development 2011, Principle 4, and World Bank Group 2017, Chapter 1, 6.  Section B, “Deposit and Credit Products and Services.” 7. See, for example, Australian Government the Treasury 2014, page 199. 8. EBA 2014, page 7. 9. For a discussion of consumer risks with these developments, see Grady, Montes, and Traversa 2018. 6   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products It is also in the interests of FSPs to have fair product design tions are proposed in the Draft Corporations Amend- standards. Given that PDD rules should result in more ment (Design and Distribution Obligations and Product appropriately designed and targeted products, FSPs that Intervention Powers) Regulations, 2018 (Draft DDO are focused on creating value for consumers will have an Regulations). The regime will come into effect in 2021. increased ability to attract new customers and retain and • EU: The EBA recently introduced legally binding deepen existing customer relationships.10 The number of guidelines—EBA Guidelines on Product Oversight and enquiries and complaints from consumers are likely to Governance for Retail Banking Products, 2015 (EBA decrease. For example, if credit products are targeted to Guidelines)—imposing PDD rules in relation to all retail segments where there is a clear need and capacity, then banking products that are expected to be imple- the risk of over-indebtedness (and corresponding loss) mented by individual Member States. In addition, Reg- should be reduced. ulation (EU) No 600/2014 (MiFIR) gives product intervention powers for some products to both the PDD rules can also assist regulatory efficiency, as well as EBA and regulators in individual Member States. effectiveness. For example, the report that led to the intro- duction of Australia’s new PDD laws noted the following: • Hong Kong: Several years ago, the Hong Kong Mon- etary Authority (HKMA) introduced a new Treat Cus- “ This [product design regulation] option would deliver tomers Fairly (TCF) Charter containing principles that benefits to industry, including strengthening internal risk banks agreed to be bound by, including, among oth- management for product design, which may mitigate ers, a high-level PDD obligation supported by some future problems, as well as signaling a higher level of cus- limited guidance from the HKMA. tomer focus. This approach should also avoid new, more complex and interventionist regulation in the future, pro- • South Africa: South Africa is in the process of intro- moting efficiency in the financial system overall.”11 ducing a new FCP regulatory regime comprising, among other measures, PDD requirements applying to a range of products, including retail banking products. 4.  INTERNATIONAL EXAMPLES The regime is proposed in the Conduct of Financial Institutions Bill—consultation draft, 2018 (COFI Bill). Country Case Studies The FCP regulator, the Financial Sector Conduct Authority (FSCA), will also be given new product inter- A range of jurisdictions have introduced or are introducing vention powers. PDD regulatory frameworks that apply to some or all retail banking products. This Discussion Note examines the fol- • UK: The Financial Conduct Authority (FCA) has includ- lowing five such jurisdictions from around the world (and ed PDD rules and related guidance in its Handbook of the EU covers a number of countries): Rules and Guidance for financial firms, in a chapter called “Product Intervention and Product Governance • Australia: Australia recently passed legislation that Sourcebook” (Sourcebook). Relevantly in this context, imposes PDD rules in relation to most retail banking these rules apply to structured deposits,12 but not to products, other than credit. It also gives the regulator, other retail banking products. The FCA has also been the Australian Securities and Investments Commission given powers in the Financial Services and Markets (ASIC), product intervention powers that would cover Act, 2000 (FSMA) to make temporary and permanent all such products, including credit. The new regime product interventions applicable to such deposits was introduced by the Treasury Laws Amendment under a separate regime. (Design and Distribution Obligations and Product Intervention Power) Act (Cth) 2019 (DDO Act), amend- Table 1 below summarizes and compares at a high level ing the Corporations Act, 2001 (Cth) (Corporations each of these regimes as applicable to retail banking Act) and the National Consumer Credit Protection Act products. The case studies set out in the annex provide a 2009 (Cth) (National Credit Act). Supporting regula- more detailed summary of each regime. 10. See Consultative Group to Assist the Poor 2016, page 12. Australian Government the Treasury 2014, page 203. 11.  Being, in summary, a deposit in relation to which interest or a return is determined according to a formula that takes into account factors 12.  such as one or more indices, one or more financial instruments, one or more commodities or other assets, or one or more foreign exchange rates. See FCA Handbook of Rules and Guidance—Glossary. TABLE 1: Country Case Studies: Summary of Key PDD Rules KEY RULES AUSTRALIA EU HONG KONG SOUTH AFRICA UK Retail banking PDD rules generally apply to all PDD rules apply to credit, deposit PDD rules apply to Full range of financial products, PDD rules apply to structured products financial products provided to and payment products offered and banking products and including retail banking products. More deposits. covered retail clients (being individuals sold to consumers (being individuals services. onerous PDD requirements apply in Product intervention powers and small businesses), acquiring products for non-business/ relation to retail financial customers. No specific product apply to regulated financial excluding consumer credit professional purposes). intervention powers. products more broadly. products. Relevant product intervention Product intervention powers powers are more limited, applying generally apply to all retail to financial instruments (which banking products, including include structured deposits). consumer credit products. Key Must determine the target •  Must establish, implement, •  Banks must comply with Must establish and implement product •  Must identify the potential •  obligations market for any product they and review effective POG the principle that banking oversight arrangements relating to the target market for each for product develop (target market arrangements. services and products design of financial products. product. issuers/ determination). should be designed to Primary responsibility for •  Each new financial product must •  Must have governance •  manufacturers meet the needs of Over time, must review •  identifying and specifying a be signed off by the institution’s arrangements in place to customers. The HKMA’s a target market determina- product’s target market, along governing body before it is marketed, ensure that products are guidance notes that this tion to ensure it remains with product testing obligations. and this sign-off must be accompanied designed having regard to means banks should appropriate. by a confirmation that the product, the target market. Should select distribution •  design services and its distribution methods, and its Must take reasonable steps •  channels that are appropriate for products that meet the Must comply with product •  disclosure documents all meet the to ensure that a product’s the particular target market and needs of their target testing obligations, requirements for financial product distribution will be consistent take all reasonable steps to ensure customer segments. including undertaking a oversight arrangements. with the target market that distributors comply with their scenario analysis for their determination. product governance arrange- Must also undertake a thorough •  products. ments. assessment of the target market when Must notify the regulator of •  Should share information •  developing a new product and its any significant dealings in the Should provide distributors with •  with distributors to allow distribution methods and disclosure product inconsistent with its clear, up-to-date, and precise each other to meet their documents. target market determination. information about the product, obligations. enabling them to understand the Must give adequate information about •  Must regularly review their •  product and properly place it in the product to distributors. products and target market the market. Products must be subject to ongoing •  determinations. Responsible for product monitor- •  monitoring and periodic review of ing and should do so on an product performance. ongoing basis. If a problem is identified, should take necessary action to mitigate the situation and prevent further detriment. Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products   7 TABLE 1, continued KEY RULES AUSTRALIA EU HONG KONG SOUTH AFRICA UK Key Must not engage in retail •  •  Must establish, implement, and Must take all reasonable steps to •  Must identify the potential •  obligations product distribution conduct review effective POG arrange- ensure that distribution or advice target market for each for product unless a target market ments. channels act in compliance with the product they distribute and distributors determination is in place. objectives of their governance policy their distribution strategy. Distributors should use this •  (including or distribution model. If distributors Must take reasonable steps •  information, along with their own Must have governance •  issuers/ become aware of a problem, they to act consistently with the knowledge, to determine whether arrangements in place to manufacturers must take remedial action. determination. a consumer belongs in the target ensure that products are who self- market. Must regularly monitor whether •  distributed having regard distribute) Must not distribute a product •  products are being distributed to the to the target market. when its target market Distributors should collect •  target market. determination may not be relevant information in order to Should share information •  appropriate. assist manufacturers with product about a product with its monitoring. manufacturer to allow each Must collect and provide •  other to meet their distribution information to obligations. product issuers. Must regularly review their •  Must notify the issuer of any •  products and target market significant dealings in a determinations. product inconsistent with its target market determination. Product ASIC may make a product The EBA has powers to temporarily N/A The FSCA may prescribe conduct The FCA has power to make intervention intervention order if satisfied prohibit or restrict a type of financial standards, including those that prohibit temporary or permanent powers that a product has resulted, or activity or the marketing, distribu- or restrict the offer of products to certain product intervention rules will or is likely to result, in tion, or sale of particular structured types of customer or the offer of certain prohibiting firms from significant detriment to retail deposits. (Regulators of Member products. engaging in certain types of 8   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products clients. Such an order can States are also given powers to conduct, including prohibit a person from make similar orders, temporarily or prohibiting entering into engaging in specified conduct permanently.) specified agreements with in relation to the specified class any person or specified of products, either entirely or person or doing so unless unless they meet specified meeting specified require- conditions. ments. Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products   9 International Commentary require that processes and procedures at the provider level: International commentary on FCP also reflects an increas- ing focus on PDD issues. For example, the G20 High- • identify and control product risks across the value chain, Level Principles for Digital Financial Inclusion, issued in including in the development and distribution phases; 2016, emphasize the need for consumer-centric product • set out a product design and pricing philosophy; and design approaches as a means of promoting digital finan- • define target clients and the process for authorization cial inclusion, noting the need to and introduction of new consumer products and ser- [e]ncourage industry . . . to adopt customer-centric prod- vices.17 uct design approaches that focus on customer needs, preferences and behaviours and facilitate the uptake and usage of digital financial services among the financially COMMON APPROACHES IN 5.  excluded and underserved.13 PDD REGULATION FOR RETAIL The World Bank’s recently published Good Practices for BANKING PRODUCTS Financial Consumer Protection notes that product regula- tion is an emerging area of regulation beyond product A number of common approaches regarding the scope suitability and includes requiring that the product design and elements of PDD regulatory frameworks for retail process ensures good consumer outcomes. The authors banking products can be observed from the regimes con- explain the following: sidered in this Discussion Note. These approaches relate to the following: Product regulation [includes] … requiring that the product design process ensures good consumer outcomes … • The policy aims of PDD regulation [which] consists of regulatory requirements regarding the • The coverage (in terms of both products and provid- efficacy of product oversight and governance by financial ers) and application of PDD regulation service providers and covers the whole product cycle from • Requirements for governance arrangements research to post-sales, with the objective of producing fair • Requirements for target market assessments outcomes for consumers in general—that is, not for a spe- • Requirements for product testing cific consumer. This approach could give clearer means for the supervisory authority to take action when unsuitable • Distribution requirements products are introduced in the market or offered to a par- • Requirements for post-sale product reviews ticular consumer, even where there are no regulatory pro- When considering how such approaches may be imple- hibitions on a specific practice or product.14 mented by any jurisdiction, it is important to keep in mind The first of the Smart Campaign’s Client Protection Princi- that PDD regulation is a relatively new field, particularly in ples (focusing on microfinance) addresses product design relation to retail banking products. Country context also and delivery issues, stating the following: matters. PDD regulatory frameworks will need to be appropriately adapted for each country. For example, a Appropriate product design and delivery country seeking to introduce PDD rules within a nascent Providers will take adequate care to design products and FCP legal framework may need to start with some simpler delivery channels in such a way that they do not cause clients harm. Products and delivery channels will be requirements. designed with client characteristics taken into account.15 Focus and Objectives of PDD Regulation Six core elements of appropriate product design and delivery are discussed in the Smart Campaign’s Detailed The main focus of PDD regulation is to require FSPs to put Guidance on the Client Protection Principles.16 The core in place POG arrangements designed to ensure that elements include, among others, suitable product design, financial products meet the needs of consumers in target suitable product delivery, and product simplicity. markets or market segments. The long-term objective of such rules is to encourage fair treatment and trust in the A model law developed by the Smart Campaign to pro- financial system. For example, when Australia’s recently vide a model legal framework for FCP contains provisions introduced PDD rules were first proposed, their stated concerning product risk management. These provisions objectives were the following: 13. Organisation for Economic Co-operation and Development 2011, page 8 (guidance on Principle 1). 14. World Bank Group 2017, Chapter 1, Section C4, page 39. 15. Smart Campaign 2015. For an example of the implementation of this principle, see Smart Campaign 2012. 16. Smart Campaign 2011. 17. Smart Campaign 2015, pages 20–21. 10   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products • Reduce the number of consumers buying products • Take a proportional approach: The onerousness of that do not match their needs, and reduce consequent POG obligations (that is, the practical compliance bur- significant consumer detriment. den on FSPs) should be proportional to the nature, scale, and complexity of both the business of the rele- • Promote fair treatment of consumers by firms that vant institution and the product in question.22 design and distribute financial products. • Cover both simple and complex products: Of the • Promote efficiency and limit or avoid the future need case studies reviewed for this Discussion Note, none for more prescriptive regulation. makes a specific distinction between applying PDD • Build confidence and trust in the financial system.18 rules to simple products such as basic banking, credit, and accounts and applying them to more complex The EU’s new PDD rules for retail banking products intro- products. Rather, the common view tends to be that a duced in the EBA Guidelines are intended to proportional or scalable approach to the application of deal with the establishment of product oversight and gov- the PDD rules should ensure that compliance for sim- ernance arrangements for both manufacturers and distrib- ple products is more straightforward and feasible to utors as an integral part of the general organisational re- apply by all FSPs.23 quirements linked to internal control systems of firms. . . . • Cover “consumers”: PDD rules are generally confined They establish procedures relevant for ensuring the inter- ests, objectives, and characteristics of target markets are to products offered to a “consumer” (or its equivalent met.19 term), as with other FCP rules. As a result, while indi- viduals are always covered, sometimes coverage is lim- ited to individuals acquiring products for nonbusiness Key Principles Relating to Scope and Coverage of purposes, such as in the case of the EBA Guidelines. PDD Regulation However, sometimes PDD rules also apply to products PDD regulatory frameworks for retail banking products sold to smaller businesses. This is the case with the tend to reflect the following baseline principles, although new Australian PDD legislation as well as the COFI Bill not all elements are found in all examples: in South Africa. Further, although the EBA Guidelines currently apply only to individual consumers, the • Apply rules to issuers, manufacturers, and distribu- Guidelines state that competent authorities may wish tors: PDD rules tend to be applied to (i) product issu- to consider extending the protections of the Guide- ers who design products and distribute them in their lines to microenterprises and small and medium-sized own name or that of a third party (under a “white-label enterprises.24 arrangement”) (in each case, the issuer has the con- tractual relationship with the end customer); (ii) prod- • Consider implementation and compliance costs: As uct manufacturers who design products for one or noted in the Australian Government’s paper that pro- more third-party issuers (that is, they have no contrac- posed its PDD reforms25 (DDO Proposals Paper), it is tual relationship with the end customer);20 and (iii) important that a PDD framework not impose unneces- third-party distributors of products.21 sary implementation and compliance costs.26 This is also reflected in the proportionality aspect of PDD • Focus on customer needs: PDD rules focus on the rules noted above. need for financial products to be designed, marketed, and distributed so they meet consumer needs and Requirements for Product Governance capabilities. Providers are required to place increased Arrangements focus on what target consumers want and need, rather than only on what products can be sold to consumers A core element of PDD frameworks is the obligation of with a view to maximizing profits. regulated entities to establish and implement clear, docu- 18. Australian Government the Treasury 2014, page 199. EBA Guidelines, para. 5. 19.  It may be the case, however, that a product manufacturer is not within the mandate of the financial system regulator. 20.  See, for example, EBA Guidelines, para. 6. 21.  See, for example, EBA Guidelines, guidelines 1.5 and 9.1, and COFI Bill, section 48(3). 22.  See, for example, Sourcebook 3.1.2R-3.1.3G. 23.  EBA Guidelines, para. 8. 24.  25. Australian Government the Treasury 2016. 26. Australian Government the Treasury 2016, page 8. Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products   11 market(s)” and the related need to assess the “financial mented POG arrangements. Though framed differently in capability” of the target market,29 and the Australian different countries, these obligations typically require that legislation refers to the “likely objectives, financial situ- such arrangements are designed to ensure a consumer ation and needs” of retail client(s).30 The UK’s rules centric PDD process for the entire product life cycle. For refer to the “identified needs, characteristics and example, the EBA Guidelines state the following: objectives” of the target market.31 The COFI Bill simply The manufacturer should establish, implement and review requires that appropriate steps be taken to identify the effective product oversight and governance arrange- consumers to whom products are targeted and that ments. The arrangements should aim, when products are the financial institutions satisfy themselves that the being designed and brought to the market, (i) to ensure products are “appropriate” to their “needs.”32 that the interests, objectives and characteristics of con- sumers are taken into account, (ii) to avoid potential con- • Assess whether the product is suitable for its target sumer detriment and (iii) to minimise conflicts of interest.27 market: Such assessments should take into account factors such as product features (including whether it is The case studies also include supporting requirements for complex or simple), risks, and, sometimes, charges. mandated governance arrangements, such as The focus with regard to charges seems to be on • having clearly articulated internal roles and responsi- requiring financial institutions to bring to the market bilities; products with charges that suit the target market pro- file,33 rather than to mandate specific requirements as • requirements for senior management and all relevant to the level of the fees and charges. For example, the functional areas (including legal and compliance) to be EBA Guidelines refer to the need to take “charges” involved in the decision-making process; into account in a target market assessment.34 Such an • requirements for the board or equivalent governing approach could be a more practical and flexible alter- body to sign off on the final product design; and native to policy makers mandating the permissible lev- els of fees and charges, a blunter and less targeted • a requirement for consultation with key stakeholders, policy approach.35 including target consumer groups and industry and proposed distributors. PDD regulatory frameworks also tend to include proce- dural requirements regarding target market assessments. Requirements for Target Market Assessments For example, assessments may be required to be in writ- ing; describe the relevant class of clients (including Another core element of PDD regulatory frameworks is clients not within the target market); describe the distri- the need for an assessment of the target market when a bution arrangements; specify the review period and trig- product is being developed. The target market is gener- ger for review; and be updated as necessary from time to ally described as the group(s) of consumers for whom a time. Assessment reports may also be required to be particular product is intended by the issuer or manufac- publicly available free of charge. There are also require- turer.28 Key requirements include the following: ments that records be kept of all decisions in relation to • Identify the target market and then consider its pro- the assessment.36 file: What should be considered in determining the profile of a target market varies but often includes fac- However, PDD regulatory frameworks tend not to describe tors such as the needs, objectives, characteristics, or how a target market should be defined beyond the gen- situations of customers within the target market. For eral elements discussed above, seemingly leaving this example, the EBA Guidelines refer to “the interests, matter to FSPs. For example, the case studies considered objectives and characteristics of the identified target in this Discussion Note generally did not include express 27. EBA Guidelines, guideline 1.1. See also guideline 9.1 for distributors. See, for example, EBA Guidelines’ definition of a “target market” at para. 15: “The group or groups of end consumers for whom the 28.  product is designed, as intended by the manufacturer.” EBA Guidelines 3.2 and 3.6. 29.  Corporations Act, section 994B(8)(b), as inserted by the DDO Act. 30.  31. FCA Sourcebook, para. 3.2.10. 32. COFI Bill, section 49(1)(b). 33. See, for example, Sourcebook 3.2.14R. 34. EBA Guidelines, section 3.3. For a discussion of issues with interest rate caps, see Ferrari, Masetti, and Ren 2018. Case studies discussed in the paper indicated that, 35.  while some forms of interest rate caps can indeed reduce lending rates and help to limit predatory practices by formal lenders, interest rate caps often have substantial unintended side effects. Corporations Act, sections 994B and 994F, as inserted by the DDO Act; Sourcebook 3.2.8R–3.2.10R; and EBA Guidelines, guidelines 1.1–1.4 36.  and 9.1–9.3. 12   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products requirements on defining a target market by reference to Distribution Requirements geographic, demographic, or socioeconomic factors. PDD frameworks tend to include a range of obligations on Additional expectations, however, could be set by regula- product issuers/manufacturers in relation to their distribu- tors through guidance. For example, the EBA, in its final tion arrangements for a product. Key obligations include report leading up to the introduction of the EBA Guide- the following:42 lines, referred to “good practice examples” for compli- ance with target market assessment requirements that • Distribution channels and distributors should be included demographic factors.37 appropriate for consumers in the target market for the product. Requirements for Product Testing • Distributors should be provided with the target market assessment and clear and appropriate information as Product testing may also be part of the required product to the target market, product features, risks, and fees design processes contemplated by PDD regulatory frame- and charges to be paid by the consumer. works. Depending on the complexity of a product, it may be required to be piloted, and even stress tested, with a • Issuers should conduct due diligence on distributors view to identifying how the product might perform in a and continuously monitor their activities. variety of market environments and assessing how cus- • Issuers should obtain ongoing and frequent feedback tomers will be affected.38 from distributors over the product life cycle, including about perceived product risks and events that should For example, under the EBA Guidelines, manufacturers trigger reviews. have product testing obligations that must be fulfilled • The risks of conflicts of interest should be minimized. before the product can be brought to market. This This includes conflicts arising from any remuneration or includes obligations relating to new products, existing commissions to be paid to distributors. products introduced to new target markets, and existing products to which significant changes have been made. A • Issuers should take appropriate action when they have manufacturer is expected to conduct product testing to concerns about distribution arrangements (for exam- assess how the product would affect its consumers under ple, by ceasing to use a distribution channel or a par- a wide range of scenarios, including stressed scenarios.39 ticular distributor). The nature and level of any required testing, however, • If either the issuer or distributor outsources all or part would depend on the complexity of the product and level of their regulated activities, then they should comply of potential risk for the consumer.40 with any separate rules on outsourcing, including retaining responsibility for the activities of the entity to In the UK, manufacturers must undertake a scenario anal- which the activities were outsourced. ysis for structured deposits to assess the risk of poor out- comes for end clients and the circumstances in which PDD frameworks also impose a range of obligations on those risks might occur.41 They must also consider whether distributors with regard to distribution activities.43 Exam- the financial instrument may represent a threat to the sta- ples of key obligations include the following: bility of financial markets. In conducting the scenario anal- • Distributors (including staff and any agents) should dis- ysis, manufacturers must assess their financial instruments tribute the product consistently with the target market under negative conditions. The Sourcebook provides an assessment and any other information or advice pro- illustrative list of such conditions, including where the mar- vided by the issuer. ket environment deteriorates, where the manufacturer experiences financial difficulties, and where demand for • Distributors should sell products outside the target the instrument is much higher than anticipated. market only with specific approval of the issuer. 37. EBA 2015, page 73. 38. For a practical discussion on testing, see, for example, Consultative Group to Assist the Poor 2016. 39. EBA Guidelines, guideline 4. 40. EBA Guidelines, guideline 1.5. 41. Sourcebook, 3.2.12R–3.12.13R. EBA Guidelines, guidelines 7–8 and Part 6, “Outsourcing”; Sourcebook 3.2.16–3.2.183; Corporations Act, sections 994E and 994F, as 42.  inserted by the DDO Act; and COFI Bill, sections 48 and 49. EBA Guidelines, guidelines 9–12; Sourcebook, Chapter 3.3; Corporations Act, sections 994E and 994F, as inserted by the DDO Act; and 43.  COFI Bill, sections 48 and 49. Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products   13 • Distributors may themselves be required to undertake PRODUCT INTERVENTION 6.  a target market assessment. POWERS • In agreeing to work with an issuer, distributors need to consider the reliability of that issuer from the perspec- The case studies examined for this Discussion Note often tive of the end clients. Distributors thus may have their include product intervention regimes that apply to some or own due diligence obligations. all retail banking products alongside PDD rules. This sec- tion highlights key trends in the makeup of such regimes. • Distributors need to understand the financial products they distribute and the related markets. What Is Meant by Product Intervention Powers • Distributors should establish and implement effective POG arrangements that are specific and proportionate PDD regimes may be supported by product intervention to their size and role. powers for regulators. Product intervention powers in this context refer to regulators’ powers to impose tem- • Distributors should have staff and agent-training pro- porary or permanent restrictions on the offer of retail cesses and procedures. banking products by FSPs. Several of the jurisdictions • Distributors should collect information to assist the discussed in this Discussion Note have introduced such issuer with their product review responsibilities. powers. Importantly, product intervention powers in this context do not refer to rules that require preapproval of • Distributors should advise the issuer of any concerns products by regulators. regarding the suitability of the marketing of the prod- uct and if any review triggers have arisen. Scope and Range of Powers Note that a number of the above requirements, such as those regarding managing conflicts of interest, are already The types of products over which regulators are granted typically covered in existing regulation, although the focus product intervention powers vary. For example, in Austra- here would be on aspects relevant to PDD. lia, ASIC has been given product intervention powers over a broad range of financial products, including banking products and consumer credit products.45 On the other Requirements for Post-Sale Product Reviews hand, the EU’s regime gives EU agencies and domestic Following product launch, the issuer (in consultation with regulators of Member States powers over a limited set of third-party distributors and other key stakeholders) may products, such as structured deposits.46 However, domes- be required periodically to review the product and related tic legislation in individual Member States can provide for disclosure materials. The aim is to assess whether the broader coverage. For example, in the UK, product inter- product still meets the needs of the target market and to vention powers granted to the FCA extend to financial identify possible follow-up actions (for example, to modify products more broadly.47 or withdraw the product or provide an exit strategy for customers). Such reviews are likely to take place more fre- The range of interventions that regulators can undertake quently when a product is still new or when there are mar- tends to be relatively broad. Where a regulator is given ket changes (such as significant changes in variable such powers, provisions tend to give a fair amount of flex- interest rates on consumer credit products).44 ibility in structuring an intervention. For example, domes- tic regulators and the EBA are given powers under EU Potential tools for conducting post-sale reviews for retail legislation to temporarily prohibit or restrict marketing, banking products might include consumer surveys and distribution, or sale of specific structured deposits or focus groups; reviews of complaints data; advice from dis- structured deposits with specific features, or to temporar- tributors; sales figures; analysis of distributors’ sales lists; ily prohibit or restrict a type of financial activity or prac- and mystery shopping exercises. tice.48 Proposed powers for the FSCA in South Africa include the power to prescribe conduct standards relating to, among other things, the prohibition of or restrictions See, for example, EBA Guidelines, guidelines 5, 6, 12.3, and 12.4; Sourcebook, 3.2.19R; Corporations Act, section 994E, as inserted by 44.  the DDO Act; COFI Bill, sections 50 and 65(6). New Part 7.9A of the Corporations Act 2001 (Cth) (Corporations Act) and Part 6–7A of the National Consumer Credit Protection Act 2009 45.  (Cth) (National Credit Act), as inserted by the DDO Act. 46. MiFIR, Articles 41–42. 47. FSMA, section 137D. 48. MiFIR, Articles 41–42. 14   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products on the offer of products to certain types of customers.49 AREAS OF FUTURE RESEARCH 7.  The UK’s FCA similarly has the power to make product AND ANALYSIS intervention rules that, among other things, prohibit entering into specified agreements (for example, a con- As previously noted, many jurisdictions are still in the pro- tract for the sale of a product) with any person or any cess of considering, developing, or implementing PDD specified person or doing so unless meeting specified rules, and there is much scope for further research on requirements.50 these topics. There is also currently a lack of long-term experience with supervising and enforcing such require- Timeframes and Process Requirements ments and a lack of evidence assessing their impact. As the experience and evidence base grows, there will be Regulators generally have greater autonomy or flexibility more information to draw from to develop effective, well- in relation to product interventions that last for a limited tested PDD approaches. period. For example, ASIC may make product interven- tion orders that last up to 18 months (or other prescribed Possible areas of further research include the following: periods). Orders that last longer require ministerial approval. If the UK’s FCA wishes to make permanent • Guidance from and for supervisors: This research product intervention rules, it must follow a general legisla- could encompass guidance from supervisors in juris- tive rule-making process contemplated in the overarching dictions that have PDD rules and product intervention legislation, rather than the more streamlined, customized powers as to their experiences, and also guidance for process specified for temporary interventions. supervisors on issues such as how compliance with principles based PDD rules should be assessed. Requirements to consult with stakeholders and notify • Analysis of target markets: Research on what quanti- them in advance will frequently apply. For example, ASIC tative and qualitative research approaches and tools must consult with persons affected by a proposed product can be used for target market assessments could be intervention order (and, where relevant, the prudential helpful, together with recent examples of good indus- regulator) before making the order. The EBA must notify try practice.51 relevant competent authorities in Member States and publish in advance on its website notices to take product • Assessing the impact of PDD regulatory frame- intervention action. works: In the longer term, and as experience with these rules develops, it could be helpful to conduct Regulators will generally need to consider a number of rigorous impact assessments of how effective they are factors relating to affected consumers, stakeholders, and in practice, as well as their impact on innovation and the market when deciding whether, and how, to exercise on the makeup of the financial sector. their product intervention powers. These include, for example, the nature and extent of the potential detriment to relevant consumers, the size of potential financial losses or of the relevant segment, and whether the proposed intervention is proportional to the potential harm. 49. COFI Bill, section 51(2). 50. FSMA, section 137D. 51. For an example of such research, see Consultative Group to Assist the Poor 2016, page 12. ANNEX COUNTRY CASE STUDIES AUSTRALIA Australia recently passed legislation introducing a new below, however, the amendments to the latter relate only PDD framework. The new framework was introduced to product intervention powers; consumer credit is other- through the DDO Act, which amends, among other laws, wise excluded from PDD requirements.) The new PDD Australia’s Corporations Act, generally regulating financial rules will be supported by regulations to be made under products other than consumer credit, and the National the DDO Act that are currently in draft—the Draft DDO Credit Act, regulating consumer credit. (As discussed Regulations. KEY TERMS SOURCE/LEGISLATION KEY TERM DEFINITION Corporations Act, Regulated A regulated person in relation to a financial product means section 994A as person the seller of the financial product, if the seller is required to make disclosures under sections 707 •  inserted by DDO Act or 1012C of the Corporations Act; or a regulated person as defined in section 1011B of the Corporations Act, being •  – the issuer of a financial product; – any person required to hold a financial services licence (or who is exempt from holding such a licence by a specified provision); – any authorised representative of a licensee; and – sellers of financial products where the sale requires a disclosure document or ‘Product Disclosure Statement’ (the Corporations Act contains an extensive regime regulating the form and content of Product Disclosure Statements); or a person prescribed by the regulations. Under regulation 7.8A.01 of the Draft DDO Regulations •  this includes –the offeror, where the sale amounts to an indirect issue by the offeror; –the offeror, where the sale amounts to an indirect off-market sale by the controller of the issuer; and –product distributors (defined by section 910A52 of the Corporations Act as authorised representatives of a financial services licensee) in relation to basic deposit products, general insurance products, and bundled consumer credit insurance products. Corporations Act, Persons who A person must generally make a target market determination for a financial product if section 994B as must make a  he person is required to prepare a Product Disclosure Statement for retail clients for the • t inserted by DDO Act target market product (or in the case of securities, a disclosure document for investors). This is generally the determination issuer of the product; or the regulations otherwise require them to do so. •  Some products (generally not being retail banking products) are excluded from the requirement to make a target market determination, namely a MySuper product (that is, an accumulation fund having certain prescribed characteristics); •  a margin lending facility; •  a security issued under an employee-share scheme; •  continued 52. As modified by ASIC, Corporations (Basic Deposit and General Insurance Product Distribution) Instrument 2015/682.   15 16   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products KEY TERMS, continued SOURCE/LEGISLATION KEY TERM DEFINITION a fully paid ordinary share in a company or a foreign company (except in certain limited •  circumstances); •a financial product issued or offered for regulated sale by an exempt body or an exempt public authority; or • a financial product of a kind prescribed by the regulations. Corporations Act, Target market A determination that (in summary) sections 994A and determination • describes the class of retail clients that comprises the target market for a relevant product; 994B as inserted by specifies any conditions and restrictions on retail product distribution conduct in relation to the •  DDO Act product (except as already mandated by the legislation); and specifies events and circumstances that would reasonably suggest that the determination is no •  longer appropriate. (The determination must also meet various other content and process requirements specified in the legislation.) Corporations Act, Issuer of a The issuer, in relation to a financial product issued to a person (the client), is the person responsible section 761E financial for the obligations owed under the terms of the product to the client or a transferee or a person product nominated by either of these. Corporations Act, Retail client A product is taken to be provided to a person as a retail client unless sections 761G (5), (6), (6A), or sections 761G and (7) or section 761GA provide otherwise. Examples of exclusions from coverage include (in 761GA summary) a product that is provided to a business that is not a “small business” as defined or provided to certain wholesale and professional investors. A small business means a business employing fewer than 100 people if it is a manufacturing business or otherwise fewer than 20 people. Who Must Comply • to notify ASIC of any significant dealings in a product that are not consistent with the product’s target market The design obligations introduced by the DDO Act are determination.55 intended to apply primarily to a person who is responsible for developing the financial product. This person is also The distribution obligations introduced by the DDO Act described in the final Explanatory Memorandum for the apply to a regulated person (as discussed under “Key legislation53 (DDO Bill Explanatory Memorandum) as “the Terms”) when they engage in retail product distribution person who is responsible for preparing the disclosure conduct. The term retail product distribution conduct document.”54 This is generally the issuer of a product but refers to dealing in the product with a retail client, giving in some prescribed circumstances includes a different per- a prescribed product disclosure document to a retail cli- son acting as a seller. ent, and providing financial product advice regarding the product to a retail client.56 This would include, for exam- The design rules under the DDO Act comprise several key ple, issuers who distribute their own product as well as obligations. These are discussed in further detail below. third-party distributors and financial advisers. The DDO Bill Explanatory Memorandum summarizes these obligations as The distribution rules under the DDO Act also comprise • to make a publicly available target market determina- several key obligations. These are discussed in further tion; detail below. They include (in summary) obligations not to engage in retail product distribution conduct unless an • to review the target market determination as required appropriate target market determination is in place; to to ensure it remains appropriate; take reasonable steps to act consistently with the determi- • to keep records of the person’s decisions in relation to nation; to collect information and complaints data required the new regime; and by the issuer; and to notify the issuer of any significant dealings that are not consistent with the determination.57 Treasury Laws Amendment (Design and Distribution Obligations and Product Intervention Power) Bill, 2018 (Cth) Revised Explanatory 53.  Memorandum. 54. DDO Bill Explanatory Memorandum, 1.46. 55. DDO Bill Explanatory Memorandum, 1.42. 56. Corporations Act, section 994A(1), as inserted by the DDO Act. 57. DDO Bill Explanatory Memorandum, 1.43. Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products   17 The DDO Act design and distribution obligations apply to shortcomings of the existing disclosure regime.64 By way of products provided to retail clients. As noted under “Key further context, the DDO Bill Explanatory Memorandum Terms,” a retail client can include certain small businesses. includes the following explanation: The Corporations Act relies heavily on disclosure to assist Affected Products consumers understand and select appropriate financial products. However, disclosure can be ineffective for a The design and distribution obligations in the DDO Act number of reasons, including consumer disengagement, generally apply to financial products for which a disclosure complexity of documents and products, behavioural document must be prepared under the Corporations biases, misaligned interests and low financial literacy. The Act.58 A financial product is defined as a facility through availability of financial advice may not be sufficient to which, or through the acquisition of which, a person does overcome these issues. A consumer may not seek financial one or more of the following: advice or may receive poor-quality advice. The Financial System Inquiry recognised these shortcom- • Makes a financial investment ings of the existing disclosure regime. In response, it rec- • Manages financial risk ommended the introduction of a targeted and principles- • Makes noncash payments.59 based product design and distribution obligation. The Government accepted this recommendation.65 In addition, a wide range of products are specifically included in the concept of a financial product (such as, for Key Requirements for Issuers/Manufacturers and example, deposit facilities provided by authorized depos- Distributors it-taking institutions).60 Governance arrangements Financial products relevantly include, for example, deposit Governance arrangements have not been expressly pro- and payment products. The design and distribution obli- vided for in the DDO Act. The DDO Proposals Paper that gations, however, do not apply to (among others) credit preceded the legislation stated that, in relation to distrib- products, although the product intervention powers dis- utor obligations cussed further below do. The DDO Bill Explanatory Mem- [i]mplementation of these proposals could form part of a orandum indicates that consumer credit products were broader governance framework put in place by financial intentionally excluded because they are already subject to firms that sets out their internal policies and procedures in specific rules under the National Credit Act, such as those relation to the design, distribution and review of products, concerning responsible lending, aimed at ensuring prod- including training, monitoring and operational controls to uct appropriateness.61 As discussed earlier in this Discus- ensure business practices are compliant.66 sion Note, it is not clear that product suitability requirements are necessarily a substitute for PDD requirements. It is Nevertheless, there is no express legislative obligation to notable, however, that the new rules are proposed to do this. However, it should be noted that financial services apply to “basic banking products”62 (which include deposit licensees are more generally subject to license conditions products that meet prescribed criteria, as well as payment imposed by ASIC under the Corporations Act requiring facilities), even though such products are exempt from them to establish and maintain compliance measures in some existing FCP requirements due to their perceived relation to financial services laws.67 lack of complexity or risk. Target market assessments The obligations generally apply to offers of financial prod- A target market determination must meet requirements ucts that require disclosure in the form of a Product Disclo- regarding its effectiveness in ensuring the suitability of sure Statement under the Corporations Act.63 This ap- products sold to retail clients. Specifically, the assessment proach is stated to have been taken in part to address the must be such that it would be reasonable to conclude that 58. DDO Bill Explanatory Memorandum, 1.14. 59. Corporations Act, section 763A. 60. Corporations Act, section 764A. 61. DDO Bill Explanatory Memorandum, 1.21. 62. Draft DDO Regulations, regulation 7.8A.02. 63. DDO Bill Explanatory Memorandum, 1.18. 64. DDO Bill Explanatory Memorandum, 1.20. 65. DDO Bill Explanatory Memorandum, 1.2–1.3. 66. Australian Government the Treasury 2016, pages 17 and 23. 67. ASIC, Pro Forma 2019—Australian Financial Services Licence Conditions (2019), page 4. 18   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products • if the product were sold to a retail client in accordance • It specifies details of the timing of reviews of the deter- with the distribution conditions and restrictions speci- mination (such timing having to be reasonable).71 fied in the determination, it would be likely that the retail client would be in the target market; and Product design and testing requirements The DDO Act does not impose specific requirements in • further, if the product were sold to a retail client in the relation to the product design process. However, as dis- target market, it would be likely that the product would cussed above, a target market determination must meet be consistent with the client’s objectives, financial situ- general requirements as to its effectiveness in ensuring ation, and needs.68 the suitability of products sold to retail clients. This obliga- The DDO Bill Explanatory Memorandum provides exam- tion, particularly as it relates to the client’s needs, thus in ples of factors to be taken into account in determining turn informs the product design process. The DDO Bill whether a product is likely to be consistent with target Explanatory Memorandum explains that retail clients’ clients’ likely objectives, financial situations, and needs, likely objectives, financial situations, and needs to be including the following: taken into account when determining a product’s target market are important for good product design.72 Though • The key features of the product, including its complex- not expressly required by the DDO Act, the Proposals ity, risk profile (over the lifetime of the product), any Paper adds that during the product design phase applicable fees, and the investment needs that the product is seeking to meet. where the nature of the product warrants it, issuers should stress-test the product to assess how consumers may be • The circumstances of persons within a particular mar- affected in different circumstances. They should also con- ket, such as their understanding of product features, sumer-test products to make key features clear and easy capacity to meet financial obligations or bear losses, to understand.73 and whether their investment needs are the same as those the product seeks to meet.69 Distribution requirements A target market determination must also meet other spe- A person who makes a target market determination and a cific requirements. They include (in summary) that the person who engages in retail product distribution conduct determination have the following characteristics: must take reasonable steps that will, or are reasonably likely to, result in retail product distribution conduct being • It is in writing. consistent with the determination. However, the person • It is freely and publicly available. will not be taken to commit an offence merely because • It describes the class of retail clients that comprise the another regulated person’s conduct is inconsistent with target market for the product. the determination, or because a retail client outside the target market acquires the product. (Exceptions have also • It specifies any conditions or restrictions on the prod- been included to allow for effective provision of personal uct distribution. advice, which is subject to a separate regime under the • It specifies events and circumstances (“review trig- Corporations Act.)74 gers”) that could reasonably determine that the deter- mination is no longer appropriate. These triggers will The DDO Proposals Paper notes that some product issu- vary from product to product. As noted in the DDO Bill ers expressed concerns about any expectation that under Explanatory Memorandum, they might include, for the new rules they would be indirectly accountable for the example, an event or circumstances that would materi- conduct of external distributors. In response, the Propos- ally change a factor taken into account in making the als Paper states that, in general, distributors will have target market determination; whether the product is direct responsibility for putting controls in place to ensure being distributed and purchased as envisaged; and, that products are distributed in line with the terms of the importantly, the nature and extent of any feedback determination. However, product issuers cannot be will- from those who distribute or acquire the product.70 fully blind to distributors who act inconsistently with issu- ers’ expectations.75 68. Corporations Act, section 994B(8), as inserted by the DDO Act. 69. DDO Bill Explanatory Memorandum, 1.59. 70. DDO Bill Explanatory Memorandum, 1.62. 71. Corporations Act, sections 994B(5)–(9), as inserted by the DDO Act. 72. DDO Bill Explanatory Memorandum, 1.58. 73. Australian Government the Treasury 2016, page 49. 74. Corporations Act, section 994E, as inserted by the DDO Act. See also DDO Bill Explanatory Memorandum, 1.84 and 1.105. 75. Australian Government the Treasury 2016, page 22. Also see DDO Bill Explanatory Memorandum, 1.101. Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products   19 Some guidance is given regarding what steps are reason- Distributors are also restricted from distributing products able in this context. Matters to be taken into account in for which no target market determination has been made.78 determining what is reasonable are stated to include the Distribution must not be undertaken in these circumstances following (in summary and without limitation): unless the distributor believes on reasonable grounds that the determination has been made or is not required. • The likelihood of any particular distribution conduct being inconsistent with the determination Product review requirements • The nature and degree of harm that might result from Target market reviews must be conducted periodically, the sale or issue of the product inconsistently with the consistently with the period for such reviews and the determination review triggers specified in the relevant determination. • What the distributor or issuer (as relevant) knows or On becoming aware of a review trigger or other relevant ought to know about the likelihood of inconsistency, circumstances indicating the determination may no longer the nature and degree of harm, and ways of eliminat- be appropriate, distribution of the product must cease as ing and minimizing the likelihood and the harm soon as practicable and otherwise within 10 business days unless a review has been conducted and a new target • The availability and suitability of ways to eliminate or determination has been made, if required (or another minimize the likelihood and the harm.76 exception applies). The person responsible for making, and reviewing, a determination (as noted above, usually The Proposals Paper offers further guidance, stating that the product issuer) must also inform distributors of their distributors ought to have reasonable controls in place to obligation to cease distribution of the product, and they act in accordance with the expectations of the product must then cease distribution.79 issuer. It contemplates that controls should be agreed upon by the issuer and distributor, and that some controls The DDO Proposals Paper describes factors that are to be may even be developed by the issuer. When a control will considered during a review. They include any consumer be reasonable will depend on the type of product, the feedback about the product, details of any complaints, distribution strategy, and other relevant circumstances. feedback from product distributors, claims outcomes, and Examples of controls provided by the Proposals Paper profit margins, all of which inform whether the product is include the following: operating as expected.80 Although such factors have not been expressly set out in the DDO Act, they are contem- • Short, targeted warnings to consumers at key deci- plated to some extent. This is the case, for example, through sion-making points • Ensuring information is delivered to consumers (such • the provisions that require target market determinations as through scripts or by using prerecorded audio or to specify information about review triggers;81 and video) • recordkeeping and reporting obligations relating to • Tools to help consumers understand/decide, such as complaints, review triggers, the matters required to be calculators or self-assessment tools covered by the target market determination, and the steps taken to comply with it.82 Obligations apply to • Requiring choice—for example, though an opt-in dis- both the maker of the target market determination and tribution model other regulated persons (including distributors). • Staff competency, such as through training • Supervision, meaning management oversight, audits, If a regulated person (such as a distributor) becomes or reviews of distribution practices to ensure that staff aware of a significant dealing inconsistent with a target follow relevant procedures market determination, they must report the dealing to the maker of the target market determination.83 Further, if the • Using customer information that the distributor can maker of a target market determination becomes aware of reasonably access—for example, where the distributor such a dealing, they must report it to ASIC. If issuers provides other services to the consumer become aware of significant dealings in the product in • Encouraging consumers to access personal advice.77 relation to a retail client, they are required to inform ASIC 76. Corporations Act, section 994E(5), as inserted by the DDO Act. 77. Australian Government the Treasury 2016, page 24. 78. Corporations Act, section 994D, as inserted by the DDO Act. 79. Corporations Act, section 994C, as inserted by the DDO Act. 80. Australian Government the Treasury 2016, page 22. 81. Corporations Act, section 994B(5)(d), as inserted by the DDO Act. 82. Corporations Act, section 994F, as inserted by the DDO Act. 83. DDO Act, section 994F(6). 20   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products in writing within 10 business days if those dealings are that it can use proactively to reduce the risk of significant inconsistent with the determination.84 detriment to retail clients resulting from financial prod- ucts.86 ASIC’s product intervention powers will cover credit products regulated by the National Credit Act87 as well as Applicable Penalties the broad range of financial products covered by the Cor- Retail clients have recourse rights following a breach of porations Act. the new provisions. In particular, they may recover loss or damages for relevant contraventions. This is regardless of To make a product intervention order, ASIC must be satis- whether the person in breach has been convicted of a rel- fied that a financial product has resulted, or will or is likely evant offense, a court has made a declaration of contra- to result, in significant detriment to relevant clients.88 If so, vention, or a court has ordered anyone to pay a penalty in an individual order can be made to the effect that a person relation to the contravention. Courts may also make must not engage in specified conduct in relation to the orders voiding contracts, orders for the return of money product, either entirely or except in accordance with spec- paid, and orders for the payment of interest in connection ified conditions.89 (ASIC can also make a market-wide with a breach.85 product intervention order in relation to an entire “class” of products, but such an order must be made as a “legislative Civil and criminal penalties may also apply. For example, instrument” and would change some of the requirements there are penalties for failures to discussed here.) The conditions specified by a product intervention order can include, for example, a condition • make a target market determination before any person prohibiting the issue of a product to a retail client unless engages in distribution conduct; the client has received personal advice. However, ASIC • make determinations available to the public free of cannot make orders specifying certain conditions, includ- charge; ing specifying that a person satisfy a standard of training • complete a review of a determination during the other than standards prescribed by (as applicable) the Cor- review period; porations Act or National Credit Act. • refrain from distributing a product when its determina- tion has ceased to be appropriate or has not been ASIC must consider the following non-exhaustive list of made; factors in determining whether there has been or will be a “significant detriment” to relevant clients: • take reasonable steps to ensure consistency with tar- get market determinations; • The nature and extent of the detriment • keep complete and accurate records; and • The actual or potential financial loss to the clients • make reports. • The impact that the detriment has had or will have on the clients Penalties include fines up to $A200,000 for individuals and $A1 million for corporations per breach and imprison- • Any other matters prescribed by the regulations.90 ment up to five years, depending on the offense. ASIC must consult with persons and statutory bodies that are affected by the order before making it. However, the Product Intervention Powers requirement to consult with persons (rather than statutory The DDO Act makes provision for ASIC to have product bodies) will be taken to have been complied with if ASIC intervention powers. This will be achieved through the makes the order or a description of the order available on introduction of new Part 7.9A in the Corporations Act and its website and invites the public to comment. Further, a an equivalent Part 6-7A in the National Credit Act. The failure to comply with the consultation requirement does object of these powers is to provide ASIC with powers not invalidate a product intervention order.91 84. DDO Act, section 994G. 85. Corporations Act, sections 994–994Q, as inserted by the DDO Act. 86. Corporations Act, proposed section 1023A.  hich, as discussed above, are not covered by design and distribution requirements introduced by the DDO Act. Credit products regulated 87. W by the National Credit Act comprise, in summary, credit provided to individuals (and strata corporations)—referred to as “consumers”—for personal, domestic, or household purposes or for investment in residential property. n the case of financial products other than consumer credit, these will be retail clients as discussed above (that is, including some small 88. I businesses). In the case of consumer credit, these will be consumers (that is, primarily individuals). 89. Corporations Act, section 1023D, and National Credit Act, section 301D, as inserted by the DDO Act. 90. Corporations Act, section 1023E, and National Credit Act, section 301E, as inserted by the DDO Act. 91. Corporations Act, section 1023F, and National Credit Act, section 301F, as inserted by the DDO Act. Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products   21 Product intervention orders remain in force for an initial context.97 For example, ASIC highlighted a historical case specified period of up to 18 months.92 ASIC may extend an study in which it may have intervened had such powers order by declaring that it remains in force until it is revoked been available to it at that time. Australian deposit-taking or remains in force for a specified period, unless revoked institutions in the past had engaged in a deliberate strat- earlier. However, this requires approval of the Minister. egy to promote their term deposits by advertising higher ASIC, with the Minister’s approval, may also amend an order interest rates available only on some deposit terms, while (although it may not extend the time of the order beyond maintaining significantly lower interest rates for all other the maximum period for the order). ASIC may revoke an deposit terms. ASIC notes that such products were mar- order, in writing, with the Minister’s approval. However, keted as suitable for consumers, including retirees who ASIC cannot remake a product intervention order unless it is wanted a safe investment with a steady return that satisfied that the circumstances have materially changed required minimal management, and this is how they were since the order was made or the Minister approves it.93 perceived by the market. However, the dual pricing prac- tice, and the fact that after their initial maturity date, term ASIC must serve a copy of the order or amendment on any deposits could automatically roll over to much lower rates, person to whom it considers the order applies. However, meant that these products functioned in a way potentially failure to do so does not invalidate the order or amend- inconsistent with expectations of relevant consumers. ment. ASIC must also publish each order or amendment on its website, along with a notice describing the signifi- cant detriment or the reasons why the amendment is EUROPEAN UNION appropriate, the consultation it undertook, and the day the order or amendment comes into force, if this day The EU’s regime for retail banking product design, distri- comes after the order is published. ASIC must also publish bution, and governance is set out in the EBA Guidelines. notice of revocation of an order on its website.94 The EBA Guidelines came into effect on January 3, 2017, and apply to various consumer credit products, deposits, Penalties apply if there is conduct contrary to a product and payment services. They do not apply to structured intervention order.95 The maximum penalty is $A200,000 deposits, which, along with other investment products and/or five years’ imprisonment for an individual and and services, are governed by the design and distribution $A1 million for a corporation. However, such penalties do obligations contained in Article 24 of the Markets in not apply if the person was not aware and could not rea- Financial Instruments Directive 2014/65/EU (MiFID II). The sonably have been aware of the order (except if it was a implementation of Article 24 is given detailed consider- legislative instrument). ation in the case study further below on the UK. Clients also have recourse rights following a breach. In The EBA Guidelines are directed at the competent author- particular, they may recover loss or damages for relevant ities of Member States, who must comply with them by contraventions.96 This is regardless of whether there has incorporating them into their legal framework or supervi- been a conviction, a court has made a declaration of con- sory processes, as appropriate.98 The Central Bank of Ire- travention, or a court has ordered anyone to pay a pecuni- land, for example, has stated on its website that it will ary penalty in relation to the contravention. Courts may incorporate the EBA Guidelines into its ongoing supervi- also make orders voiding contracts, orders for the return of sory practices and processes but does not currently pro- money paid, and orders for the payment of interest. pose changes to the country’s legal framework.99 According to the EBA,100 some or all competent authorities in nine In recently released draft guidance, ASIC has highlighted countries, including Belgium, Croatia, Norway, and Swe- how it may use such powers, including in a retail banking den, had complied with the EBA Guidelines by February 92. Corporations Act, section 1023G(2), and National Credit Act, section 301G(2), as inserted by the DDO Act. 93. Corporations Act, sections 1023H–1023K and 1023M, and National Credit Act, sections 301H–301K and 301M, as inserted by the DDO Act. 94. Corporations Act, section 1023L, and National Credit Act, section 301L, as inserted by the DDO Act. 95. Corporations Act, section 1023P, and National Credit Act, section 301P, as inserted by the DDO Act. Corporations Act, section 1023Q. The National Credit Act already contains provisions that allow for equivalent recourse. See DDO 96.  Explanatory Memorandum, 2.80. Australian Securities and Investments Commission 2019, pages 11–14. See also recent ASIC proposals with regard to short term credit 97.  (https://asic.gov.au/regulatory-resources/find-a-document/consultation-papers/cp-316-using-the-product-intervention-power-short-term- credit/) and the sale of certain complex and risky products to retail clients (https://asic.gov.au/about-asic/news-centre/find-a-media-release/ 2019-releases/19-220mr-asic-proposes-ban-on-the-sale-of-binary-options-to-retail-clients-and-restrictions-on-the-sale-of-cfds/) EBA Guidelines, page 3, paragraph 2. 98.  Central Bank of Ireland n.d. 99.  100. EBA 2018. 22   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products 2018. Authorities in a further 21 countries, including the structured deposits under MiFIR. At present, the EBA’s UK, had indicated that they intended to comply.101 Certain product intervention powers do not extend to retail authorities had notified the EBA that they will not com- banking products other than structured deposits. This is ply—for example, authorities in Austria and Slovakia indi- because they are part of a separate regime for invest- cated they will not be compliant because they lack the ment products and services (including structured regulation necessary at the national level to implement deposits) established by MiFID II and its supporting the EBA Guidelines. regulations in MiFIR. MiFIR provides for product inter- vention powers over relevant products being given to The case study below also considers the EBA’s (and national authorities but also provides that the EBA may national regulators’) product intervention powers for exercise its own product intervention powers in excep- KEY TERMS SOURCE/LEGISLATION KEY TERM DEFINITION EBA Guidelines, para. 15 Manufacturer An undertaking that designs (that is, creates, develops, combines, or significantly changes) products to be offered to consumers and that is • a credit institution;102 • a creditor;103 • a payment institution;104 or • an electronic money institution;105 or that would otherwise be a distributor but is involved de facto in the design of the product. EBA Guidelines, para. 15 Distributor A person who offers and/or sells the product to consumers. This includes business units of manufacturers that are not involved in designing the product but are responsible for bringing the product to the market. EBA Guidelines, para. 15 Consumer A natural person who is acting for purposes that are outside their trade, business, or profession. EBA Guidelines, para. 15 Target market The group or groups of end consumers for whom the product is designed, as defined by the manufacturer. EBA Guidelines, para. 15 Products • Credit agreements relating to immovable property;106 • “deposits”;107 • “payment accounts”;108 • “payment services”;109 • “payment instruments”;110 • other means of payment;111 • “electronic money”;112 or •  ther forms of credit for consumers (that is, in addition to credit agreements relating to o immovable property) provided by the manufacturers listed above, in line with Article 1(5)(e) of Regula tion (EU) No 1093/2010.  ote that since January 3, 2017 (the date the EBA Guidelines came into effect), competent national authorities that have not implemented 101. N the EBA Guidelines are considered noncompliant, even if they continue to intend to comply.  efined in Article 4(1) of the Capital Requirements Regulation (EU) 575/2013 as an undertaking the business of which is to take deposits or 102. D other repayable funds from the public and to grant credits for its own account.  efined in Article 4(2) of Directive 2014/17/EU (Mortgage Credit Directive) as a natural or legal person who grants or promises to grant 103. D credit falling within the Directive in the course of his or her trade, business, or profession.  he EBA Guidelines refer to several definitions in Directive 2007/64/EC (Payment Services Directive), which has now been replaced by 104. T Directive 2015/2366/EU (PSD2). The cross-reference to the previous Directive is preserved here for consistency with the wording of the Guidelines, noting where the same or similar definitions are now included in PSD2. Article 4(4) of the Payment Services Directive defined a payment institution as a legal person that had been granted authorization in accordance with the Directive to provide and execute payment services throughout the European Union. This definition is replicated in PSD2.  efined in Article 2(1) of Directive 2009/110/EC (Electronic Money Directive) as a legal person that has been granted authorization to issue 105. D electronic money.  efined in the Mortgage Credit Directive as an agreement whereby a creditor grants or promises to grant, to a consumer, a credit falling 106. D within the scope of the Directive in the form of a deferred payment, loan, or other similar financial accommodation.  efined in Article 2(3) of Directive 2014/49/EU (Deposit Guarantee Scheme Directive) as a credit balance that results from funds left in an 107. D account or from temporary situations deriving from normal banking transactions and that a credit institution is required to repay under the legal and contractual conditions applicable, including a fixed-term deposit and a savings deposit.  efined in Article 4(14) of the Payment Services Directive as an account held in the name of one or more payment service users that is used 108. D for the execution of payment transactions. The definition has been replicated in PSD2.  efined in article 4(3) of the Payment Services Directive as any business activity set out in its Annex, which included, for example, cash 109. D deposit and withdrawal services, execution of payment transactions, and money remittance. PSD2 contains a similar list.  efined in Article 4(23) of the Payment Services Directive as any personalized device(s) and/or set of procedures agreed between the payment 110. D service user and the payment service provider and used by the user to initiative a payment order. A similar definition is included in PSD2.  s listed in Annex 1(5) of Directive 2013/36/EU (Capital Requirements Directive IV)—for example, travellers’ cheques and bankers’ drafts. 111. A 112. As defined in Article 2(2) of the Electronic Money Directive (in summary, electronically, including magnetically, stored monetary value accepted by persons other than the issuer of the electronic money). Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products   23 tional cases where competent national authorities have POG arrangements. These should aim to ensure that, not intervened. when products are being designed and marketed, the interests, objectives, and characteristics of consumers are Who Must Comply taken into account, that potential consumer detriment is avoided, and that conflicts of interest are minimized.115 The POG arrangements set out in the EBA Guidelines are applicable to creditors; credit intermediaries; and credit, There is provision for proportionality in relation to POG investment, payment, and electronic money institutions arrangements. A manufacturer’s POG arrangements that fall within the definition of a “manufacturer” or a “dis- should be proportionate to the nature, scale, and com- tributor” set out under “Key Terms” above.113 These per- plexity of the manufacturer’s business, and potential con- sons and institutions are covered by the EBA Guidelines in sumer risk and product complexity need to be considered relation to products offered and sold to “consumers” as in the implementation and application of the arrange- defined. ments.116 The requirement for distributors is that they have arrangements that are proportionate to their size The EU Guidelines also note that competent authorities and role.117 may wish to extend the scope of application of the Guide- lines. In particular, it is suggested that competent authori- Both manufacturers and distributors should ensure that ties could consider extending the Guidelines as follows: POG arrangements are an integral part of their gover- nance, risk-management, and internal control frame- • The Guidelines could apply to intermediaries other work.118 Their management bodies need to endorse the than credit intermediaries covered by the EU Mort- establishment of POG arrangements and subsequent gage Credit Directive, such as consumer credit inter- reviews. Senior management of manufacturers should be mediaries. (It is understood that this is a reference to responsible for continued internal compliance, periodi- unsecured credit intermediaries who are outside the cally checking that their POG arrangements are still scope of the EU Mortgage Credit Directive, although appropriate.119 Manufacturers’ senior management should they may be covered by the EU Consumer Credit also ensure that staff members involved in designing a Directive.) product are familiar with the POG arrangements, under- • The protections in the Guidelines could apply for the stand the product’s features, characteristics, and risks, and benefit of persons outside the current definition of a are competent and appropriately trained.120 “consumer,” such as microenterprises and small and medium-sized enterprises.114 When launching a new product, the manufacturer should ensure that the POG arrangements are considered in its new product approval policy. Having such a policy is a Affected Products requirement of the EBA’s Guidelines on Internal Gover- The product categories to which the Guidelines apply are nance.121 listed under “Key Terms.” They cover a wide range of products including, relevantly in this context, consumer Manufacturers and distributors also have recordkeeping credit and account and payment/transaction products. obligations. All actions taken by the manufacturer and the distributor in relation to their POG arrangements should Key Requirements for Issuers/Manufacturers and be documented, kept for audit purposes, and made avail- Distributors able to competent authorities on request.122 Governance arrangements Target market assessments The EBA Guidelines require both manufacturers and dis- Target market assessments are primarily the manufactur- tributors to establish, implement, and review effective er’s responsibility under the EBA Guidelines. Manufactur- EBA Guidelines, page 4, paragraph 6. 113.  EBA Guidelines, para. 7–8. 114.  EBA Guidelines, guidelines 1.1 and 9.1. 115.  EBA Guidelines, guideline 1.5. 116.  EBA Guidelines, guideline 9.1. 117.  EBA Guidelines, guidelines 2.1 and 10.1. 118.  EBA Guidelines, guideline 2.2. 119.  EBA Guidelines, guideline 2.4. 120.  121. EBA Guidelines, guideline 1.3. 122. EBA Guidelines, guidelines 1.4 and 9.3. 24   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products ers must include, in their POG arrangements, steps and meet such interests, objectives, and characteristics and features that need to be followed to identify (and update benefit the target market.128 as necessary) the relevant target market of a product. Hav- ing identified the target market, the manufacturer should Manufacturers also have product testing obligations that ensure that the product is deemed appropriate for the must be fulfilled before a product is brought to market. interests, objectives, and characteristics of the target mar- These obligations apply to new products, existing prod- ket, considering the features, charges, and risks of the ucts brought to new target markets, and also to significant product.123 The manufacturer should also consider how changes made to existing products. The manufacturer the product fits within their product range and whether should conduct product testing to assess how the product the existence of too many product variants prevents would affect its consumers under a wide range of scenar- informed decisions.124 The manufacturer should also iden- ios, including stressed scenarios, and make changes to tify the market segments for which the product would be the product to address poor test results.129 inappropriate.125 Distribution requirements In identifying whether a product meets the interests, objec- The manufacturer should select distribution channels that tives, and characteristics of a target market, manufacturers are appropriate for the particular target market.130 To that should assess the degree of financial capability of the tar- end, manufacturers should select distributors who have get market.126 The EBA, in its final report leading up to the the appropriate knowledge, expertise, and capability to introduction of the EBA Guidelines, referred to “good prac- place each product in the market correctly and to provide tice examples” for compliance with target market assess- to consumers appropriate explanations of the characteris- ment requirements, providing the following examples: tics and risks of the product. When selecting its distribu- tion channels, a manufacturer may consider limiting the Target market distribution of a specific product to channels that offer Manufacturers could consider the following: specific features to consumers. (i) tax status implications for different products, Manufacturers should take all reasonable steps to ensure (ii) level of risks of the product to be designed, that distributors act in compliance with the objectives of (iii) liquidity accessibility that the consumer is expected to the manufacturer’s POG arrangements.131 Manufacturers get, should monitor distribution, and both manufacturers and (iv) level of risks that the consumer is willing to bear, distributors should ensure that sales outside the target (v) demographic factors, market are made only on a justified basis.132 The distribu- (vi) level of knowledge and understanding of the com- tor should be able to provide information to justify to the plexity of the product, or manufacturer why it offered a product to a consumer out- (vii) potential creditworthiness of the consumer or finan- side the target market.133 cial capability of the consumer.127 Manufacturers should provide distributors with informa- Product design and testing requirements tion about a product that is clear, precise, up to date, and Product design must take the target market into account. of an adequate standard. Distributors should be given a As noted above, manufacturers must ensure that a prod- description of the main characteristics of the product, its uct is deemed appropriate for the interests, objectives, risks and any limitations, and the total price of the product and characteristics of the target market and consider how to be borne by the consumer, including all related fees, it fits in their product range. The EBA Guidelines explicitly charges, and expenses. The information should be suffi- say that a manufacturer should design and bring to mar- cient to enable the distributor to understand the product ket only products with features, charges, and risks that and properly place it in the market, and to recognize the 123. EBA Guidelines, guidelines 3.1–3.2. 124. EBA Guidelines, guideline 3.4. 125. EBA Guidelines, guideline 3.5. 126. EBA Guidelines, guideline 3.6. 127. EBA 2015, page 73.  BA Guidelines, guideline 3.3. 128. E  BA Guidelines, guideline 4.1. 129. E  BA Guidelines, guideline 7.1. 130. E  BA Guidelines, guideline 7.3. 131. E  BA Guidelines, guidelines 7.2 and 12.2 132. E 133. EBA Guidelines, guideline 12.2. Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products   25 target market for whom the product is designed. Distribu- Product Intervention Powers tors should then disclose this information to the consumer, Article 42 of MiFIR contemplates that competent authori- along with any additional information supplied by the ties may exercise product intervention powers in relation manufacturer.134 Further, distributors should use this infor- to (among other products covered by MiFIR) structured mation along with their own relevant knowledge to deter- deposits. Such powers comprise prohibiting or restricting mine whether a consumer belongs to the target market.135 • the marketing, distribution, or sale of certain struc- Product review requirements tured deposits or structured deposits with certain Once a product is brought to market, the manufacturer is specified features; or ultimately responsible for product monitoring. The manu- • a type of financial activity or practice. facturer should monitor the product on an ongoing basis to ensure that the interests, objectives, and characteristics A competent authority may exercise these powers only if of consumers continue to be taken into account appropri- all of the following conditions are fulfilled (in summary): ately.136 To assist the manufacturer with this obligation, distributors should, on an ongoing basis, collect relevant • The relevant structured deposit or activity or practice information about the product. If the distributor identifies gives rise to significant investor protection concerns or any problems related to the product’s features, its infor- poses a threat to the orderly functioning and integrity mation, or the target market when offering and selling the of financial markets or to the stability of whole or part product, the distributor should promptly inform the man- of the financial system within at least one Member ufacturer.137 State. • Existing regulatory requirements under applicable EU If a manufacturer identifies a problem related to a product law do not sufficiently address relevant risks, and the in the market, they should take necessary action to miti- issue would not be better addressed by improved gate the situation and prevent further detriment. The supervision or enforcement of existing requirements. remedial actions should include promptly notifying the distributor of any changes or modifications to the prod- • The action is proportionate, taking into account the uct, and any additional actions that need to be taken to nature of the risks identified, the level of sophistication remedy the situation.138 of clients concerned, and the likely effect of the action on such clients. Outsourcing • The competent authority has properly consulted com- Manufacturers and/or distributors, when their activities petent authorities in other Member States that may be are wholly or partly outsourced, should ensure that they significantly affected by the action, and the action comply with the requirements established in the Commit- would not discriminate against services or activities tee of European Banking Supervisors Guidelines on Out- from another Member State. sourcing. Among other things, these guidelines provide that “the ultimate responsibility for the proper manage- A competent authority may impose a prohibition or ment of the risks associated with outsourcing or the out- restriction on a precautionary basis before a structured sourced activities lies with an outsourcing institution’s deposit has been marketed, distributed, or sold to clients. senior management.”139 A competent authority must consider the following crite- Applicable Penalties ria, among others, in determining whether there is a sig- nificant investor protection concern or a threat to the The EBA Guidelines themselves do not include any penal- orderly functioning and integrity of financial markets or to ties for manufacturers or distributors in the event of the stability of the financial system within at least one breach. The EBA Guidelines are directed at competent Member State: authorities of Member States, who in turn must adopt them and apply domestic enforcement regimes. 134. EBA Guidelines, guidelines 8 and 12.1. 135. EBA Guidelines, guideline 11. 136. EBA Guidelines, guideline 5. 137. EBA Guidelines, guidelines 12.3–12.4. 138. EBA Guidelines, guideline 6. 139. EBA Guidelines, page 15. 26   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products • The degree of complexity of the structured deposit protection concern or a threat to the orderly functioning and its relation to the type of client to whom it is mar- and integrity of the financial markets or to the stability of keted and sold the whole or part of the EU’s financial system: • The degree of innovation involved • The degree of complexity of the product and its rela- • The size or notional value of the structured deposits tion to the type of client to whom it is marketed and sold • The leverage a structured deposit provides • The size or notional value of the product A competent authority must notify the European Securi- • The degree of innovation involved. ties and Markets Authority and other competent authori- ties at least one month prior to exercising such powers. Where the first condition is fulfilled, the EBA may impose However, in certain prescribed circumstances, the author- the prohibition or restriction on marketing, distribution, or ity may take provisional action in the meantime (for up to sale of a structured deposit on a precautionary basis, three months) with at least 24 hours’ notice. before it can be brought to the market. A competent authority must publish on its website notice When using these powers, the EBA must ensure that the of any decision to exercise these powers. The notice must action does not have a detrimental effect on the markets specify details of the prohibition or restriction and a time or on investors that is disproportionate to the benefits of after the publication of the notice at which the measures the action. The EBA must also ensure the action does not will take effect and the evidence on which they are based. create a risk of regulatory arbitrage. A prohibition or restriction shall apply only to action taken after the measures take effect. Before deciding to exercise its product intervention pow- ers, the EBA must notify competent authorities of Mem- Article 41 of MiFIR also gives the EBA temporary product ber States of the action it proposes. It must also publish intervention powers in relation to structured deposits. on its website notice of any decision to exercise the pow- These powers allow the EBA to temporarily prohibit or ers. The notice must specify details of the prohibition or restrict in the EU restriction and specify a time after the publication of the • the marketing, distribution, or sale of certain struc- notice at which the measures will take effect. A prohibition tured deposits or structured deposits with certain or restriction shall apply only to action taken after the specified features; or measures take effect. Any prohibition or restriction imposed must be reviewed by the EBA at appropriate • a type of financial activity or practice. intervals and at least every three months. If the prohibition or restriction is not renewed after that three-month period, The EBA can exercise these powers only if all of the fol- it shall expire. lowing conditions are fulfilled: • The proposed action addresses a significant investor The exercise of these powers by the EBA will prevail over protection concern or a threat to the orderly function- any previous action taken by the competent authorities of ing and integrity of the financial markets or to the sta- Member States. bility of the whole or part of the EU’s financial system. • Regulatory requirements under EU law that are appli- HONG KONG cable to the relevant structured deposit or activity do not address the threat. Design and Distribution Obligations • A competent authority or competent authorities have Hong Kong does not currently have detailed design and not taken action or have not taken adequate action to distribution obligations relating to retail banking prod- address the threat. ucts.140 However, in October 2013, the HKMA issued its TCF Charter for retail banks, addressing, among other The EBA must consider the following criteria, among oth- things, product design obligations for banks. According to ers, in determining whether there is a significant investor the HKMA, all retail banks have signed up to the Charter.141  ote, however, that the HKMA issued a circular on October 28, 2013, setting out high-level principles applicable to retail banks, including 140. N the principle that banking services and products should be designed to meet the needs of customers.  ee HKMA, “HKMA’s Work in Relation to Strengthening Financial Consumer Protection” and “List of the 22 Retail Banks Which Have 141. S Signed Up to the TCF Charter.” Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products   27 Principle 1 of the TCF Charter addresses product design. The COFI Bill specifies the following overarching princi- It relevantly states: “Banking services and products should ples for the design and provision of financial products be designed to meet the needs of customers.” By circular (Principles):147 issued on March 28, 2014, the HKMA provided examples • Financial products must be designed with due regard of measures that banks should take to implement Princi- to the interest of financial customers and, in the case of ple 1, noting that “[b]anks should design services and retail financial customers, must be designed to meet products that meet the needs of their target customer the needs of identified groups of financial customers segments, rather than designing services and products and must be targeted accordingly. just to maximize profit.” • A financial product provider must ensure that their financial customers are provided with products that Product Intervention Powers perform as that provider has led its customers to The HKMA has powers (as held by many licensing author- expect, through the information, representations, and ities) to restrict the business that may be undertaken by advertising provided by or on behalf of the financial entities that it authorizes to carry on banking business or product provider. undertake deposits. It can modify the conditions of its • A financial product provider must ensure that relevant authorizations to impose restrictions, either generally or in personnel involved in designing a financial product any particular case, on the business that may be carried on possess the necessary skills, knowledge, and expertise by an authorized institution.142 (However, it does not seem to understand properly the financial product’s main to have intervention powers under a regime similar to that features and characteristics, as well as the interests, discussed in other cases studies here.) objectives, and characteristics of the target market. SOUTH AFRICA Who Must Comply While in South Africa there are currently very limited prod- The new PDD requirements introduced by the COFI Bill uct intervention provisions,143 the recently proposed COFI apply primarily to a “financial product provider.” This term Bill would introduce a broad new PDD regime. A consulta- appears to be intended to cover issuers or manufacturers tion draft of the COFI Bill was published for public com- of financial products. However, the provisions also refer to ment, along with an accompanying Explanatory Policy institutions involved in distributing (or advising on) finan- Paper on December 11, 2018.144 The COFI Bill sets out a cial products. proposed market conduct framework to apply under South Africa’s new twin-peaks regulatory model. It includes pro- Affected Products posed PDD obligations for financial institutions. The stated objective of chapter 4 of the Bill, which includes the new All products covered by section 2 of the FSRA are subject PDD rules, is “to promote the supply to financial custom- to the new obligations. These include but are not limited ers of products that are appropriate to targeted customer to, deposits, credit products and warranties, guarantees, needs, circumstances and expectations, while facilitating or other credit support arrangements. While the provi- efficiency, flexibility and innovation.”145 The COFI Bill also sions apply to products provided to financial customers provides for the FSCA to have product intervention pow- generally, as discussed below, key obligations focus on ers.146 These provisions are discussed below as if they were retain financial customers. to be passed in their current form. They may of course change as the result of the ongoing consultation and leg- islative development process. Banking Ordinance (Cap 155), section 16(9). 142.  For example, section 89(e) of the National Credit Act, 2006 contemplates that the National Credit Regulator may issue notices to stop 143.  credit providers from offering particular forms of credit agreements. National Treasury, Republic of South Africa 2018. 144.  COFI Bill, section 46. Chapters 6 and 7 of the COFI Bill also set out (among other matters) requirements concerning product promotion, 145.  marketing, distribution, and disclosure. COFI Bill, section 51. 146.  COFI Bill, section 47. 147.  28   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products KEY TERMS SOURCE/LEGISLATION KEY TERM DEFINITION COFI Bill, section 1(1) Financial product The COFI Bill refers to the definition of a “financial product” in section 2 of the Financial Sector Regulation Act, 2017 (FSRA). The products covered include in summary and among others • deposits; • the provision of credit; and • a warranty, guarantee, or other credit-support arrangement. COFI Bill, section 1(1) Financial The COFI Bill refers to the definition of a “financial institution” in section 1(1) of the FSRA, which institution includes • a financial product provider; • a financial service provider; • a holding company of a financial conglomerate; or • a person licensed or required to be licensed in terms of a financial sector law. FSRA, section 1(1) Financial product There is no separate definition in the COFI Bill, but section 1(1) of the FSRA relevantly defines this provider term as a “person that, as a business or as part of a business, provides a financial product.” 148 FSRA section 1(1) Financial Section 1(1) of the FSRA relevantly defines this term as a “person to, or for, whom a financial customer product, a financial instrument, a financial service or a service provided by a market infrastructure is offered or provided, in whatever capacity, and includes a successor in title of the person and the beneficiary of the product, instrument or service.” COFI Bill, section 1(1) Retail financial A “retail financial customer” is, in summary, a financial customer that is a natural person or a customer juristic person whose asset value or annual turnover is less than the threshold value to be determined by the Minister. Key Requirements for Issuers/Manufacturers and acteristics of targeted financial customers are duly Distributors taken into account; Governance arrangements • be appropriate to account for risks borne by financial Financial product providers must establish and implement customers or groups of financial customers for a finan- product oversight arrangements relating to the design of cial product; financial products. These arrangements must provide for • allocate clear roles and responsibilities for the people the monitoring and review the design process and proce- responsible for establishing and implementing the dures on an ongoing basis and ensure that remedial oversight arrangements; action is taken with regard to financial products that are • incorporate effective assessment by the risk and com- reasonably expected to lead, or are leading, to poor or pliance functions of the extent to which relevant princi- unfair outcomes for financial customers. Each new finan- ples and objectives are being achieved; cial product must be signed off on by the provider’s gov- erning body before it is marketed, and this sign-off must • include senior management confirmation that a prod- be accompanied by a confirmation that the product, its uct adequately meets the required outcomes for the distribution methods, and its disclosure documents all fair treatment of financial customers, including the meet the requirements for financial product oversight requirement that it will perform as financial customers arrangements discussed below.149 are led to expect; • include appropriate measures and procedures to The financial product oversight arrangements must also ensure the financial institution’s compliance with the • support the achievement of the principles and objec- COFI Bill’s product design provisions; and tive specified in chapter 4 of the COFI Bill (as noted • be reviewed regularly by the financial product pro- above) and must include senior management confir- vider to ensure that the arrangements remain valid mation in this regard; and up to date and must be amended where appro- • support the proper management of conflicts of inter- priate.150 est and ensure that the objectives, interests, and char- 148. Section 1(1) of the COFI Bill states that terms not defined in the bill but defined in the FSRA have the same meaning.  OFI Bill, section 48. 149. C 150. COFI Bill, section 48(2). Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products   29 The COFI Bill expressly provides for proportionality of – are appropriate, taking into account considerations application of these requirements. The product oversight of fairness. arrangements may vary depending on the product and • Take appropriate steps to identify the needs of the tar- considerations of proportionality, taking into account the get market prior to making the product available to the nature, scale, and complexity of the relevant business and market, and ensure, on an ongoing basis, that the the product.151 product is appropriate to meet those needs. In addition, providers who are not “small enterprises”152 • Ensure that the design provides sufficient flexibility to must cope with reasonably expected changes in a custom- er’s needs during the lifetime of the product. • include a product approval process and a product design policy in their oversight arrangements (and • Adjust the design to respond to identified changes ensure that the policy is not compromised as a result of affecting the product and customers.155 commercial, time, or funding pressures); Distribution requirements • review and update the product approval process on a regular basis to ensure that it remains robust and fit for Chapter 7 of the COFI Bill contains provisions relating to purpose; and distribution of a financial product. The stated purposes of the chapter are to ensure (in summary) that distribution • set out their financial product oversight arrangements in their governance policy prescribed by the Bill153 and • supports the delivery of appropriate financial products make them available to all relevant persons involved in and instruments to customers; product design.154 • enables customers to understand and compare the nature, value, and costs of these products and instru- Target market assessments and product design and ments; testing requirements • enhances standards of professionalism; A financial institution providing products to “retail cus- tomers” must do the following: • enables customers and distributors to benefit from fair competition; and • When developing the product, make use of adequate information on retail financial customers’ needs and • supports viable, sustainable business models to deliver undertake a thorough assessment of the main charac- fair customer outcomes over the long term.156 teristics of a new product, proposed distribution meth- ods, and related disclosure documents. This assessment Financial institutions must satisfy themselves that the must be done by competent persons with relevant skills methods used to distribute their product are appropriate to ensure that each of these items to the nature and complexity of that product and to the target market. They must, if selecting distributors, select – are consistent with the financial institution’s busi- those possessing the necessary knowledge, expertise, ness model, risk-management approach, and appli- and competence to understand the target market, cor- cable conduct standards; rectly place the product in the market, and give appropri- – target the retail customers for whose needs the ate information to customers.157 Distribution services must product is likely to be appropriate, while taking rea- also be provided in an objective manner and must not be sonable measures to limit access by retail custom- conflicted where conflict can be avoided (and conflict ers for whom it is likely to be inappropriate; must be disclosed in all instances).158 – take into account any risks of harm to retail custom- ers resulting or potentially resulting from the prod- Product providers must give adequate information about uct; and their product to distributors. The information must be of an 151. COFI Bill, section 48(3). Defined in section 1 of the National Small Enterprise Act, 1996, as a separate and distinct business entity managed by one owner or more 152.  predominantly carried on in a particular sector of the economy (specified by the Act) and classified as a micro-, very small, small, or medium enterprise by satisfying the criteria specified in the Act. 153. See COFI Bill, section 36. 154. COFI Bill, sections 48(4)–48(6). 155. COFI Bill, section 49. 156. COFI Bill, section 63. 157. COFI Bill, sections 65(1)–65(2). 158. COFI Bill, section 64. 30   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products adequate standard, clear, precise, and up to date and allow Applicable Penalties distributors to identify and understand the target market There are no specific penalties for contravention of the and correctly place the product in it and identify the cus- provisions discussed above. However, penalties may be tomers for whom the product will be inappropriate.159 specified as the draft Bill progresses. It should also be noted that the COFI Bill sets up a licensing regime for A distributor must take all reasonable steps to ensure that financial institutions, which must be licensed by the FSCA. their distribution or advice channels act in compliance Compliance with the COFI Bill’s provisions is one of the with the objectives of their governance policy and distri- conditions for obtaining and keeping a license.165 bution or advice model. Where distributors are of the opinion that their distribution or advice channels don’t meet these objectives, they must take remedial action.160 New Conduct Standard for Banks Notably, at the time of writing the FSCA is proposing to The COFI Bill sets out several requirements for distribu- introduce a Conduct Standard for banks pursuant to its tion models. These include requirements that distribution existing powers under the FSRA166 that would impose, models must among other obligations, some PDD obligations ahead of • provide that ultimate responsibility for the customer the enactment of the PDD rules discussed above.167 The rests with the product provider and that distributors are Conduct Standard would impose on banks obligations responsible to both the customer and the product pro- with regard to financial product design very similar to vider with regard to the quality of distribution activities; those proposed in the COFI Bill (particularly with regard to governance arrangements and target market assess- • ensure that adequate information is provided to the ments) as discussed above. product provider to enable them to be sufficiently informed about the product so that they can comply with their own obligations and adequately monitor and Product Intervention Powers assess the performance of the distribution model; and The FSCA is given product intervention powers under sec- • ensure that adequate information is obtained from tion 51 of the COFI Bill. Section 51(2) gives the FSCA the customers to ensure that the sale and distribution of power, among others, to prescribe conduct standards the product or instrument are appropriate.161 regarding prohibition of or imposition of restrictions on the offer of products to certain types of customer. The Both product providers and distributors must ensure that FSCA may also prescribe conduct standards that address the distribution model used is compliant with the require- prohibited financial products. The Policy Paper accompa- ments of the COFI Bill.162 nying the COFI Bill states the following: The FSCA can prescribe conduct standards that provide It is anticipated that the FSCA will be able to […] prohibit additional requirements, limitations, or prohibitions on the inclusion of potentially harmful product features, distribution.163 either in their entirety or when products are designed for specific target markets. The FSCA will have intervention Product review requirements powers where it becomes apparent that products or ser- vices issued are not delivering appropriate outcomes.168 Products must be subject to ongoing monitoring and peri- odic reporting of product performance, to allow financial When prescribing conduct standards, the FSCA must con- customers to make ongoing, informed decisions. Distrib- sider the following, among other things: utors must monitor, on a regular basis, whether the prod- ucts or instruments they distribute are being provided to • The nature, scale, and complexity of different financial customers within the target market.164 institutions, products and services 159. COFI Bill, sections 65(3)–(4). 160. COFI Bill, sections 65(5)–(7). 161. COFI Bill, section 66(1). 162. COFI Bill, sections 66(2)–(3). 163. COFI Bill, section 69. 164. COFI Bill, section 65(6). 165. COFI Bill, Chapter 2. 166. Draft Conduct Standard 1 of 2019 (Banks). 167. See Statement Supporting the Draft Conduct Standard (2019). 168. National Treasury, Republic of South Africa. 2018, page 47. Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products   31 • The need to tion to them in a way which is clear, fair and not – provide fair access to appropriate products and ser- misleading.170 vices; The rules are applicable to financial instruments, including – enable financial customers to understand and com- structured deposits, but do not apply to other retail bank- pare the nature, value, and cost of financial prod- ing products, such as credit products and ordinary depos- ucts and financial services; its and payment products. – enable financial customers to benefit from fair com- petition for quality financial products and financial The purpose of the rules is to improve firms’ POG pro- services; cesses and to set out the FCA’s statement of policy on – support sustainable business models that enable making temporary product intervention rules. The Source- financial institutions to be able to deliver fair cus- book notes that the result of good governance should be tomer outcomes; and products that meet the needs of one or more identifiable – facilitate access to market for emerging financial target markets, are sold to clients in the target markets by institutions.169 appropriate distribution channels, and deliver appropriate client outcomes.171 UNITED KINGDOM The rules contained in the Sourcebook build on, and make obligatory, the guidance provided by the FCA in its non- The UK’s PDD regime discussed here comprises the rules binding Guidance Note on the Responsibilities of Provid- (and related guidance) set out in the Sourcebook. These ers and Distributors for the Fair Treatment of Customers, rules have been drafted with reference to the FCA’s Princi- which is applicable to all regulated firms. The rules also ples for Businesses, particularly the following: give effect to the FCA’s guidance as to consumer out- • Principle 2: A firm must conduct its business with due comes that firms should strive to achieve in order to ensure skill, care, and diligence. fair treatment of customers, particularly Outcome 2, which requires that “products and services marketed and sold in • Principle 3: A firm must take reasonable care to orga- the retail market are designed to meet the needs of iden- nize and control its affairs responsibly and effectively, tified consumer groups and are targeted accordingly.”172 with adequate risk-management systems. • Principle 6: A firm must pay due regard to the inter- The FCA is given product intervention powers by the ests of its customers and treat them fairly. FSMA. As contemplated by the legislation, the FCA has • Principle 7: A firm must pay due regard to the infor- issued a statement specifying how it will exercise such mation needs of its clients and communicate informa- powers. KEY TERMS SOURCE/LEGISLATION KEY TERM DEFINITION FCA Handbook of Rules Manufacturer A firm that creates, develops, issues, and/or designs investments (which relevantly include and Guidance—Glos- structured deposits), including when advising corporate issuers on the launch of new sary173 (FCA Glossary) investments. FCA Glossary Distributor A firm that offers, recommends, or sells investments or provides investment services to clients. FCA Glossary, Financial For relevant purposes, a financial instrument includes structured deposits. Sourcebook, 3.1.1R instruments FCA Glossary Client The definition includes (subject to exceptions) a person to whom a firm, in the course of carrying on a regulated activity, provides, intends to provide, or has provided a service (or, in the case of MiFID firms, any of certain specified services). 169. COFI Bill, section 107(2). “The Responsibilities of Providers and Distributors for the Fair Treatment of Customers,” FCA Handbook of Rules and Guidance, 1.5, 170.  https://www.handbook.fca.org.uk/handbook/document/RPPD_FCA_20130401.pdf. 171. Sourcebook, 1.1.3G. 172. FCA 2015. 173. FCA Handbook of Rules and Guidance – Glossary. 32   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products Who Must Comply and Affected Products Both manufacturers and distributors must periodically review their governance arrangements. Such reviews, as The Sourcebook imposes product governance obliga- well as initial development, must be monitored by their tions on firms that manufacture and distribute, relevantly internal compliance function. They must also ensure that for this discussion, financial instruments, which include their management bodies have effective control over the structured deposits. These rules implement the provisions product governance process, and that relevant staff mem- of the EU’s MiFID II. bers have the expertise to understand the features of the target market and the risks and characteristics of the finan- The obligations governing the manufacture and distribu- cial instruments being manufactured or distributed.177 tion of financial instruments apply to credit institutions and investment firms within the ambit of relevant EU Manufacturers and distributors must establish and main- directives and branches of third-country investment firms tain procedures and measures to ensure compliance with that manufacture and distribute financial instruments.174 applicable conflict of interest requirements in connection Other firms that manufacture or distribute financial instru- with manufacture and distribution. Distributors must also ments are to take account of the rules in the Sourcebook establish procedures and measures to ensure that all as if they were guidance on the FCA’s Principles for Busi- other applicable rules (including those relating to disclo- nesses and other relevant rules sure, suitability, appropriateness, and inducements) are complied with when deciding the range of financial instru- Key Requirements for Issuers/Manufacturers and ments to be distributed.178 Distributors Firms are expected to comply with the product gover- Governance arrangements nance rules in a way that is proportionate as well as appro- Both manufacturers and distributors must have product priate. In doing so, they should take into account the governance arrangements in place. These should aim to nature of the financial instrument in question and its target ensure that products are designed and distributed with market.179 the adequate consideration given at each stage to the characteristics, needs, and objectives of the identified tar- Target market and distribution strategy assessments get market. Both distributors and manufacturers must identify the potential target market for each instrument, and distribu- Manufacturers must maintain, operate, and review a prod- tors must also identify their distribution strategy.180 In uct approval process for each financial instrument before identifying the target market, manufacturers must reach a it is marketed or distributed to clients. This process must sufficiently granular level of analysis and must specify the specify a target market and assess risks to that target mar- types of clients that are within the target market and those ket. It must also ensure that the strategy for distribution of that are not. In determining whether an instrument is a financial instrument is consistent with the identified tar- compatible with the target market, manufacturers must get market. Manufacturers should also institute adequate examine whether the instrument’s risk/reward profile is systems and controls to manage any risks posed by the consistent with the target market, and whether the design design process.175 of the instrument is driven by features that benefit the cli- ent and not by a business model that relies on poor client Distributors also have a wide range of obligations. They outcomes to be profitable. When a manufacturer does not must understand any instrument they distribute, assess engage in distribution conduct, its determination of the compatibility of the instrument with the target market whether the product is compatible with clients must be and the needs of the client, and ensure that a financial based on its theoretical knowledge and past experience instrument is distributed only when it is in the best inter- of the instrument or similar instruments, the markets, and ests of the client to do so.176 the needs of the client.181 174. Sourcebook, 1.3.1R. 175. Sourcebook, 3.2.3R–3.2.5R. 176. Sourcebook, 3.3.1R. 177. Sourcebook, 3.2.3R, 3.2.31R–3.2.33R, 3.3.16R, 3.3.20R–3.3.22R. 178. Sourcebook, 3.2.27R–3.2.30R, 3.3.18R. 179. Sourcebook, 3.1.2R. 180. Sourcebook, 3.2.8R and 3.3.11R. 181. Sourcebook, 3.2.8R–3.2.11R. Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products   33 Distributors conducting their own target market analysis Manufacturers must also ensure that the information is of must use information obtained from manufacturers and an adequate standard to enable distributors to under- information they have on their clients. Distributors should stand and recommend the instrument properly. Manufac- assess when they need additional information or training turers should make clear whether the information provided from manufacturers, and they should not distribute a is intended for end consumer use.189 financial instrument if they do not understand it suffi- ciently.182 Distributors should understand the financial To support the reviews carried out by manufacturers strength of the manufacturer, and how efficiently and reli- (which are discussed in greater detail in the next section), ably the manufacturer will deal with the distributor or the distributors must provide manufacturers with information end client at the point of sale and subsequently.183 Distrib- on sales and the distributors’ own reviews of the product, utors must also identify and assess the circumstances and where appropriate. In determining when it will be appro- needs of the clients they intend to focus on, to ensure that priate to provide such information, distributors should their clients’ interests are not compromised as a result of have regard to the totality of the manufacturer’s obliga- commercial or funding pressures.184 tions. Such information should be shared if the manufac- turer requests it.190 Product design and testing requirements Manufacturers must undertake a scenario analysis of their Product review requirements financial instruments to assess the risk of poor outcomes Manufacturers and distributors must regularly review their for end clients, and the circumstances in which those risks financial instruments, considering any event that could might eventuate.185 They must also consider whether the materially affect the potential risk to the identified target financial instrument may represent a threat to the stability market. In doing so, both distributors and manufacturers of financial markets.186 In conducting the scenario analysis, must assess manufacturers must assess their financial instruments under • whether the instrument remains consistent with the negative conditions. The Sourcebook provides an illustra- needs, characteristics, and objectives of the identified tive list of such conditions, including where the market target market; and environment deteriorates, where the manufacturer experi- ences financial difficulties, and where demand for the • whether the intended distribution strategy remains instrument is much higher than anticipated.187 Manufactur- appropriate. ers must also consider the charges proposed for each Additionally, manufacturers must assess instrument against the features of the target market and the instrument’s return expectations (for example, where • whether the financial instrument is being distributed to costs would equal, exceed, or remove almost all of the the target market; and expected tax advantages linked to an instrument). Charging • whether the financial instrument is reaching clients for structures must also be assessed for transparency.188 whose needs, characteristics, and objectives it is not compatible.191 Information-sharing requirements between manufacturers and distributors When carrying out these reviews, manufacturers should Manufacturers must make all appropriate information on communicate contractual “breakpoints” to end consum- an instrument, the product approval process, the target ers (such as the end of a long tie-in period that may have market, and appropriate distribution channels available to a material impact on the consumers that they could not any distributors. In doing so, they may consider what reasonably be expected to recall or know about already). information distributors already have, their likely level of If the manufacturer does not know the identity of the end knowledge and understanding, their information needs, consumer, they should communicate these breakpoints to and what form or medium would best meet those needs. the distributor.192 182. Sourcebook, 3.3.4G. 183. Sourcebook, 3.3.11G. 184. Sourcebook, 3.3.15R. 185. Sourcebook, 3.2.12R. 186. Sourcebook, 3.2.15R. 187. Sourcebook, 3.2.13R. 188. Sourcebook, 3.2.4R. 189. Sourcebook, 3.2.16R–3.2.18G. 190. Sourcebook, 3.3.30R–3.3.31R. 191. Sourcebook, 3.2.19R, 3.3.26R–3.3.27R. 192. Sourcebook, 3.2.21R. 34   Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products If an event occurs that affects the potential risk or return firm from the relevant product or business area and a expectations of the instrument, manufacturers must take percentage of that revenue that may form the basis of appropriate action. This may include, for example, provid- the penalty. ing relevant information to distributors or consumers, • Mitigating and aggravating factors: The FCA may changing the product approval process or the distribution increase or decrease the amount of the penalty by ref- process, changing the instrument, and stopping further erence to various mitigating or aggravating factors. issuance of the instrument.193 • Adjustment for deterrence: If the FCA considers that Manufacturers must consider relevant factors (such as the the figure arrived at is insufficient for deterrence, it may complexity or innovative nature of investment strategies increase the penalty. It will take into account the result pursued) to determine how regularly to review their finan- of actions taken after previous breaches. cial instruments. However, prior to reissue or relaunch of • Settlement discount: The FCA may seek to agree the an instrument, they must review if they are aware of any amount of any financial penalty with the affected entity event that could materially affect the potential risk to cli- as part of agreeing other settlement terms.196 ents or the potential risk or return expectations of the instrument.194 Product Intervention Powers Distributors also have review obligations. If a distributor becomes aware that they have wrongly identified the tar- The FSMA grants the FCA the power to make temporary get market for a financial instrument, or the financial or permanent product intervention rules prohibiting firms instrument no longer meets the circumstances of the mar- from engaging in certain types of conduct.197 Temporary ket, the distributor must take appropriate steps, including rules may be made before consultation where the FCA at least identifies a significant risk of detriment to consumers that requires prompt action.198 The rules will have a maximum • reconsidering the target market; and/or duration of 12 months, although the FCA may specify a • updating their product governance arrangements.195 shorter duration.199 According to the FCA website, in practice such rules will allow the FCA to take actions including restricting the use of certain product features, Applicable Penalties requiring that a product not be promoted to some or all The Sourcebook does not specify penalties for breach of types of customers, or—in the most serious cases—requir- the design and distribution rules but breach of any rules ing that a product not be sold altogether.200 promulgated by the FCA can attract enforcement action, including the imposition of penalties, pursuant to powers The FCA has provided a policy statement in chapter 2 of the FCA has under the FSMA. The FCA’s policies in rela- the Sourcebook201 setting out the circumstances in which tion to enforcement action are set out in its Enforcement it will exercise its product intervention power by making Guide and its Decision Procedure and Penalties Manual. temporary rules. The chapter also provides guidance on Chapter 6 of the Manual refers to the following five steps certain aspects of the FCA’s policy on permanent rules. normally followed for determining penalties: Extent of the rules the FCA may make • Disgorgement: Where the FCA seeks to deprive a firm of the financial benefit derived directly from the Under section 137D(2) of the FSMA, the FCA may prohibit breach. authorized persons from • The seriousness of the breach: The FCA will determine • entering into specified agreements or doing so with- a figure that reflects this, giving consideration to mat- out satisfying certain requirements specified by the ters such as the amount of revenue generated by a FCA; and 193. Sourcebook, 3.2.24R. 194. Sourcebook, 3.2.25R–3.2.26R. 195. Sourcebook, 3.3.28R. 196. FCA Handbook of Rules and Guidance – Decision Procedure and Penalties Manual, 6.5–6.5A. 197. FSMA, section 137D.  SMA, sections 138L (which also specifies some more general consultation exemptions for rule making) and 138M. 198. F  SMA, section 138M, and Sourcebook, 2.14.1G. 199. F  CA 2013. 200. F  s required by FSMA, section 138N. 201. A Product Design and Distribution: Emerging Regulatory Approaches for Retail Banking Products   35 • doing anything that would or might result in autho- • possible unintended consequences, such as any det- rized persons entering into specified agreements or riment caused by the rules or the timing of the inter- holding an interest in such agreements or doing so vention; without satisfying certain requirements specified by • any negative impact on competition; the FCA. • when making temporary product rules, the regulatory In the event of a breach, the temporary product interven- principles it must apply under section 3B of the FSMA, tion rules may provide for agreements to be unenforce- which include efficiency and economy, transparency, able, for the recovery of money or property, and for the proportionality, sustainable growth, consumer respon- payment of compensation for any loss sustained.202 sibility, and senior management responsibility; and • when making temporary product rules, the potentially The extent of any rules the FCA may make will generally deterrent effect on entry to the market and innovation. depend on the type of intervention deemed necessary to address the issues identified. The FCA will have regard to Decisions to make any rules will be taken by the FCA whether the intervention will be a proportionate response Board, which will consider all the available relevant evi- to the perceived risk to consumers, competition issues, dence, as well as the impact of the measure to be intro- and market integrity issues. The rules may include requir- duced by the rules.206 ing certain product features to be included, excluded, or changed; requiring amendments to promotional materi- Process for making product rules als; the imposition of restrictions on marketing; or a ban In making temporary product rules, the FCA will follow the on sales or marketing of a product in relation to all or process that it has outlined in the Sourcebook. Once initial some types of client.203 proposals have been discussed, a paper will be prepared for a committee containing proposed temporary rules. Considerations before making rules The committee will either endorse the proposals or sug- The FCA will consider making product intervention rules gest amending them. If the committee decides that the where it identifies a risk of consumer detriment, a threat to proposals should go to the FCA Board, the paper will be market integrity, or ineffective competition arising from a taken to the next available FCA Board meeting.207 If there particular product, type of product, or related practices. It is sufficient time to do so, the FCA will generally seek the will make temporary rules (importantly, without the need views of various panels. Before any rules are made for consultation) where there is a need for prompt action (whether temporary or not), the FCA will consult the Pru- in order to reduce or prevent these risks from eventuat- dential Regulation Authority.208 Rules will be published by ing.204 In making product intervention rules, the FCA will the FCA with reasons for their introduction. They may also also consider205 be reviewed by the FCA while they are in force. As a result of these reviews, where necessary, the FCA may revoke or • whether the proposed rules are appropriate and pro- amend a rule.209 portionate to the risks identified, supported by evi- dence, transparent in aim and operation, likely to be The making of permanent rules would require the FCA to beneficial to consumers as a whole, and compatible follow the rule-making process specified in the FSMA.210 with other applicable laws; • the scale of detriment in the market and to individual consumers; • the social context, including social issues that lead to detriment for particular vulnerable consumer groups; • the market context; 202. Sourcebook, 2.3.1G. 203. Sourcebook, 2.2.5G–2.2.6G. 204. Sourcebook, 2.5.1G–2.5.2G. 205. Sourcebook, 2.6.2G, 2.7.1G, 2.8G, 2.9G. 206. Sourcebook, 2.4.5G. 207. Sourcebook, 2.10G. 208. Sourcebook, 2.11G–2.12G. 209. Sourcebook, 2.13G. 210. See, among others, FSMA, sections 137E and 138I. 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Client Protection Principles: Model Law and Commentary for Financial Consumer Protection. https:// www.smartcampaign.org/tools-a-resources/1049-model-law. ———. n.d. “The Client Protection Principles” (web page), https://www.smartcampaign.org/about/smart-microfi- nance-and-the-client-protection-principles. WBG (World Bank Group). 2017. Good Practices on Financial Consumer Protection: 2017 Edition. Washington, DC: World Bank Group. https://openknowledge.worldbank.org/handle/10986/28996 ———. 2018. South Africa Retail Banking Diagnostic: Treating Customers Fairly in Relation to Transactional Accounts and Fixed Deposits. Washington, DC: World Bank Group. http://documents.worldbank.org/curated/en/ 732111536246467778/South-Africa-Retail-Banking-Diagnostic-Treating-Customers-Fairly-in-Relation-to- Transactional-Accounts-and-Fixed-Deposits. Zetzsche, Dirk A., et al. 2017. “Regulating a Revolution: From Regulatory Sandboxes to Smart Regulation.” Fordham Journal of Corporate and Financial Law 23, no. 1: 31–103. https://ir.lawnet.fordham.edu/jcfl/vol23/iss1/2/. Annex II: Examples of Key Facts Statements   39