From Soccer to Financial Products: Product Governance in Perspective

The ongoing World Cup has inspired me to use a metaphor in this blog to explain exactly what product governance within the financial sector is, and how it differs from “know your customer.”

Product governance rules have been around for some time now. So why take a step back to the basics of this concept all of a sudden? Regulators expect market participants to make progress in the area of product governance. See, for example, the areas for improvement in investor protection for smaller asset managers that the AFM published on its website in March of this year.

In my experience, a number of market participants are unable to make these improvements due to a lack of understanding of the intent and purpose of these rules. An illustration from a different context might help.

Product governance for soccer ball manufacturers

Soccer ball production starts with manufacturers who produce soccer balls. They do so in various sizes and weights, categorized from 1 to 5. The right choice depends on factors such as age, skill level, and intended use, including competition rules and training methods. In addition, there are, of course, different price categories within these sizes and weights, based in part on material and brand. Furthermore, there is a difference between indoor soccer balls and outdoor soccer balls. The manufacturer will need to inform distribution channels of all the characteristics of the soccer balls produced, so that they can be presented to the right target audience by physical sports stores, online retailers, or soccer clubs. In addition, a manufacturer will also need to warn sellers about who certain balls are not suitable for; for example, machine-stitched balls that break quickly with intensive use. These are best avoided by soccer coaches.

Product governance for sports retailers

A sports store must fully understand all the characteristics of a soccer ball in order to sell it to the right audience. To do so, it relies partly on the information provided by the manufacturer, but its own knowledge and experience also play a role. Every sports store must have a distribution strategy: a logical system that ensures an indoor soccer ball doesn’t end up with an outdoor player, or a size 5 ball doesn’t go to a beginner youth player. In addition to a positive target audience, the sports store must therefore also consider a negative target audience.

Feedback from customers indicating that products do not meet expectations must be relayed to the manufacturer. Consider, for example, an outdoor soccer ball that becomes unplayably heavy in the rain even though it was marketed for all-around use. The manufacturer can then modify the product or adjust the target audience description.

Know Your Customer for Sales Staff

And then all the soccer balls are in place, and the store opens its doors. Customers walk in; some browse on their own, while others ask for advice. The sales associate speaks with customers and asks various questions to identify an individual customer’s needs: what is the soccer player’s age, what is the intensity of use, on what surface is the game primarily played, etc. In this way, the sales associate’s extensive product knowledge is combined with an understanding of the customer, maximizing the likelihood that the customer will go home with the right soccer ball. And what is right for one customer is, of course, not necessarily right for another. That is “know your customer”: a complement to product governance, not an equivalent.

The Shift to Product Governance for Financial Institutions

Virtually every financial market participant must comply with product governance rules. There are differences at the detailed level for each sector, but conceptually the rules are the same. Even the leap from product governance regarding soccer balls to product governance in the financial sector isn’t that big. The example of soccer balls can help make the rules more tangible. I’ll illustrate this using three questions I’m frequently asked.

 

1. Isn’t product governance only necessary for developers?

This confusion is likely caused, in part, by the term “Product Approval and Review Process” (PARP), which is also used to refer to product governance products. Another term that is used is “Product Oversight Governance” (POG).

When we talk about developers of financial products, we’re referring to a wide range of market participants, some of whom may or may not be subject to supervision themselves. These can include issuers of shares, managers of investment funds, or providers of consumer credit. Distributors of financial products include, for example, telecom stores where you can buy a smartphone on credit or execution-only investment platforms. Asset managers also fall under this category; I will return to this point later.

The soccer example illustrates that the target audience definitions of the developer and the distributor complement each other. The developer’s target audience definition will often be more general than that of the distributor. The distributor is closer to the target audience than the developer and can therefore refine the definition. Consider my local sports store, which knows which soccer ball is preferred by which club. In addition, it is the distributor who, through a distribution strategy, can ensure that a product reaches the positive target audience rather than the negative one. The distributor thus forms an important link between the developer and the customer.

 

2. An asset manager isn’t a distributor, is he? He makes investment decisions for the client himself, doesn’t he?

In their service model, asset managers also ensure that financial products reach the end customer. Product governance is not about who makes the investment decision, but about ensuring that a product reaches the customer for whom it is intended. The fact that the end customer delegates the purchase decision to another party does not detract from the objective of product governance.

Consider the situation where the youth coordinator (ages 8–18) of a soccer club must decide to purchase training balls for various teams. The individual players, spanning a wide range of ages and skill levels, must play with the right ball. The fact that they do not personally decide exactly which ball that will be does not diminish the youth coordinator’s obligation to familiarize themselves with the characteristics of the types of soccer balls from which a choice must be made, and to determine which team these balls should be allocated to. The distribution strategy could involve marking the balls with a specific label and storing them in designated ball bags in the ball storage room.

 

3. How does clustering work?

For financial firms that distribute a wide variety of financial products, the question arises as to whether product governance must be carried out for each individual product. Consider, for example, a brokerage platform where a broad range of global financial instruments is accessible to investors. Product governance for each individual product is then practically unfeasible, and not always necessary. It is permissible to group products with the same characteristics together and assess them as a product group. Consider, for example, publicly traded stocks. However, the category “private investment funds” is too broad for a cluster. After all, there are investment funds with different characteristics in terms of, for example, liquidity, tradability, and volatility. The category “soccer balls” or even “children’s soccer balls” would also be too broad for a sports store, given the other relevant characteristics, such as surface, size, and material.

Product governance remains a focus for regulators

The AFM regularly emphasizes the importance of product governance. It does so by addressing individual market participants (think of informal enforcement proceedings but also published fines) and by publishing market-wide expectations. This is not new. For instance, as early as November 2020, it called for the attention of investment firms in its letter to the sector outlining regulatory standards. Nearly six years later, the standards still appear to be challenging for the sector, as evidenced by the aforementioned areas for improvement in investor protection for smaller asset managers that the AFM published on its website in March of this year. The “product approval and review process” (PARP) is part of the standards where the AFM identifies compliance risks.

ESMA also regularly comments on product governance. For example, on May 6, it issued a Public Statement providing insight into the results of the investigation it conducted, with the assistance of national competent authorities, into, among other things, how market participants incorporate a product’s sustainability objectives into their target audience determination. ESMA acknowledges that this is a difficult task and is asking national regulators not to make this a priority for enforcement at this time, but does encourage the sector to address it.

All in all, this is reason enough for the industry to place product governance high on the compliance agenda. With a solid understanding of the underlying concept, this will hopefully become more of a no-brainer than a rearguard action.