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Documentation of ESG preferences at banks

From the current EU-regulations and from the specific changes of ESG-preferences in the Delegated Regulations of MiFID II and the Guidelines of ESMA, there is a requirement to document the sustainability factors/risks in the internal policies and procedures. And the extended selection process (extended by ESG factors/risks) has to be described accordingly. This concerns both the description of the algorithm as well as the data fields and, if applicable, the ranking of the product proposals addressed under point 71 of the ESMA-guidelines (… companies could, for example, rank the financial instruments in their product range for each of the ESG preferences). Below are the relevant text passages of the Delegated Regulations/MACOMP and ESMA Guidelines (highlighted in bold).

Delegated Regulation on MiFID 2 concerning ESG preferences

The following are added to the organizational requirements concerning ESG-preferences:  Article 21 – Organisational requirements 

General organizational requirements (Article 16(2) to (10) of COMMISSION DELEGATED REGULATION (EU) 2017/565 of 25 April 2016 and DELEGATED REGULATION (EU) of 21.4.2021 supplementing Directive 2014/65/EU) concerning ESG-preferences. 

1.   Investment firms shall comply with the following organisational requirements:

(a) establish, implement and maintain decision-making procedures and an organisational structure which clearly and in documented manner specifies reporting lines and allocates functions and responsibilities;

(b) ensure that their relevant persons are aware of the procedures which must be followed for the proper discharge of their responsibilities;

(c) establish, implement and maintain adequate internal control mechanisms designed to secure compliance with decisions and procedures at all levels of the investment firm;

(d) employ personnel with the skills, knowledge and expertise necessary for the discharge of the responsibilities allocated to them;

(e) establish, implement and maintain effective internal reporting and communication of information at all relevant levels of the investment firm;

(f) maintain adequate and orderly records of their business and internal organisation;

(g) ensure that the performance of multiple functions by their relevant persons does not and is not likely to prevent those persons from discharging any particular function soundly, honestly, and professionally.

Investment firms shall take into account sustainability risks when complying with the requirements set out in this paragraph.

When complying with the requirements set out in this paragraph, investment firms shall take into account the nature, scale and complexity of the business of the firm, and the nature and range of investment services and activities undertaken in the course of that business.

Article 23 

Risk management (Article 16(5) of Directive 2014/65/EU). 

1.   Investment firms shall take the following actions relating to risk management:

(a) establish, implement and maintain adequate risk management policies and procedures which identify the risks relating to the firm’s activities, processes and systems, and, where appropriate, set the level of risk tolerated by the firm. In doing so, investment firms shall take into account sustainability risks;

Investment Advice 

Article 52 Information on investment advice

3.   Investment firms shall provide a description of:

(a) the types of financial instruments considered;

(b) the range of financial instruments and providers, analysed per each type of instrument according to the scope of the service;

(c) where relevant, the sustainability factors taken into consideration in the selection process of financial instruments;

(d) when providing independent advice, how the service provided satisfies the conditions for the provision of investment advice on an independent basis, and the factors taken into consideration in the selection process used by the investment firm to recommend financial instruments, including risks, costs and complexity of the financial instruments.

Article 54 (Suitability Assessment and Suitability Reports) contains even more specifications on the suitability statement for the ESG preferences.

MACOMP in Germany

BT 7.7 Necessary arrangements for understanding products.

1. firms must implement appropriate procedures by which they can understand product features and characteristics (including costs and risks) so that they can make appropriate investment recommendations or invest in appropriate products on behalf of their clients.

(2) Firms must implement resilient processes, and tools, through which they can objectively and consistently classify the individual products in their investment universe based on the various characteristics and relevant risk factors (such as default risk, market risk, liquidity risk, etc.). In doing so, firms must take into account their own analysis undertaken as part of the product monitoring/target market identification process.

In this context, firms need to carefully consider how certain products might perform under certain circumstances (e.g., convertible bonds or other debt instruments subject to the bail-in mechanism19 that may, for example, change their form and be converted into shares).

3. companies should pay particular attention to considering the degree of “complexity” of products that needs to be matched with the customer’s information (especially in terms of their knowledge and experience). However, when determining the level of complexity of products for suitability testing and then grading products appropriately, firms must also consider the criteria for determining complexity set forth in the WpHG.

(4) Firms must implement procedures to ensure that the information used to understand and properly classify investment products in their product range is accurate, consistent and up-to-date. In establishing these procedures, companies must take into account the various characteristics and nature of the products in question.

5 In addition, companies must review the information used to determine whether any changes have an impact on the classification of the product. This is of particular importance in the context of continuous change and increasingly rapid developments in financial markets.

BT 7.8 Identifying suitable investments for customers

(8) To ensure consistency in suitability assessments conducted using automated systems (even if contact with clients is not through automated systems), firms must monitor and test the algorithms underlying transactions recommended or executed on behalf of clients. In determining these algorithms, companies must take into account the nature and characteristics of the products that are part of their offering. In particular, companies must, at a minimum:

– Establish appropriate system design documentation that clearly identifies the purpose, scope, and design of the algorithms. Decision trees or decision rules used must be part of this documentation;

– Have a documented testing strategy that explains the scope of testing for the algorithms. This must include test plans, test scenarios, test results, troubleshooting (if applicable), and final test results;

– etc

ESMA Guidelines on certain aspects of the MiFID II suitability requirements

Articles 16(2) and 25(2) of MiFID II, and Article 54(9) of the MiFID II Delegated Regulation – General guideline

69. Firms should ensure that the policies and procedures implemented to understand the characteristics, nature and features (including costs and risks) of investment products allow them to recommend suitable investments, or invest into suitable products on behalf of their clients. 

70. Firms should adopt robust and objective procedures, methodologies and tools that allow them to appropriately consider the different characteristics, including sustainability factors, and relevant risk factors (such as credit risk, market risk, liquidity risk45, …) of each investment product they may recommend or invest in on behalf of clients. …. 

71. When considering the sustainability factors of products in view of the subsequent matching with the client’s sustainability preferences, firms could, for example, rank and group the financial instruments included in their product range in terms of: i) the proportion invested in economic activities that qualify as environmentally sustainable (as defined in Article 2, point (1), of Taxonomy Regulation); ii) the proportion of sustainable investments (as defined in Article 2, point (17), of SFDR); iii) the consideration of principal adverse impacts. Such grouping should also be consistent with the firm’s analysis conducted for the purposes of product governance obligations. Firms are reminded that a grouping of financial instruments for the purpose of the suitability assessment cannot replace the collection of information from clients as described in paragraphs 25 and 26 above. 

88. In order to ensure the consistency of the suitability assessment conducted through automated tools (even if the interaction with clients does not occur through automated systems), firms should regularly monitor and test the algorithms that underpin the suitability of the transactions recommended or undertaken on behalf of clients. When defining such algorithms, firms should take into account the nature and characteristics of the products included in their offer to clients. In particular, firms should at least: 

• establish an appropriate system-design documentation that clearly sets out the purpose, scope and design of the algorithms. Decision trees or decision rules should form part of this documentation, where relevant; 

• have a documented test strategy that explains the scope of testing of algorithms. This should include test plans, test cases, test results, defect resolution (if relevant), and final test results; 

• have in place appropriate policies and procedures for managing any changes to an algorithm, including monitoring and keeping records of any such changes. This includes having security arrangements in place to monitor and prevent unauthorised access to the algorithm; 

• review and update algorithms to ensure that they reflect any relevant changes (e.g. market changes and changes in the applicable law) that may affect their effectiveness; 

• have in place policies and procedures enabling to detect any error within the algorithm and deal with it appropriately, including, for example, suspending the provision of advice if that error is likely to result in an unsuitable advice and/or a breach of relevant law/regulation; 

• have in place adequate resources, including human and technological resources, to monitor and supervise the performance of algorithms through an adequate and timely review of the advice provided; and 

• have in place an appropriate internal sign-off process to ensure that the steps above have been followed. 

Delegated Regulation amending Delegated Directive (EU) 2017/593 by including sustainability factors in product monitoring obligations

  • In paragraph 9, the first subparagraph is replaced by the following:

‘9. Member States shall require investment firms to identify at a sufficiently granular level the potential target market for each financial instrument and specify the type(s) of client with whose needs, characteristics and objectives, including any sustainability related objectives, the financial instrument is compatible. As part of this process, the firm shall identify any group(s) of clients with whose needs, characteristics and objectives the financial instrument is not compatible, except where financial instruments consider sustainability factors. Where investment firms collaborate to manufacture a financial instrument, only one target market needs to be identified.’;

(b) paragraph 11 is replaced by the following:

‘11. Member States shall require investment firms to determine whether a financial instrument meets the identified needs, characteristics and objectives of the target market, including by examining the following elements:

(a) the financial instrument’s risk/reward profile is consistent with the target market;

(b) the financial instrument’s sustainability factors, where relevant, are consistent with the target market;

(c) the financial instrument design is driven by features that benefit the client and not by a business model that relies on poor client outcomes to be profitable.’;

(c) in paragraph 13, the following second subparagraph is added:

‘The sustainability factors of the financial instrument shall be presented in a transparent manner and provide distributers with the relevant information to duly consider any sustainability related objectives of the client or potential client.

Next steps

The obligation to document sustainability related factors (ESG preferences) and risks in the bank’s processes is already in place. And as the new ESG-MiFID 2 regulation for investment advice has started on the second of August 2022 the respected processes should have already been adapted. If you want to improve the documentation of the ESG preferences and may implement changes in your product governance process, contact us.

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Georg Tichy

Georg Tichy is a management consultant in Europe, focusing on top-management consultancy, projectmanagement, corporate reporting and fundingsupport. Dr. Georg Tichy is also trainer, lecturer at university and advisor on current economic issues. Contact me or Book a Meeting