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ASIC releases report on Compliance with Design and Distribution Obligations by Retail OTC Derivative Issuers

ASIC issued Report 770 Design and Distribution Obligations: Retail OTC Derivatives (“Report 770”) after conducting a review of compliance with the design and distribution obligations (“DDO”) by over-the-counter (“OTC”) derivative issuers to retail clients. The findings of Report 770 are relevant and applicable to all retail product issuers. The OTC derivative sector reviewed contains over 60 Australian financial services licensees (“AFSLs”) that issue complex, high-risk OTC derivatives to retail clients as well as many more distributors for these products.

Report 770 builds on previous reports and guidance issued by ASIC in relation to the DDO such as:

This article summaries the key findings and observations in Report 770.

Key Findings and Observations in Report 770

ASIC identified three areas that require improvement by product issuers and distributors:

  • Making an appropriate Target Market Determination (“TMD”);
  • Distribution consistent with the TMD and reasonable steps; and
  • Monitoring and review arrangements.

 

Report 770 outlines 7 key findings which we have summarised in the table below including good and bad examples for each finding.

Finding 1: Use of available data
Examples of good practices observed:
- using both qualitative and quantitative data in developing a TMD;
- drawing on data from both internal and external resources such as market reports or academic research; and
- using existing data on a regular basis to exclude consumers for whom the product would likely be inappropriate, such as analysing the characteristics of loss-making accounts.
Examples of poor practices observed:
- determining the target market by describing the existing consumer base instead of considering whether the product is appropriate for these consumers and their likely objectives, financial situation and needs; and
- not using any data in product design or assessing whether the product would likely be consistent with the objectives, financial situations and needs for the consumers in the target market.
Finding 2: Insufficient granularity in TMDs
Examples of good practices observed:
- appropriately describing the high-risk nature of derivative products; and
- using available data to identify target market characteristics such as consumers' trading history, timing and types of trades, characteristics of loss-making accounts.
Examples of poor practices observed:
- not clearly defining the target market;
- inappropriate risk profiles being used in the target market - for example stating that CFDs are high risk products that are not appropriate for consumers seeking 'medium risk' investments; and
- inappropriate investment timeframes - CFDs are unlikely to be suitable for consumers seeking longer investment timeframes due to the volatility, leverage, potential for capital loss etc.
Finding 3: Over-reliance on client questionnaire
Examples of good practices observed:
- use of questionnaires as a final check instead of as the primary or only method of assessing whether a consumer is within the target market;
- use of 'knock-out' questions to exclude consumers from the onboarding process when responses provided would indicate that the consumer is not likely to be within the target market; and
- use of lock-out periods to stop consumers from re-attempting the questionnaire if they were unsuccessful during the first onboarding process.
Examples of poor practices observed:
- using prompts that allow potential consumers to review any "unacceptable answers" so that consumers who would not ordinarily fall within the target market are prompted to change their responses;
- allowing excessive attempts to pass the questionnaire; and
- asking consumers to self-certify that they are in the target market. ASIC noted this practice is inconsistent with the objectives of the DDO regime.
Finding 4: Over-reliance on existing controls
Examples of good practices observed:
- utilising questionnaires that involve a range of questions targeted to the TMD eligibility criteria;
- engaging in a regular, formal and external review of the TMD and compliance with the DDO; and
- having and implementing formal policies covering distribution, marketing, advertising, product development, and governance.
Examples of poor practices observed:
- relying on a 'client qualification' test designed for RG227 disclosure benchmarks to assess whether a consumer is within the target market;
failure to change arrangements for distribution of CFDs following the commencement of the DDO. ASIC noted product issuers should re-consider distribution conditions in line with their current target market; and
- failure to update the TMD following the annual review.
Finding 5: Marketing practices
Examples of good practices observed:
- using existing client data to exclude and restrict the potential audience base for certain marketing strategies;
- using targeted campaigns for specific distribution channels and publications such as targeting existing experienced users rather than new 'first time' traders; and
- applying the key words and filters to narrow the potential audience base and exclude certain groups of retail consumers.
Examples of poor practices observed:
- engaging in mass marketing advertising campaigns such as television commercials, sponsorship of sporting teams, advertising at sporting events and/or billboard advertising;
- marketing through 'partner' campaigns; and
- marketing through comparison websites and social media which are accessible to any consumer.
Finding 6: Poorly defined TMD review triggers
Examples of good practices observed;
- conducting client outcome reviews which monitor the frequency, value and time period of losses when reviewing client outcomes to determine if the target market might not be appropriate and should be adjusted; and
- having realistic complaint triggers. This means that issuers may explore triggers that are not only referring to the number of complaints received but factors such as nature of the complaints and the percentage increase of the complaints during different periods.
Examples of poor practices observed:
- implementing review triggers that are unrealistic, especially when the triggers are set too high so there is a low probability of a review trigger being instigated;
- not using all available information but only restricting data gathered through the onboarding process. It is recommended that product issuers consider all available data obtained throughout the lifecycle of the product; and
- reactive in responding to review triggers rather than proactively monitoring and analysing available data.
Finding 7: Leadership engagement needed
Examples of good practices observed:
- Board of product issuers taking a close interest in product management and consumer outcomes;
-incorporating data collection and analysis to generate quantitative reports for senior management and the Board for product management purposes; and
- having regular formal reviews that involve various departments across the business and presenting findings to the Board for review.
Examples of poor practices observed:
- having no formal role for Board reviews in the DDO compliance framework;
- the Board does not take a proactive role and limits their monitoring to receiving compliance updates; and
- not considering the appropriateness of new issuance to existing clients.

Other Insights

Report 770 and ASIC’s recent enforcement actions have triggered product issuers and distributors to review their DDO framework as well as their TMDs. Sophie Grace has written a previous article on ASIC’s TMD reviews which may also be helpful to issuers of financial products.

Based on our recent experience, we have further observed that:

  • some issuers do not take non-individual retail clients (such as companies and trusts) into account in their product design and TMD preparation. In particular, some issuers lack documented records showing the likely objectives, financial situations and needs for non-individual retail clients;
  • some issuers that onboard retail company clients do not require all persons who are authorised by the company to place trades or transact on the company’s behalf to pass the suitability test and/or qualification test; and
  • some issuers have shell companies as retail clients and are unsure about how the DDO regime and their existing TMD apply to these clients.

Sophie Grace can assist retail OTC derivative issuers to navigate their compliance with the DDO regime as well as the following previous ASIC publications on retail OTC derivatives:

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