Sales representatives at banks and securities firms, the managers who approve, and the internal control departments that verify the process all check that the client and the trade are a good match, from before solicitation until after the contract. What they confirm is recorded on a client card or similar record, and they judge against internal criteria whether soliciting is appropriate.

Why the checks are made

The suitability principle is a rule for financial instruments business operators, such as securities firms, and for registered financial institutions, such as banks. It requires them to conduct business so that they do not solicit in a way that is inappropriate in light of the client's knowledge, experience, financial situation, and purpose in entering into the contract1. The series of steps in which staff collect client information, compare it against internal criteria, and keep a record is the suitability check.

For OTC derivatives, these checks also shape what is explained. When a bank trades derivatives with a client, whether together with a loan or on their own, it gives an explanation suited to the product and its risks, based on the client's knowledge, experience, financial situation, and purpose of the trade2.

When the party being solicited is a professional investor (an investor defined in the Financial Instruments and Exchange Act, such as a qualified institutional investor, the national government, or the Bank of Japan), the solicitation rule of the suitability principle does not apply in principle. It does apply in cases specified by Cabinet Office Order as likely to harm the public interest or the protection of professional investors3. When a client that is not a professional investor asks to be treated as one, the financial institution considers whether this is appropriate in light of the client's knowledge, experience, financial situation, and investment purpose before deciding whether to agree4.

The steps of the checks

Suitability checks start before an institution decides to offer a product and continue after the contract. The list below follows the Financial Services Agency's "Comprehensive Guidelines for Supervision of Major Banks, etc." (the FSA's supervisory guidelines for major banks) and its "Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc." (the FSA's supervisory guidelines for financial instruments business operators). It also follows the rules of the Japan Securities Dealers Association (JSDA). Each step has its own source and applies to different institutions, so the source is noted at the end of each step.

  1. Understanding the product. Securities firms and similar businesses analyze the risk, return, and cost of each product they handle, and they provide training and explanatory materials so that the staff who solicit can explain it correctly (the FSA's supervisory guidelines for financial instruments business operators)5. Association members (members of the Japan Securities Dealers Association) do not sell a product that is new to them if they cannot identify clients it would suit (the JSDA rules)6.
  2. Understanding and recording client information. Securities firms and similar businesses find out the client's investment purpose, experience, assets, and other attributes, and record them on a client card or similar record (the FSA's supervisory guidelines for financial instruments business operators, the JSDA rules)57. For a hedging trade, a bank also checks whether the trade works as an effective hedge for the client's business and is likely to keep doing so until the end of the contract (the FSA's supervisory guidelines for major banks)8. How to ask about and confirm actual needs is covered in Understanding Client Needs.
  3. Comparing against internal criteria. For clients starting derivatives trading and similar transactions, association members set criteria for starting such trading, based on investment experience, assets held with the member, and other factors, and they enter into contracts only with clients who meet them (the JSDA rules)9.
  4. Considering whether there is a reasonable basis, and approval. Before soliciting, securities firms and similar businesses consider whether there is a reasonable basis for the product, and for the frequency and size of trades, to suit the client's attributes and purpose. Depending on the client's attributes, soliciting certain products requires a manager's approval (the FSA's supervisory guidelines for financial instruments business operators)5.
  5. Explanation and confirming the client's intention to contract. A bank's sales representatives explain the product and its risks in writing, confirm with the client that the client received the explanation, and keep this in writing (the FSA's supervisory guidelines for major banks)10.
  6. Review after the contract. Even after the contract, a bank checks whether the hedge is effective as the client's business conditions and actual needs change (the FSA's supervisory guidelines for major banks)11.

Items recorded and internal criteria

What has been confirmed is kept on record. The JSDA rules require association members to keep a client card with the following items for every client other than professional investors7. Client cards and similar records are prepared after fully confirming the client's investment purpose, and the registered purpose is shared by the financial institution and the client5.

Item What it covers
Name, address, and contact details Information that identifies the client
Occupation and date of birth (for individuals) Attributes of an individual client
Investment purpose The purpose of the trade, such as hedging or investment
Assets A basis for judging the financial situation
Whether the client has investment experience, and the types of transactions A basis for judging knowledge and experience
Other Items each association member adds as it considers necessary

Internal criteria are set in advance to fit the features of each product. Securities firms and similar businesses decide beforehand which factors and procedures to use when considering whether there is a reasonable basis5. Association members make internal rules on matters such as investigating clients and criteria for clients starting derivatives trading, and they make their officers and employees follow them12. The content of the criteria (which level of experience or assets is required for which product) depends on the products an institution handles and the clients it serves, so it differs from one institution to another.

Departments and roles

Suitability checks are not left to the staff who solicit alone. They are shared among the managers who approve and the departments that verify the process. The parties and roles that appear in the points of focus of the FSA's supervisory guidelines for financial instruments business operators are as follows5.

Party Role in the points of focus of the guidelines
Officers and employees involved in solicitation Understand the risk, return, and cost of the product correctly, and explain them to the client
Managers Approve the solicitation of certain products, depending on the client's attributes
Managers responsible for the sales department (someone other than the staff member in charge, including internal control managers and branch or department heads) Meet the client when the content of trades needs to be confirmed directly with the client
Internal control department Verify the understanding of products, the understanding of client information, the consideration of a reasonable basis, and whether any inappropriate solicitation has occurred, and review the framework. Set how the responsible managers hold client meetings, and verify how they are carried out

The sales representatives in the front office (sales and trading), who deal with clients, are the officers and employees in the first row of the table. On the framework for explaining to clients, the FSA's supervisory guidelines for major banks list as points of focus that the board of directors builds the internal control framework for the whole bank, and that internal checks through inspections and audits are working13. The titles of the people who approve and how the verifying departments are organized depend on the size of the organization and the products it handles, so they differ from one institution to another.

Elderly individual clients

Securities firms and similar businesses solicit elderly individual clients with more care than other clients. Even with enough investment experience, elderly individual clients may become physically frail, and their ability to make judgments may change within a short time. For this reason, they have a framework for careful solicitation and sales, and a system to detect problematic sales early14. The definition of elderly clients, the products offered to them, how explanations are given and orders are taken, and similar matters are set in internal rules15. Under the JSDA rules, each firm decides from what age a client counts as elderly.

Reviews after the contract

A derivatives contract lasts for years, so the checks do not end at the contract. Even after the contract, a bank checks regularly, and when needed, based on the client's business conditions and financial condition. It checks whether the hedge is effective, and whether the client can keep the hedge in place, in light of how much of the actual needs remain11. Even if the hedging instrument itself shows no loss, it may stop working as a hedge before the end of the contract, for example because the business shrinks8. Securities firms and similar businesses monitor the actual state of long-running derivatives trades through means such as meetings held by managers responsible for the sales department5.

Consider a hypothetical example in which a corporate client, Company M, imports raw materials and pays USD 1 million a month. To cover these payments, it has entered into FX forwards to buy USD 1 million a month for three years. Suppose the review one year after the contract finds that imports have fallen to USD 500,000 a month. For the remaining 24 months, USD 500,000 a month, or USD 12 million in total, exceeds actual needs. This part is a position with nothing to hedge, and it can produce a gain or a loss depending on the market. If the review leads the client to consider ending the contract before maturity, the procedure is covered in Early Termination.

When a review shows changes in the client's assets, income, or investment purpose, securities firms and similar businesses check with the client whether to change the registered details on the client card or similar record before changing them, and they share the updated details with the client. Later solicitation follows the updated details5.

If the client asks, a bank also provides the market value of the position and the amount of the termination payment, which the client uses for financial statements or for deciding whether to terminate11.

Inappropriate solicitation and how to prevent it

Even with suitability check procedures in place, solicitation can still turn the checks into a formality. The FSA's supervisory guidelines for financial instruments business operators give the following three examples of inappropriate or dishonest solicitation5.

  1. Recommending trading at a high frequency that does not fit the client's attributes or purpose, so that the client bears more fees.
  2. Getting the client to change the investment purpose registered in step 2 to fit the product the firm wants to recommend, without making the client understand what the change means.
  3. Recommending a product with higher fees without reason when several products would suit the client.

To prevent solicitation that does not fit the client's purpose, securities firms and similar businesses require a manager's approval to solicit certain products depending on the client's attributes (step 4). The internal control department verifies whether such solicitation has occurred and reviews the framework5.

Notes

  1. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 40, item 1. Financial instruments business operators and registered financial institutions together are called "financial instruments business operators, etc." under Article 34 of the same Act. ↩

  2. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.), III-3-3-1-2(2)①イ (page 217) (in Japanese). ↩

  3. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 45, main clause and item 1. Professional investors are defined in Article 2, paragraph 31 of the same Act. ↩

  4. Financial Services Agency, "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.), III-2-3-2-1(1)⑥ (page 53) (in Japanese). The request is based on Article 34-3, paragraph 1 of the Financial Instruments and Exchange Act. ↩

  5. Financial Services Agency, "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.), III-2-3-2-1 "適合性原則" (Principle of suitability), preamble and (1)① to ⑤ (pages 51–53) (in Japanese). ↩ ↩2 ↩3 ↩4 ↩5 ↩6 ↩7 ↩8 ↩9 ↩10

  6. Japan Securities Dealers Association, "協会員の投資勧誘、顧客管理等に関する規則" (Rules on investment solicitation and customer management by association members), Article 3, paragraph 3 (in Japanese). ↩

  7. Japan Securities Dealers Association, "協会員の投資勧誘、顧客管理等に関する規則" (Rules on investment solicitation and customer management by association members), Article 5, paragraphs 1 and 2 (in Japanese). ↩ ↩2 ↩3

  8. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.), III-3-3-1-2(2)①イ, item c and its notes 1 to 3 (pages 218–219) (in Japanese). ↩ ↩2

  9. Japan Securities Dealers Association, "協会員の投資勧誘、顧客管理等に関する規則" (Rules on investment solicitation and customer management by association members), Article 6, paragraph 1 (including item 4 on securities-related derivatives transactions, etc. and item 5 on specified OTC derivatives transactions, etc.) and paragraph 2 (in Japanese). ↩

  10. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.), III-3-3-1-2(2)①イ, items a and d (pages 217–219) (in Japanese). ↩

  11. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.), III-3-3-1-2(2)①イ, item h (pages 219–220) (in Japanese). ↩ ↩2 ↩3

  12. Japan Securities Dealers Association, "協会員の投資勧誘、顧客管理等に関する規則" (Rules on investment solicitation and customer management by association members), Article 24, paragraph 1 (in Japanese). ↩

  13. Financial Services Agency, "主要行等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Major Banks, etc.), III-3-3-1-2(1)① and ③ロ (page 216) (in Japanese). ↩

  14. Financial Services Agency, "金融商品取引業者等向けの総合的な監督指針" (Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.), IV-3-1-2(3) "高齢顧客への勧誘に係る留意事項" (Points to note in soliciting elderly clients) (page 129) (in Japanese). ↩

  15. Japan Securities Dealers Association, "協会員の投資勧誘、顧客管理等に関する規則" (Rules on investment solicitation and customer management by association members), Article 5-3 (in Japanese). ↩