Blog: FINRA’s potential regulation of ‘complex products’ meets serious blowback from investors – Financial Planning

FINRA opened for comments on a potential rule to regulate “complex products,” and investors made their feelings crystal clear.

More than 800 commenters expressed opposition to the regulator’s queries about  whether it should limit access to complex products for self-directed retail investors. The regulator is considering rules that could prevent or restrict U.S. investors from buying a broad range of securities, including crypto and crypto futures funds, options, leveraged and inverse ETFs without taking an exam that proves their understanding of the investment vehicles. 

There are still unanswered questions, however, about who would create the training materials to help investors prepare for the exams and what would happen if investors fail them. 

“The restrictions on individual investors that FINRA is considering are staggering and unprecedented,” ProShares Advisors, an issuer of inverse and leveraged ETFs, said in a statement to Financial Planning. “For the first time ever, individual investors could be prevented or deterred from buying everything from target-date funds to closed-end funds, to all public funds that use futures contracts or are related to cryptocurrency.”

In an interview, a FINRA spokesperson said it welcomes the comments and will evaluate them as part of determining what changes may be appropriate.

FINRA’s comment period comes as trading volumes and market scale of those products have grown rapidly, with retail traders playing a key role, according to JPMorgan strategists cited by Bloomberg. Listed options trading volume has grown to over 38.6 million contracts a day on average, more than 30 percent higher than the 29.5 million contracts traded per day in 2020 and almost doubled from the 19.8 million contracts traded per day in 2019, according to FINRA. Launched in 2018, defined outcome ETFs have grown to nearly 150 ETFs with almost $10 billion in market value. 

Complex products

In FINRA regulatory notice 22-08, the regulator describes complex products as any with “features that may make it difficult for a retail investor to understand the essential characteristics of the product and its risks.” 

One example offered is defined-outcome ETFs, which offer structured retail product-type features such as exposure to the performance of a market index or reference asset but with downside protection and an upside cap on potential gains over a specified period. Defined-outcome ETFs provide the specified outcome if an investor buys the ETF at the beginning of the period and holds it until the end. Otherwise, an investor’s returns could deviate significantly from the specified outcome, FINRA said. 

“If a product has features or payout structures that would be confusing to retail investors, or if it performs in unexpected ways in various market or economic conditions, investors may not fully understand the attendant risks,” the notice states. 

While FINRA said the protective measures are primarily designed for retail customers accessing products through a self-directed platform without the assistance of a financial professional, it also implies that financial advisors should follow the same advice. 

“When recommending complex products to retail customers, (FINRA) members should consider whether a less complex product could achieve the same result,” according to the notice.  

“I’m a bit terrified by the scope the notice includes as a potential definition for what constitutes a ‘complex’ product,” Dave Nadig, financial futurist at ETF Trends & ETF Database, wrote in a comment to FINRA. “In filings and commentary referenced, FINRA has suggested everything from structured notes with knock-out features all the way down to the simplest target date fund would be scooped up.” 

Nadig said a look-through approach wouldn’t be easy to implement, and it would require a reset of a lot of existing products. Therefore, asset managers would find it difficult to reach consensus on issues such as asset allocation and the level of leverage it should take. 

For investors, it also means they have to read additional disclosures and make additional attestations to get their brokerage account approved to trade options and futures or use margin, he wrote. 

“If regulators are going to get into the business of defining the buckets, the definition needs to be crystal clear, un-gameable and not require the daily monitoring of portfolio positions,” Nadig wrote. 

From disclosure to exams

Many investors oppose the idea of requiring investors to pass competency exams, which they argue would not only limit investor access but also shake the current disclosure-based system in the industry. 

“We are concerned about various points FINRA is inquiring about. Once implemented, it could unduly restrict investor access to publicly offered securities and run contrary to the disclosure-based system that underpins our securities laws.” Jonathan R. Simon, general counsel of Van Eck Securities Corporation, wrote in a comment to the FINRA rule. “If FINRA deems our current disclosure-based regime inadequate, the solution is not for FINRA to erect arbitrary barriers to a vast universe of publicly offered securities but for the SEC to review and consider enhancing the regime.”  

Ric Edelman, co-founder of the Digital Assets Council for Financial Professionals, said that an easier way to solve FINRA’s concern is to encourage investors to rely on the services of professional financial advisors, a solution that is already in place. 

“Asking consumers to pass a test proving they are knowledgeable about investments before they can invest is like asking patients to pass a test about health care before they are permitted to swallow a pill.” Edelman wrote in a comment to FINRA.

Advisors are already required to pass an extensive battery of exams at both the federal and state levels and are obligated to complete ongoing continuing education requirements to maintain their proficiency. Investors should be encouraged to talk to an advisor so they can rely on that professional’s demonstrated knowledge, skills and experience to guide them, Edelman said. 

Instead of placing the responsibility of risk management entirely in the hands of product issuers and regulators, Phil Bak, founder and CEO of atNav thinks that it would make more sense to allow investors to access those options-enhanced strategies not directly on their own, but through funds managed by professionals. 

“Requiring millions of people to take exams could prevent them from participating in the financial markets and interfere with their ability to achieve financial security,” he said. 

Nadig of ETF Trends & ETF Database agreed.

“I believe that the investment management industry has worked well with the point-of-sale providers — financial advisors and brokers primarily — to improve the lot of the average investor with radical certainty since the 1990s,” Nadig wrote. “Any further regulation here should be trying to fix real problems without cutting off access to real, valuable investment opportunities for the average investor.” 

SEC concerns

FINRA isn’t alone in worrying about exchange-traded products or the state of current rules. 

In 2015, the SEC requested comment on ETPs generally, noting their increased prevalence. In particular, the regulator wanted opinions on the ways in which broker-dealers market ETPs — especially to retail investors — and the extent to which individual investors understand the nature and operation of ETPs. 

In 2019, the SEC proposed rules that would require broker-dealers and SEC-registered investment advisors to exercise due diligence in approving a retail customer’s or client’s account to buy or sell shares of certain “leveraged/inverse investment vehicles” before accepting an order from, or placing an order for, the customer or client to engage in such transactions. It stated that the SEC staff would review the effectiveness of the existing regulatory requirements in protecting investors — particularly those with self-directed accounts — who invest in leveraged/inverse products and other complex products. 

“I believe the SEC is the appropriate jurisdiction to continue to define and maintain any kind of classification of products by type or structure,” Nadig wrote. “Should the SEC take up that battle again, I would argue that the appropriate rubrics for bucketing are portfolio intent as stated in the prospectus and structure — essentially, a look-through to what a fund actually plans to do.”

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