Industry leaders largely agree that “complex” products should not be gatekept, and think that doing so would negatively impact the entire industry, stalling innovation.
The Financial Industry Regulatory Authority (FINRA), an independent, nongovernmental organization that writes and enforces the rules governing registered brokers and broker-dealer firms in the U.S., issued Regulatory Notice 22-08 in March, “reminding members of their sales practice obligations for complex products and options and [to] solicit comments on effective practices and rule enhancements.”
Of concern specifically are options, leveraged and inverse ETFs, and crypto future funds, and FINRA has targeted the platforms that service primarily retail investors, such as Robinhood. The regulator has gone so far as to suggest a possible test for retail investors before they are able to invest in these “complex products,” ETF Trends and ETF Database previously reported.
What Constitutes a “Complex” Product
The vagueness of the notice has led ETF industry leaders to different interpretations of what may be considered a “complex” product.
In an open comment letter on FINRA Regulatory Notice 22-08, Dave Nadig, financial futurist at ETF Trends and ETF Database, wrote, “I’m a bit terrified by the scope the notice includes as a potential definition for what constitutes a ‘complex’ product.”
“If you chase all of the footnotes and referenced documentation (hand up!), it’s not hyperbole to suggest that every fund providing anything but plain vanilla beta exposure to stocks and bonds would be included,” Nadig added. “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 also wrote that he believes the SEC to be the appropriate jurisdiction to continue to define and maintain any kind of classification of products by type or structure, rather than FINRA.
On the other hand, Nick Elward, senior vice president, head of institutional product and ETFs at Natixis Investment Managers, expects FINRA’s focus to have a much more narrow scope.
“We do not expect active semi-transparent ETFs to be deemed complex products,” Elward said. “We expect that ETFs using more complicated underlying investments, such as derivatives or leverage, are more likely to be FINRA’s focus.”
Which Investors Will Be Most Affected by the Mandate?
It is easy to assume that the investors most affected by enhanced regulation of complex products are aggressive gamblers, but that is rarely the case, according to ETF veteran Phil Bak.
In an open comment letter on FINRA Regulatory Notice 22-08, Bak, founder and CEO of Nav, wrote, “every investor is unique with their own investment goals. For many clients cookie-cutter investment advice is entirely appropriate. For others, their goals will best be attained through more complex strategies. It is easy to dismiss those clients as overly aggressive gamblers, but in my experience the exact opposite is the case.”
Bak said that many retirees in particular are seeking downside protection strategies, or other investments that mitigate market risk, whereas others may need to hedge against certain assets or scenarios.
“The asset management industry has never before had such a liquid and healthy derivative market from which they can create, optimize and customize better strategies for these investors. It would be a shame if we were to limit product creators to using only the blandest of ingredients,” Bak added.
There Is a Serious Need for Increased Financial Literacy — But Testing Won’t Solve the Problem
Ric Edelman, founder of Digital Assets Council of Financial Professionals (DACFP), said that there’s no question that there is a huge problem with financial illiteracy in this country.
“Wall Street has, over the last several decades, created more and more complex products that go beyond the comprehension of most investors,” Edelman said. “But demanding that the client pass an exam to demonstrate competency is like asking a cancer patient to get a medical degree before they agree to surgery or chemotherapy. It’s absurd.”
“This is why you go to the advisor. It’s the advisor who needs to demonstrate competency so they can determine on behalf of the client if this product is appropriate, suitable, and in the best interests of the investor,” Edelman added. “To ask the investor to do that is a bridge too far.”
Direxion, with $31 billion in assets in its index-based products that deliver directional options, magnified exposure, and long-term, rules-based strategies, intends to issue a formal comment to FINRA fully explaining the firm’s point of view.
“Generally speaking, educated investors are our best customers – regardless of the platforms they use to access our products. Rather than limiting investor choice, we believe that investor education, transparency, and risk disclosure should be the industry’s primary focus,” David Mazza, head of product at Direxion, said.
Edelman and Nadig each questioned the logistics of the exam.
“Who’s going to write the exam? How many questions are there going to be? Who’s going to determine whether you answer the questions correctly, sufficiently, and in quantity to demonstrate your competency?” Edelman said.
Nadig said that he found some of the suggested new gates in the regulatory proposal disturbing, particularly that it’s strongly hinted that FINRA members (in the case of a retail investor, their broker-dealer) would be expected to administer and track actual testing of investors to determine their financial literacy.
“This simple idea sounds attractive – we all want investors to know what they’re doing before they trade. However, it’s so wildly impractical and so fraught with peril as to bring to mind poll taxes and the Supreme Court cases on literacy tests for voting,” Nadig wrote.
Edelman pointed to colleges throughout the U.S. dropping the SAT requirement, which has been long debated for its status as a gatekeeper for educational opportunities.
“Colleges around the country are dropping the SAT because they’ve concluded it’s an inaccurate way to assess a high school student’s candidacy, and they’ve also found that these exams damage the ability for minorities to pass them because of the inherent bias that these exams contain,” Edelman added. “So is this notion going to further deny the rights of minorities from engaging in the financial markets?”
Alternative Solutions For FINRA’s Consideration
Nadig said that as an alternative, he would support positive attestations for complex products, both at account opening (much like options are handled today) and at some predetermined interval clearly codified in regulation (perhaps an annual reattestation).
“Any further regulation here should be trying to fix real problems without cutting off access to real, valuable investment opportunities for the average investor,” Nadig wrote. “A smart combination of clear, well-understood, definitions and disclosure-based gates is the best angle to take.”
“Innovation, however, will not be held back. Just as regulators increased their grip on financial products, the one area of the financial system that slipped out of regulatory jurisdiction – cryptocurrency – has seen innovation, enthusiasm and excitement like we have never seen in the asset management industry in decades,” Bak wrote. “Cryptocurrencies have attracted levels of human capital, monetary capital, and creative enthusiasm that we mainstream asset managers could never dream of. The lack of regulatory friction, I believe, has been a key driver in allowing innovation and enthusiasm to flourish.”
Placing the onus of risk management entirely in the hands of product issuers and regulators will lead to even more investor complacency, which itself poses a far greater long-term risk to those same investors. People will swim to deeper waters when waves appear calm, Bak added.
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