FINRA Complex Product Proposal: Bad Policy

As I pack my bags for Exchange next week, I can’t forget a minor detail facing the ETF industry – and financial advisors and all other types of investors: we’re at a point of very strange shift for financial investors. regulation. These are clearly interesting times: from war to inflation to Fed policy and a boom in retail investors trading options. Some ETFs are still closed to trading as the war in Ukraine drags on with no end in sight. Index providers rebuilt global indexes in response. Meanwhile, Barclays committed one of the biggest goals in ETF history by overselling its ETNs, forcing a massive potential loss of $600 million for the company. Topics for conversation abound.

But what really worries me is FINRA’s Regulatory Notice 22-08. I briefly covered it on CNBC last week, but I can’t leave well enough on my own, so here’s my official comment letter to FINRA, which I’ll be filing next week.

Jennifer Piorko Mitchell
Office of the Corporate Secretary
1735 K Street NW
Washington, D.C. 20006-1506


Good morning all. I’m Dave Nadig, financial futurist for ETF Trends and ETF Database. For the better part of the past 25 years, my job has been to help asset managers understand investors and to help investors understand the products that asset managers build. Since 1993 I have been in and around the regulatory framework for ETFs – arguably the most egalitarian financial product ever created. Fundamentally, ETFs have lowered costs and increased access for all categories of investors, especially retail investors and financial advisors.

To briefly summarize my interpretation of Settlement Notice 22-08, it poses two fundamental questions and offers various potential answers.

Question 1 (The definition): Are some financial products complex enough to require additional investor protections, and how would we define this bucket of products.

Question 2 (The Door): If we agree on what’s in the bucket, what should we do to truly protect investors?

The definition

While I understand this is only a request for comment at this time, I’m a bit terrified of the scope the review includes as a potential definition of what constitutes a “complex” product. If you chase all the footnotes and referenced material (hands up!), it’s not hyperbole to suggest that all funds offering anything other than ordinary beta exposure to stocks and bonds would be included. In the filings and referenced comments, FINRA suggested that everything from structured notes with opt-out features to the simplest of target date funds would be clawed back.

I agree that some products are complex, but modern markets are complex. The role of the SEC is to determine which products are available to investors under which rules. Just a few years ago, after 20 years, they finally codified what is and isn’t an ETF under the 6C11 rule. I believe the SEC is the appropriate jurisdiction to continue to define and maintain any kind of classification of products by type or structure.

The SEC has looked into this issue in the past and considered various labeling and other product “bundling” strategies, primarily exchange-traded products. If the SEC were to take up this battle again, I’d say the proper headings for bucketing are portfolio intent, as stated in the prospectus, and structure — essentially, an overview of what a fund actually plans to do. For example, it is understood that exchange-traded notes may present counterparty risk and be subject to continuous issue issues, making them suitable to receive any “Scarlet C” that might be applied to complex products. .

Beyond structure, a regime in which mutual funds, closed-end funds and Bill 40 ETFs have been categorized based on their holdings takes some precedence. In Europe, for example, asset managers can manage funds either as UCITS (essentially their vanilla ’40 structure), as UCITS alternative products (which make extensive use of derivatives) or as alternative investment funds (which act as a bridge between public and private markets).

Such a transparent approach would not be very easy to implement and would require redefining a large number of existing products in any new compartments that might be created, and of course asset managers would find it difficult to hear about things like “what percentage of a fund can be options” or “investing in a Cayman Islands subsidiary does it count”, or “how much leverage is OK”, but the basic premise of the categorization according to the expected portfolio makes sense. As an investor, I must read additional information and make additional certifications in order for my brokerage account to be approved to trade options or futures or use margin. It makes sense (if practically difficult) that simply bundling those same derivatives into a fund structure shouldn’t change those certification and disclosure rules.

Such a transparent definition would also provide instant clarity on many issues related to crypto regulation and the use of cryptocurrencies and associated digital assets within these structures. However, the most important issue is clarity: if regulators are to embark on defining compartments, the definition must be crystal clear, unplayable, and not require the daily monitoring of portfolio positions.

The door

Just arriving at a definition of “complex” is substantial work (and again, work that I believe is best done at the SEC). However, suppose we imagined that such a definition was the law of the land. In this case, the second question is “how do we use this to protect investors”.

With very few exceptions, most interactions between manufacturers of financial products and the actual end user take the form of mandatory and regulated disclosures, the most obvious of which is the prospectus. The disclosure challenge at the prospectus level is well documented, and the modern prospectus is now primarily a research document for the insomniac or market plumbing obsessive (raise your hand!). At a minimum, something similar to the EU’s Key Investor Information Document (KIID) could go a long way towards improving disclosure.

Importantly, disclosure as a concept remains central to the (admittedly Byzantine) US regulatory regime, and I found some of the new doors suggested in the regulatory proposal disturbing. In particular, it is strongly suggested that FINRA members (in the case of a retail investor, their broker) should administer and follow the actual tests of investors to determine their financial literacy. While I am a strong advocate for increased financial literacy efforts, I strongly oppose the idea that my retail broker, increasingly just an app on my smartphone, will be the judge and jury to determine which retail customer is authorized to access which products. based on a test that could be as subject to bias, misinterpretation and misapplication as any other standardized test. This simple idea sounds appealing – we all want investors to know what they are doing before they trade. However, it is so impractical and so perilous that one thinks of poll taxes and Supreme Court rulings on literacy tests to vote.

As an alternative, I would support positive certifications for complex products, both at account opening (much like options are managed today) and at a predetermined interval clearly codified in regulation (perhaps a re-certification annual).

Conclusion: First, Do No Harm

When discussing new rules for retail investors, I tend to think old Hippocrates was right: Primum Non Nocere – first, do no harm. Any action taken by regulators should be based on the principle of not breaking the unbreakable. There is no doubt that complex products exist, and there are many opportunities for a student with a smartphone to get into financial trouble. However, they can also do this in penny stocks and sports betting. I believe the investment management industry has worked well with point-of-sale providers – primarily financial advisors and broker-dealers – to improve the lot of the average investor with radical certainty since the 1990s.

Any additional regulation in this area should attempt to address the real issues without cutting off access to real and valuable investment opportunities for the average investor. A smart combination of clear, well-understood definitions and disclosure-based gates is the best angle to take.


David Nadig
financial futurist
ETF Trends and ETF Database

For more market trends, visit ETF Trends. Follow Dave on Twitter @DaveNadig

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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