As I’m packing my bags for Exchange next week, I can’t seem to let go of one minor detail facing the ETF industry – and financial advisors and all other kinds of investors: we’re at a very odd tipping point for financial regulation. These are clearly interesting times: from war to inflation to fed policy to a boom of retail investors trading options. We have some ETFs still closed for trading as the war in Ukraine extends with no end in sight. Index providers have rebuilt global indexes in response. Meanwhile, Barclays committed one of the greatest own-goals in ETF history by overselling their ETNs, forcing a massive $600 million potential loss for the firm. There’s no shortage of stuff to talk about.
But what I’m really worried about is FINRA Regulatory Notice 22-08. I covered it briefly on CNBC last week, but I can’t seem to leave well enough alone, so here’s my formal comment letter to FINRA, which I’ll be filing in the next week.
Jennifer Piorko Mitchell
Office of the Corporate Secretary
1735 K Street, NW
Washington, DC 20006-1506
To Whom It May Concern,
Hi there. I’m Dave Nadig, Financial Futurist for ETF Trends and ETF Database. For most of the last 25 years, my job has been to help asset managers understand investors and help investors understand the products that asset managers build. Since 1993, I’ve been in and around the regulatory framework for ETFs – arguably the most egalitarian financial product ever created. At the core, ETFs have driven costs down and increased access for all classes of investors, especially smaller investors and financial advisors.
To briefly summarize my interpretation of Reg Notice 22-08, it asks two fundamental questions and proposes various potential answers.
Question 1 (The Definition): Are some financial products complex enough to require additional investor protections, and how would we define that bucket of products.
Question 2 (The Gate): If we agree on what’s in the bucket, what should we do to actually protect investors?
While I understand that this is solely a request for comments at the moment, 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. 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.
I agree that some products are complex, however modern markets are complex. The role of the SEC is to determine what products are available to investors under what rules. Just a few years ago, after 20 years, they finally codified what is and isn’t an ETF under rule 6C11. 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 at this in the past and entertained various labeling and other strategies for “bucketing” products, mainly Exchange Traded Products. 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. For example, it’s well understood that Exchange Traded Notes can have counterparty risk and be subject to problems of continuous issuance, making them appropriate to receive whatever “Scarlet C” might be applied to complex products.
Beyond structure, a regime where ’40 Act Mutual Funds, Closed-End Funds, and ETFs were put into categories based on their holdings has some precedence. In Europe, for example, asset managers can run funds either as UCITS (essentially their vanilla ’40 Act structure), Alternative-UCITS products (which make extensive use of derivatives), or Alternative Investment Funds (which act as a bridge between public and private markets).
Such a look-through approach wouldn’t be super easy to implement, and would require a re-set of a lot of existing products into whatever new buckets might created, and of course, Asset Managers would find it difficult to agree on things like “what percentage of a fund can be in options” or “does investing in a Cayman Islands subsidiary count,” or “how much leverage is OK,” but the core premise of categorizing based on the expected portfolio is sensible. I, as an investor, have to read additional disclosures and make additional attestations to get my brokerage account approved to trade options or futures or use margin. It’s logical (if practically challenging) that simply wrapping those same derivatives in a fund structure shouldn’t change those attestation and disclosure rules.
Such a look-through definition would also provide instant clarity on many issues surrounding crypto regulation and the use of Cryptocurrencies and related digital assets within these structures. The most important issue however is clarity: 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.
Just getting to a definition of “complex” is substantial work (and again, work I believe best done at the SEC). However, suppose we imagine that such a definition was the law of the land. In that case, the second question is, “how do we use this to protect investors.”
With surprisingly few exceptions, most of the interaction between the manufacturers of financial products and the actual end-user comes in the form of mandatory, regulated disclosures, the most obvious of which is the prospectus. The challenge of prospectus-level disclosure is well documented, and the modern prospectus is now primarily a research document for the insomniac or market-plumbing obsessed (hand up!). At a minimum, something similar to the EU’s Key Investor Information Document (KIID) could go a long way toward improving disclosures.
But importantly, disclosure as a concept remains at the core of the (admittedly byzantine) American regulatory regime, and I found some of the suggested new gates in the regulatory proposal disturbing. In particular, 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. While I am a staunch advocate for greater efforts in financial literacy, I am firmly against the idea that my retail broker, increasingly just an app on my smartphone, is going to be the judge and jury on which retail customer is allowed access to 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 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.
As an alternative, I 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).
Conclusion: First, Do No Harm
When considering new rules for retail investors, I’m inclined to think old Hippocrates was right: Primum Non Nocere – first, do no harm. Any action taken by regulators should start from a principle of not breaking what isn’t broken. There’s no question that complex products exist, and there’s ample opportunity for a college kid with a smartphone to get themselves in financial trouble. However, they can do that in penny stocks and sports betting as well. 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.
Any further regulation here should be trying to fix real problems without cutting off access to real, 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.
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