Presented by Syntax Advisors.
Deborah Fuhr: Welcome to ETF TV, I’m Deborah Fuhr and today we’re at the exchange event in Florida and we’re going to be discussing the FINRA Rule 2208, which is defining how to regulate complex products.
I’m joined by Stacy Fuller (Partner, K&L Gates) and Dave Nadig (Financial Futurist, ETF Trends).
Welcome to the show.
Stacy Fuller: Thank you for having me.
Dave Nadig: Glad to be here.
Deborah Fuhr: So, Dave, what types of ETFs, ETNs, mutual funds are considered complex under this document?
Dave Nadig: Well, unfortunately, I can’t give you a super clear answer, because they’ve left it very vague and I suspect that’s intentionally. If you chase all of the footnotes that they put in here on things that they’ve referenced in the past, it pretty much looks like anything that is not pure, beta exposure to a clean, underlying asset could probably get caught in.
Anything that’s using derivatives certainly would get caught into the mix. Honestly, even funds like target-date funds have historically been called complicated by FINRA. So if you really chase it all the way down, once you get past really ‘vanilla’ equity, ‘vanilla’ bond exposure, I suspect you could get scooped up under this definition of complex.
Stacy Fuller: Some products have been around since, indeed the time of the 1940 Act, some of them are actually codified in the 1940 Act. Closed-end funds comes to mind. It’s hard to think of something more plain vanilla than something Congress in 1940 decided was appropriate for investors. This really would reach, potentially, any mutual fund that uses derivatives for hedging, any mutual fund that has, what in my trade is called a tax blocker. But it’s just a wholly owned subsidiary through which the fund holds investments to make it tax efficient. These are standard structures and have been for decades. And so I think folks really want to pay attention to the fact that they might have some products unexpectedly swept in here.
Deborah Fuhr: And what might investors need to do in the future to purchase these products?
Stacy Fuller: It’s hard to tell what exactly FINRA is thinking of doing here. On the one hand, they are suggesting that potentially additional disclosures could suffice. So, that’s point of sale disclosures or investor attestations, so to get investors to say when they’re purchasing the product. ‘Yes, I understand this product. Yes, I understand what I’m doing.’ Those types of gates actually exist today and are arguably working well.
More concerningly, they (FINRA) also suggest that they might revise the securities trading framework to impose an options-like framework on just regular investors who want to just trade, as Dave was saying, complex products. And that would require a lot more work by investors and brokers upfront at the time of account opening. The other thing they’re suggesting as a possibility would be to put investors through a test to sort of give them an exam to see if they really understand the complex product they’re planning to invest in.
Deborah Fuhr: Dave, why is this happening now?
Dave Nadig: We’re obviously in the middle of what I would call a bit of a regulatory Renaissance, although that’s probably too positive a spin on it. The SEC is clearly in a sweep-and-destroy mode on a lot of interesting things going on, frankly, in innovation, in investment management. I think this is part and parcel of that.
I actually think one of the biggest problems with this is that this is not coming from the SEC. I’m quite concerned that FINRA would be put in the position of being this arbiter of what is a complex product, a non-complex product, because that has historically always been something the SEC has handled or in some cases, the CFTC. So FINRA stepping into that position, I find deeply concerning.
I think it’s also a reaction to a legitimate rise of retail interest in investing. I think that’s a great thing. I love that we have a new renaissance of retail investing, but because we’ve had sort of some meme stock hysteria and folks looking at leveraging the ability to trade by phones, I think there’s a lot of concern that retail investors aren’t getting enough education. Taking the step to actually testing investors feels like a bridge. Way too far to be, though.
Deborah Fuhr: Isn’t this have been unusual because usually the US works on a disclosure regime?
Stacy Fuller: It is. I think one of the points made was a complex product is a product that might behave in a way that the investor doesn’t expect. And in the US, our federal securities law regime has relied for 90 years on disclosures to set investor expectations. In suggesting something more might be required, fINRA seems to really sort of be moving away from the notion that disclosure can be the core of effective regulation, and I think that’s a seminal signal.
The other thing I think is unusual here is FINRA has historically really limited its regulation, I guess, is the right word, of members to their interactions with investors. So when broker dealers make recommendations to investors, making sure those are suitable and in the best interests of the client. This type of regulation, it would really be much more akin to FINRA regulating an investors’ sort of conduct with respect to itself, almost suggesting that investors can’t make good decisions on their own and they need these extra protection of FINRA. So I think that is pretty new.
Deborah Fuhr: What are the next steps after the consultation period ends on May 9th?
Dave Nadig: Well, because this is FINRA, it’s a little bit less clear than it would be in something that’s more of a legislative process. FINRA, because it’s effectively an SRO, can kind of do whatever it wants, so it’s not out of the question that they could, for instance, collect a bunch of comments by May 9th, turn around on June 15th and propose a new set of regulations that all FINRA members would have to abide by. And that would sort of be it.
Now, I think that that’s probably a little bit fearmongering. Most of the regulator folks that I’ve actually worked with have been are relatively rational people, so I suspect they will actually take in the comments from industry and investors and all sorts of related parties. And I suspect what they’re going to hear is a lot of; ‘whoa, whoa, whoa, whoa, whoa!’ So I hope that what we actually get is perhaps a round of proposals that we can then comment on.
What we saw from them was not a proposal. What we saw from them was truly ‘spaghetti up against the wall,’ to try to address this issue. I think it’s really important that folks in this industry and individual investors too, actually put those comment letters in, even if we simply say, ‘hey, look, I’m an individual investor, I think I know what I’m doing. I really don’t need a nanny to tell me whether or not I’m good enough at it, and I certainly don’t want to take your darn test.’
So I think it’s really important that we sort of mobilize investors and industry to respond to this however you want to respond to it, but recognize this is pretty intrusive.
Deborah Fuhr: Who can and how should investors and others respond?
Stacy Fuller: Definitely prepare a comment letter and definitely get it in by May 9th. I think investor comment letters are so important. Investors who invest in closed-end funds. Investors who invest in index based ETFs that track smart beta indexes. If you’re an investor in those, those are important comments. Industry sponsors looking at the footnotes, as Dave was saying of the releases to see, ‘oh wow, actually my closed-end fund and my target-date fund of all things, would potentially be swept up.’ So the best thing to do is to file a comment letter that’s available on Center’s website.
Deborah Fuhr: Another product that’s being captured yours is ESG ETFs, which are popular with many investors around the world. So I think anyone who is using those products should consider responding to FINRA.
Thank you, Stacy. Thank you, Dave, for joining us.
Stacy Fuller: Thank you, Debbie.
Dave Nadig: Thanks for having us.
Deborah Fuhr: Thank you Syntax Advisors for being the sponsor of the show.
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