ETF Edge - Concern about "Complexity"

Episode Date: March 28, 2022

CNBC's Bob Pisani spoke with Thomas Gorman, attorney at Dorsey and Whitney, Dave Nadig, Financial Futurist at ETF Trends, and Kim Arthur, CEO of Main Management. FINRA recently raised the alarm on exposing retail investors to complex products like leveraged and inverse ETFs, options, and even bitcoin futures ETFs ... more and more regulators are warning the brokerage community to be careful about recommending the products and asking whether more rules and vetting are necessary. For instance, should retail traders be required to take tests before they allowed to trade these products? In the ‘Markets 102’ portion of the podcast, Bob continues the conversation with Dave Nadig from ETF Trends. Hosted by Simplecast, an AdsWizz company. See https://pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge podcast is sponsored by InvescoQQQ, Supporting the Innovators Changing the World, Investco Distributors, Inc. Welcome to ETF Edge, the podcast, if you're looking to learn the latest insights on all things, exchange, traded funds. You're in the right place. Every week, we're bringing you interviews and market analysis, breaking down what it all means for investors. I'm your host, Bob Tizani. Finra recently raised the alarm on exposing retail investors to complex products. What's a complex product? It's leverage and inverse ETFs. Bitcoin futures ETFs. It could even include options.

More and more regulators are warning the brokerage community to be careful about recommending these products and asking whether more rules and vetting are necessary. For instance, should retail traders be required to take tests before they are allowed to trade these complex products? Today on the show we'll discuss all of this and more. Here's my conversation with Thomas Gorman, Attorney at Dorsey and Whitney, Dave Naughtick, financial futurist at ETF Trends, and Kim Arthur, CEO of Maine Management.

You know, Dave, it looks like FINRA is trying to describe a whole new class called complex products, and they seem to imply these complex products need even higher levels of regulatory scrutiny than there are already. So, suss this out for us. What's the implications for the ETF community and for retail traders, if this goes ahead? Well, I think the important thing to remember is this is really just a race. request for comments right now, but we all know that that's often sort of the stalking horse for new regulation. What they're really trying to do is create sort of a, if you will, a second-class citizen of product. But it's not based on structure. And this is a really different way of approaching regulating products in the United States. Historically, we think about a structure

and we say, oh, well, if you're not an accredited investor, for instance, you can't invest in this type of fund. This isn't doing that. This is saying that a regular old Fortyact mutual funder ETF that meets certain inclusion criteria based on what it owns would be in a different bucket. And then the question is, once you put everything in that bucket, how do you get access to it? It's not clear where we'll end up, but they have said in the past that things like target date funds or emerging market funds or even a tactical asset allocation fund are all too complex to be considered plain vanilla.

With a broad definition like that, this could have a pretty chilling effect on not just the sales of those products, but. but frankly, investor portfolios, because these are really powerful tools that investors have come to rely on. Yeah. You know, Tom, Finra seems not just concerned about a lack of education on the part of retail traders. They also seem concerned about the lack of education on the part of the brokers. Some of these products are incredibly complex. You and I had a conversation about this last week, and you quipped that you could have a Ph.D. in economics and still not understand them.

Is there some reason for FINRA to be concerned? Thank you, Bob. Thanks for having me. Yes, you're exactly right. There's real concern here on the part of not just FINRA, but the person behind FINRA, otherwise known as the Securities and Exchange Commission, because they've been bringing enforcement actions based on this issue. And it's an important issue. It's just starting to emerge in their enforcement cases. But the point here is these products are incredibly complicated. They have one, for example, that I'm familiar with, that was in one of the enforcement actions where you were supposed to trade it for one day. One day, the people that were put into it by their broker held it for a year. You can imagine what happened to those people. They got slaughtered. It's not enough to be a sophisticated investor, which is largely based on money. It may not be enough, as you said, they even have a PhD in economics.

You've got to understand what these particular. products, which are oftentimes very complicated, are designed to do. This is classic Warren Buffett. If you don't understand it, you can't invest in it. And that's what's happening here. And the first line of defense here is the broker dealer. The broker dealer is supposed to have policies and procedures in place that say, this is how you teach people about this stuff. This is what this stuff is. And in the cases the SEC's brought, those weren't being followed. This is a simple situation of not following the rules in the beginning. Yeah. So, Tom, what intrigues me is they went through great lengths, Finrad did, to remind their members that regulation best interest, that's Reg B.I. That was adopted in 2020.

That it requires brokers to act in the best interest of their customers when they're making these recommendations. And that implies brokers need to be able to explain to the clients the nature of the products they're recommending. and the risks and rewards, and they're supposed to determine if the investments are suitable for the clients. The tenor of all of this seems to be some of these products are just not suitable at all. That seems to be the underlying tenor, Tom, or am I trying to read too much into this? No, I think there's a legitimate question here. I wrote an editorial about some of these a while ago raising the question, is disclosure enough? and in some instances, it almost seems like it's not.

These products, the one that I was talking about a minute ago, that you can only buy for one day, that's in the disclosure. Now, the disclosure looks like a lot of these documents, it's probably 40, 50 pages of fine print that nobody can read, but this has got to be implemented. You don't necessarily need to write new rules. You need to make sure that the ones that are on the books are being enforced so that people understand what they're buying

and selling them. They don't hold a one-day product for a whole year because you just you just lose. So that's this place to start. That's where FINRA is trying to start. That's why they put that release out. I'm sure that that follows in the wake of those SEC enforcement cases. And if that starts to come up along with Reg. VI, which you're exactly right. That's what should be governing a lot of this stuff. Then you might say, well, maybe we need to do the disclosure a little bit different. Maybe the broker has to say, Here's the pamphlet, but here's five things that if you don't understand them, you don't want to buy this. You know, Kim, you run a management firm. Do you use these complex products like leverage and inverse ETFs?

Is there a reason for FINRA and the SECD be concerned about these products, in your opinion, as a financial advisor? Yeah, Bob, thanks a lot. Yes is the answer. We do use these complex products, mostly auctions. and they're mostly covered call options. So the big difference with that is you're using that to dampen volatility, create another stream of income or hedge against larger swings. I agree with what Tom just said that, you know, like you said,

red B.I is best interest. And if you don't have enforcement of the disclosures that are written in there, that's a problem. But when you do have enforcement, it's a blunt reminder that there are consequences. So I think personally that they are complex, but there's tons of disclosures that are written there. Make sure the regulators are there to enforce to show that there's consequences. But in the meantime, you just continue to do increased education alongside the regulation, or in the case with our clients,

like sold to you main management. You guys are the professionals. If you choose to use these complex instruments, I trust and know because you have our best interest that you will do the right thing for us because you have that by do share. Yeah. You know, Dave, embedded here, there was a whole series of comments on what they're calling self-directed platforms. They seem to mean Robin Hood and online brokers, platforms that don't have any financial advisors. And many of these complex products they note are sold through these self-directed trading platforms. FINRA seems to imply that the platforms have very high levels of obligation to their clients. And I guess the question is, what are those obligations? And if there are obligations, where do you

draw that line? If somebody wants to go broke, you know, trading stupidly complex products on Robin Hood, is it the fault of Robin? And where's the line here? Well, you don't need a complex product to go broke day trading on Robin Hood, right? You can just go to the OTC bullet board stocks and you can do just fine on that. But I think the problem here is that we've had a 90-year record of a pretty solid disclosure-based system for these issues, right? We have chosen in the past not to look inside product and say what this owns is bad and therefore it has something else. That's what's really nefarious about the way this is being positioned, because not only are we going to do that look in, but then you're going to obligate the broker to somehow segregate that out. and then create some sort of testing regime, probably with a continuing education requirement,

that you then have to enforce an individual investors. That's really a slippery slope, because you introduce all sorts of issues of education, bias, access. It becomes a real problem. So I'm not saying that there's no issue here. There are obviously very complex products out there that folks really should understand before they invest in them. But I think the system we have right now is the right direction. I agree we need to enforce it. I think better standards, around what appropriate use of disclosure in a self-directed environment is important. For instance, do you need more than just a little pop-up window the first time you trade a leverage an inverse fund, or should you be reminded every time you interact with a product like that

about its features that make it complex? That would be my approach here, right? Improve the disclosure system by providing clear guidance. Although, as Tom pointed out, you can have disclosure and still have confusion, as he did with that ETF that only trade. one day or resets one day at a time. So Tom, what about Dave's point? There's already numerous safeguards in place for investors who want to trade anything, want to trade options or futures and warrants, whatever. There's suitability requirements when recommending these products. They already exist. And determining that there's a reasonable belief, the customer has the knowledge, the customer has the experience to evaluate the risks. Why do we need more? Is it a good

idea to require tests. That seems to be a whole new level of regulatory interference, perhaps, not necessarily interference, but a whole new regulatory structure. Dave makes a good point, and I agree with him. There's plenty of disclosure out there. There's all these documents written that lay out in minute detail in some instances what's going on with this. What's the problem with that is retail investors don't read them. Retail investors don't understand them, and you can't make them read that. But what you can do, and this is where FINRA is really stepping in here and doing a good service, at least the start of a good service, is you can make the brokers implement them

so that in the policies and procedures that your brokerage firm has, for example, you might single out some of these so-called complex products and say, look, we want you to do this, this, and this to make sure that people understand. understand what they are. I don't think you want investors taking tests. One of the things that's happening now though is you see with, and let's not pick on Robin Hood, but they're an example of this is with more and more investors coming in and particularly younger investors who are not particularly sophisticated in this stuff, they start trading and they put their money in and they've got, you know, whatever they've got for money to put in there, they put it all in,

and then they lose it. Why? Because they didn't read what they were, what they were supposed to read. And the broker, more importantly, didn't tell them. So in my favorite case about the one day, the one day turnover, had the broker sat down and said, look, one day, really one day. What's more suitability? How long can you hold this if it says one day? You hold it for two days, three days a year? The broker hasn't done what he really needs to do.

What he or she really needs to do is say, what? You can't buy this thing if you're not going to trade it out in one day. You can't buy this thing unless you can really have. afford to lose all of the money here. If you want to buy it after I tell you those things, that's your decision. I'm not going to tell you not to buy it. That's up to you. You're the investor. My job is the broker, which is what Finner is trying to do here. What the SEC's trying to do here and what they probably spurred Finran to doing is saying write better rules. We don't need new ones. We need better ones to mirror what's going on in the marketplace today so that we're

protecting investors. But a test would be a new. rules. So, Kim, from your point of view, as a guy who manages money, is it reasonable to ask for some kind of minimal competency test? That's what we're talking about here. This would be the new regulation. Is it reasonable to ask for a minimal competency test? Tom's point is, disclosure may not always be enough. If they're so complex, nobody reads it or understands it, they just have a sort of very, very minimal understanding of what's going on. Yeah, I think the minimum competence makes sense, and a lot of that exists. Like, if I first have to fill out, if I'm going to trade options for myself and my own account, I've got to fill out a forum that asks me some questions about my experience and understanding of options. So that definitely hits it. I would make a comment to what Tom just said for myself personally, and I think for a lot of people, one of the best educators and one of the best educators and one of

best life lessons is when you lose some of your own capital. When you lose some of your own capital, you usually stop and then go back and educate yourself so that you don't make the same mistake again. So I think making it too burdensome with a test, again, on the self-directed platform, people have the ability to go ahead and outsource to professionals, and they know that that they're professional going to take care of them. If they're doing it on self-directed, it's kind of like I like to look at, Bob. I don't have to take a test to select a health care provider with my PPO, and the consequences are far higher, lots of life versus lots of capital.

So, again, I go back that that system set up there in the capital markets, that when you lose money, you usually double up your effort personally to make sure you're not going to make that mistake again. So I just, I kind of firmly believe you can't make it so burdensome. Right. Tom, the SEC is also very worried about this. Finra regulates brokerage firms and exchanges, but it's subject to the oversight of the SEC. It's important for people to understand the relationship between the SEC and FINRA, that SEC essentially subcontracts, regulatory functions, a lot of it to FINRA that has oversight over the brokerage and the exchanges. But Gary Gensler, the head, head of the SEC has been very critical of these complex products in the past.

So my point is, it's not a coincidence, right, that suddenly FINRA is very concerned about this. Can you draw the relationship between Gensler and FINRA at this point? Oh, exactly. Gary Gensler is very worried about these products because they're not the kind of products that he wants to see individual retail investors trading absent the kind of disclosure that I'm talking about. I'm talking about changing the way that brokers do to do. disclosure so that they're sure they can make sure that people understand what the limitations of

these things are. And unless people really get that, you don't have to write new disclosure rules. But if your brokerage firm, for example, say, look, this is a very complex product. So here's five things about it that you need to know. Put them on a flash card, hand them to the guy, and let them take a look at it. And then they know. And if they want to trade, then they can trade. Self-directed platforms are a different problem because you don't have that. And for those, I think either you're going to have to add on to the disclosure rules to say something's going to get delivered to these people before they can buy some of these very sophisticated products. Or you may want to put them off in a different category. There are whole categories of products that individual retail investors can't buy

because they don't have sufficient experience and knowledge to do these things. So, and And that's, you know, that's one of the things that I think we need to really look at here. Yeah. You know, Dave, looking at the questions that FINRA asks in this note, I'm reminded that this is kind of the way Gensler works with his other regulatory proposals that the SEC has. Just ask questions. So let's ask, do you think we should make retail traders take tests? What do you guys think? Then they craft a regulation that essentially do it. To do that. Yeah. Can you, like, I know it's hard, but can you handicap the chances of this actually happening going through like this? It's going to take some time. So I wouldn't be too panicked that this is all of a sudden in June we're going to have a different regime, right? this is a request for comments. Those comments are due by May.

Then there'll be a period where they do nothing. And I would suspect towards the fall we'll start seeing some comprehensive looks at whether it's through FINRA's eyes or SEC's eyes how to approach this issue. My hope is that we use this period to give good comments, right, to put our actual opinions in there. I encourage investors and advisors to do that as well. Put those comments in. Talk about how you use these products.

And hopefully that will push us into a direction more like what Tom was just talking about. maybe a better disclosure system, a clear disclosure system, but not when we're building standardized tests for people who want to invest in a target date fund. Yeah, and Dave, just to remind everyone how this actually works. So the comment period runs through May 8th. People can comment on it. And what happens after that? Of course, then they have to go through the standard procedure.

They have to look at the comments and issue if they want or comment or requests, or they can go through a rulemaking stage, right? Yeah. So until there's actual proposed rule, making. We probably shouldn't run around like hairs on fire. But I do feel like we need to pay attention to these initial salvos in these battles because we've seen this before, right? I mean, this is sort of how we ended up with good regulation like the ETF rule, right, 6-E-11, was through a long process of this commenting back and forth on what should or shouldn't happen. I think we're probably

going to go through something similar here. So I think it's really important to pay attention. I don't suspect we'll see new rules in place this year. I do think we'll see new rules proposed. this year. Yeah. So I think it's important that we would look at this and stay on top of it because these have a way of sneaking up on you. So folks, I would just pay attention to all of that. Now it's time to round out the conversation with some analysis and perspective to help you better understand ETFs. This is the Market's 102 portion of the podcast. Today we'll be continuing the conversation with Dave Notic from ETF trends. A new title there. Financial Futurist, Dave. Congratulations on the new title. You used to be CIO, and now you're the financial futurist. Is that a different job title or just a fancy way of saying what you did before?

It's a little bit of both. I think the goal here is to really make sure that we're leaning forward into regulation and everything else like that. So it is largely still covering markets, looking forward into the future, figuring out what the next generation of financial products is going to look like and how that's going to impact investors. Of course, you're always on the cutting edge. You're always pushing forward with some. new functions. So that's one of things I really like about you, Dave. We had a very interesting conversation about retail investors and regulators talking about how FINRA and the SEC are increasingly concerned about retail traders getting sold complex products like leverage and inverse ETFs. And even they mentioned Bitcoin futures ETFs. But I'm wondering, this comes up all the time, this problem with leverage and inverse ETFs.

and to a certain extent, exchange traded notes. We've talked about this before, and I guess the question is, even though people can use it, are they really necessary? So, for example, do we really need three times leverage inverse oil ETFs? Is the world really need those products? I've said before, these leverage and inverse ETFs, and even volatility ETFs are 2% of the volume in ETFs,

and they're 98% of the problems. Is there a reason? Should the ETF community look around and say, should we consider these sort of separate products like even the regulators are starting to look at? Is there a reason to do that? Yeah, I mean, I think it's important, Bob, to remember that exchanges in general don't exist solely

for the benefit of the individual investor saving for retirement. I think you and I are often thinking of that person, but there are a lot of folks out there who need, access to products to do all sorts of things, right? So the leverage and inference products are not just used by day traders who are trying to speculate. They're also used by, you know, hedge funds that are counteracting exposure they have elsewhere in their portfolio, right? These are tools. They are not portfolios. And so I think it's dangerous to start putting ourselves in the position where the government decides whether or not a particular kind of exposure is suitable to be

traded at all, right? We've really not done that since the 33 Act. We've really set up this regime where you put the guardrails around, you put the structure in place, and then you explain that product to the investor, and they can make that decision for themselves, whether it's suitable or not. That's the disclosure regime. I agree that the disclosure regime is insufficient, because you end up with 90-page prospectuses, people don't read, and 15-page disclosure documents.

So I'm not saying nothing needs to be done. I'm just very wary of picking a non-structural thing, i.e., like what something holds, and saying that's the flag. I think there are buckets we could make here, and they have, like the leverage and inverse products, right? Those are effectively discussed separately in regulatory circles than regular ETSs, and there are separate rules around them. Remember, they've stopped letting people issue new 3x ETSs.

Right. So I think you gave a very cogent answer to the question, why do we need, you know, three times leveraged inverse oil ETS? The answer is for the average retail trader, you don't need it. And they probably should have nothing to do with it. However, there are professionals who may need them in the course of their everyday activities, and for that reason, they should be allowed to exist. I tend to agree with you, providing they don't create some kind of systemic risk to the system.

Would you agree with that, at least? Yeah, for sure. And obviously, if any of these products, if I believed that they were somehow really endangering the plumbing of the markets in someone, way, I'd be the first one raising that flag and running around the room. I don't think that that's the case here. I think that there have been narrow cases, which I've written about many times, where I think that we should be paying attention when the volatility ETF complex got very, very large at one point, sort of back in the Volmageddon days, I think that's when we got a little over our skis. And there was an appropriate regulatory response. You can now only get one and a half

times leverage in the volatility space. You can no longer buy just sort of these giant leverage products. Now, it's a separate question. Should people be allowed to trade volatility futures? Okay, well, that's a different question than whether or not you can put it inside an ETF. So I think we have great structures in place. I think they're really minimal ways that the, or they're very simple ways that the regulators could, in fact, do something like, say, we don't want to have anybody getting exposure to volatility futures. They could simply say that, right? They don't need to create a whole new regime here around investor education and testing.

in order to do that. And I also think this sort of blanket idea of everything that's a little different is complex and therefore goes into this kettled bucket. It's a real problem. I mean, the FINRA has themselves called target date funds complex before. Are they really going to make every retirement investor take a test before they get in their 401K? Yeah, I think you're right. Speaking of exchange traded notes, we had talked a little over a month ago about, how Barclays had halted creations of one of their volatility products, the VXX. Today we find out apparently the reason why. Can you break this down for us and explain what happened?

Yeah, sure. So, you know, banks issue notes all the time, right? That's part of what a bank does is they issue debt out to the market. At Barclays, there's a desk that issues the ETN, structured products, warrants, a whole bunch of different sort of individualized securities that are launched on a continuous basis. and they file what's called a shelf registration. And Barclays has had a $20 billion shelf registration sitting around, I think, since 2019. And the idea is every time they issue a new product or they do another tranche of structured notes

or they want to issue more shares of VXX, they have to go then mark that shelf filing, drink down until they run out of the ability to issue those shares, at which point they need to go ask for another shelf filing. Now, the reason they don't just ask for an infinite shelf filing is you have to pay. So if you want to get another $10 billion of room to issue securities, you'd have to write a big check. Well, nobody wrote the big check. And so for the past year, it seems, Barclays has been in violation of their own shelf registration, effectively selling unregistered securities to the market. When they discovered this, they shut down all issuance from that desk, including the ETNs,

you know, VXX and the oil ETN, but also their whole structure products division. Obviously, it's going to be a huge investigation. They're talking about a $600 million write down over this. This seems like a neglect here more than anything. So when this happened, we made you, and I remember you and I were talking about this, were why did they stop? Was there some problem with, were they hedging something part of this volatility product? It appears that that wasn't happening, that this had to do a broader issue.

This is just flat out mismanagement, right? This is just like this is an accounting error if you want to put it in that context, right? There literally was paperwork with boxes to be checked that did not get checked or that did not get sent in. And because of that, it shut down this whole division at Barclays that does these types of products. The good news is it's not like ETN shareholders somehow lost out on this, but because these products have been suspended, if you were, for instance, short one of these things, yeah, you're in a world of hurt, right now. But if you were a longholder of this product, it's not that it's doing something that you weren't expecting. I imagine there are going to be lawsuits here, and I'm for sure

there's going to be an investigation. Well, you know, what's interesting is we were speculating about why they stopped doing it, and it seemed like maybe they were hedging some way or something happened. That's what I thought, yeah. And apparently not. Apparently it was some reason that had nothing to do with actually running of the VXX itself. Am I correct? that conclusion? Yeah, no, this is not. My initial assumption here was that they had gotten over their skis on the amount of volatility risk, the amount of Vega they wanted to get out of the market, which is a common issue in a big bank desk. And this has happened before with Credit Suite. So I assumed we were seeing that again. Instead, it just turned out that some intern didn't

check a box. Oh, boy. Okay. Well, I'm glad you clarified that for it. Dave, appreciate that. I'm out of time, Dave, but I thank you, as always, for coming by. Everybody, Dave Notting is the financial futurist at ETF Trends and an old friend of ours. Everybody, thank you for listening to the ETF Edge podcast. InvescoQQQ believes new innovations create new opportunities. Become an agent of innovation. Investco QQQ, Invesco Distributors, Inc.