Regulators are worried that retail traders are getting in over their heads

Trader Talk

People wait in line for t-shirts at a pop-up kiosk for the online brokerage Robinhood along Wall Street after the company went public with an IPO earlier in the day on July 29, 2021 in New York City.
Spencer Platt | Getty Images News | Getty Images

Hey Mr. Retail Trader: do you like to trade options? How about leveraged and inverse ETFs? Want to buy structured notes?

These kinds of “complex” investment products have exploded in popularity in the last several years, particularly as self-directed investors have been trading at home during Covid.

Here’s the bad news: Regulators are getting worried that you may be getting in over your head, and they seem to be looking to erect more “guardrails” to protect you against making stupid investments. They may even want you to take a test to prove you know what you’re doing.

The recent market volatility is not helping, and likely making regulators even more nervous.

FINRA is sending a warning signal

The Financial Industry Regulatory Authority, which is the regulator for all the brokerage firms and exchanges in the U.S., recently released a regulatory notice to its members (brokerage firms), reminding them of the risks of these “complex” products and the legal obligations they have of making sure their investors are in products that are suitable for them.

“The number of accounts trading in complex products and options has increased significantly in recent years,” FINRA wrote in the note. “However, important regulatory concerns arise when investors trade complex products without understanding their unique characteristics and risks.”

FINRA reminded its members that Regulation Best Interest (Reg BI), which was adopted in 2020, requires brokers to act in the “best interest” of the customer when making such recommendations. That means brokers need to be able to explain to clients the nature of the product they are recommending and the potential risks and rewards, and to determine if these investments are “suitable” for the client.

FINRA seems to want broader rules on these products

FINRA said it was seeking comments on whether the current regulatory framework is adequate to protect investors. It noted that the old rules were adopted when most financial products were bought through financial professionals, whereas today many of these products are bought and sold through self-direct trading platforms like Robinhood or other online brokers.

“This is clearly a stalking horse for a new piece of rulemaking,” Dave Nadig, financial futurist at ETF Trends, told me.

“The SEC is concerned there is a new raft of retail investors who are under-educated about what they are doing,” Nadig said.

“It is partly a reaction to retail investing in options, but it is even broader than that. They are proposing to create a class of new products called ‘complex’ that is basically everything besides plain vanilla stocks and bonds.”

‘Complex’ products could include your crypto ETF fund

In its note, FINRA describes a complex product as “a product with features that may make it difficult for a retail investor to understand the essential characteristics of the product and its risks (including the payout structure and how the product may perform in different market and economic conditions).”

These can include leveraged and inverse exchange-traded products, volatility-linked ETPs, structured products, and defined outcome ETFs, which offer exposure to the performance of a market index but with downside protection and an upside cap on potential gains over a specified period.

Also on the list: “Mutual funds and ETFs that offer strategies employing cryptocurrency futures.”

“We continue to believe that the features of these products are such that they may be difficult for a retail investor to understand the essential characteristics of the products and their risks and, are, therefore complex,” FINRA said.

“These concerns may be heightened when a retail customer is accessing these products through a self-directed platform and without the assistance of a financial professional, who may be in a position to explain the key features and risks of the product to the retail investor.”

FINRA is doing more than warning about these products. It is asking if additional requirements are necessary to protect investors.

It is particularly concerned about the growth of “self-directed platforms” and asks, “are additional guardrails needed for these types of platforms?”

Should retail traders be required to take tests?

FINRA also seems to want the retail investor to demonstrate a lot more knowledge of the products they are buying.

For example, it is asking whether retail customers should be required “to demonstrate their understanding of those common characteristics and risks of complex products by completing a knowledge check and, if the customer fails to show the requisite knowledge, requiring the completion of a learning course and additional assessment?”

Essentially, FINRA is asking if retail traders should be required to pass a test before they can trade these products.

FINRA is also worried about plain-vanilla options trading

Even the trading of options has become a source of concern. FINRA notes that listed options trading volume has grown to over 38.6 million contracts a day on average, 30% higher than 2020 and almost 100% higher than 2019.

“Similar to transactions in complex products, buying or selling options can be risky for retail investors who trade options without understanding their vocabulary, strategies and risks. Members should consider whether investors understand the various risks of trading options…” FINRA said.

There are already rules in place: Do we need more?

FINRA already has numerous safeguards in place for investors who want to trade options, futures and warrants, including suitability requirements when recommending these products and determining that there is a reasonable belief that the customer has the knowledge and experience to evaluate the risks.

But Thomas Gorman, a former SEC attorney now with Dorsey Whitney, thinks FINRA has a right to be concerned.

“FINRA is not just concerned about lack of education on the retail trader’s part, they are concerned about lack of education on the brokers part,” he told me. “Some of these products are incredibly complex. You could have a PhD in economics and still not understand them.”

Gorman was broadly supportive of FINRA’s efforts: “FINRA is trying to get to these brokers, and say, ‘You guys should take some classes in this, and you have to do a better job of explaining this to your clients.'”

What about the warning shot to self-directed accounts, where there is no financial advisor?

“The message is, you can’t let people go on your platform and buy whatever they want,” Gorman said. “Even the platforms should have a duty to investors, even if they are not strictly financial advisors with a fiduciary obligation.”

Amy Lynch, president of FrontLine Compliance and a former SEC compliance official, agrees, but points out this raises a whole new set of questions.

“They are indirectly trying to place some pressure on the self-directed platforms,” she told me. “Are these self-directed platforms going to be deemed to be liable for bad trades put on by retail investors? If someone starts trading options and loses a lot of money, is that the responsibility of Robinhood or Schwab?”

“Should those products be available to retail investors? Are some products so risky that the average retail investor should not be involved? But who should make that decision? It’s that fine line: Where should the line be drawn?”

The public comment period runs through May 9, after which FINRA may decide to propose new rules.

The SEC is worried about these complex products, too

FINRA regulates brokerage firms and exchanges subject to the oversight of the SEC, but SEC Chair Gary Gensler has also been critical of these “complex products.” In October, he directed the SEC to study this area and recommend changes. FINRA said it would “coordinate its response to this request for comment with the SEC’s development of its regulatory approach to this topic.”

Gorman said it was clear FINRA and the SEC are working together to increase regulation around retail trading.

“It is not a coincidence that Gensler has been very big on protecting investors and has talked about protecting against complex products before, and that FINRA is now taking this up,” he said. “The SEC wants them to look into this.”

—Thomas Gorman and Dave Nadig will be on ETF Edge Monday at 1 PM to discuss the SEC’s and FINRA’s push for more regulation. ETFedge.cnbc.com.

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