Finra maintains scrutiny of retail structured products

Regulatory body to focus on rate-sensitive products and protection for retail clients

Finra headquarters

Structured products targeted at retail investors that feature complex payouts, lengthy maturities or a link to non-traditional underlyings will all face scrutiny from the Financial Industry Regulatory Authority (Finra) this year, the US-based authority has said.

In its annual regulatory and exam priorities letter, published on January 6, Finra highlights concerns around structured notes aimed at retail investors that have complex payout structures and use proprietary indexes as reference assets, as well as products exposed to a shift in interest rates – a nod to a likely rise in interest rates by the US Federal Reserve later this year.

"Complex features, long maturities, and linkages to less-traditional or less well-understood reference assets in some structured retail products may present investors with unique or unfamiliar risks," the letter notes. It also states that Finra is concerned some brokers and retail investors may "not be familiar with the complexities of structured retail products, compounded by the uncertain impact of a changing interest rate environment".

Structured products remain a perennial focus of Finra's regulatory priorities, having been singled out in all but one of the annual letters it has published over the past decade. Products' sensitivity to interest moves were first raised as a regulatory concern by Finra back in 2014.

One New York-based private banker argues further scrutiny of rate-sensitive products this year would be timely: "The long-dated step-outs and steepeners have not-so-subtly changed over the last few years," he says. Many such products, which previously tended to be fully protected notes at maturity, have been turned into hybrids in the past two years, he adds, with the protection in most now contingent on equity market performance.

There's the potential with a large block of these trades… for clients to be sitting on something they felt was a bond that's trading significantly under par

"Where it used to be just a regular principal-protected note with some sort of interest rate payment feature, now it's that, plus your principal protection contingent on the S&P not being down more than 40%. So the risk of that product, which is traditionally more for a bond buyer, has stepped up meaningfully. Yet you still have the same buyer buying them, and that stuff has been pumped out in the billions over the past few years." he says.

The private banker notes that such products have been among the biggest sellers for retail distributors this year. While they have generally proved good trades for clients so far, he adds, they are inherently more risky. In addition to being turned into hybrids, many have also had their tenors extended, he says, with one-year non-calls often carrying 15- or 20-year terms.

"There's the potential with a large block of these trades, when interest rates eventually move up and equity markets move down, for clients to be sitting on something they felt was a bond that's trading significantly under par," he says.

Another key area of scrutiny for Finra will be investments based around proprietary indexes. Tom Layton, structured products director at Florida-based distributor Raymond James, says such products have long attracted regulatory attention, adding that the firm has spent a lot of time enhancing educational efforts and transparency around them.

"I'll fully agree that there are more complex components to them, and [investors and brokers] need to be fully educated. While we do participate in those types of products, we have been very selective as to which ones – and the ones we have participated in have driven some pretty meaningful returns for clients," Layton says.

But with products referencing proprietary indexes as their underlying becoming more common across the industry as a whole, Layton believes some of their perceived opacity will disappear, helping assuage regulators' concerns.

"A lot of what were proprietary products are now coming out in other formats: you'll see them in annuities, in exchange-traded funds and other vehicles. That will create more transparency and more familiarity, and probably remove some of that uncertainty that Finra is cautious about," he says.

If the regulator seeks the provision of more guidance around the products, that should be considered a good thing for the industry as a whole, he adds.

Finra says it will also scrutinise firms' incentives to increase revenue from structured products sold through distribution channels that may lack adequate controls to protect customers' interests, such as the distribution of structured or complex products through retail distributors that do not have the expertise to make satisfactory suitability reviews.

In order to mitigate these risks that are created with sales incentives, Finra says wholesalers "should have robust know-your-distributor policies and procedures reasonably designed to ensure potential distributors have adequate controls and systems in place. Finra examiners will focus attention on additional conflict issues that might arise where the distributor and wholesaler are affiliated companies."


To hear more from Finra on its regulatory priorities for 2015, attend the Structured Products Americas conference at the Biltmore Hotel, Miami on the 14th-15th May, 2015.

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