Remarks From the SIFMA Complex Products Forum

Susan F. Axelrod

Executive Vice President, Regulatory Operations

New York, NY

October 29, 2014

As prepared for delivery.

Good afternoon and thank you for the invitation to join you this afternoon.

Two years ago, when I spoke at this conference, we were emerging from the Great Recession. Yields on money market funds were near zero, and mid-duration fixed income investments were not offering sufficient yield to satisfy customer income needs. As for lowest-risk bank deposits and CDs, the yields were even more paltry. So the chase for yield was on, with an influx of money into riskier products as customers searched for income on their assets, assets that were becoming more complex and moving further out on the risk curve in the quest for yield.

I’d like to tell you that a lot has changed since then. But I can’t. The current yields on money market funds remain near zero. And we continue to see assets moving into complex financial products and longer-duration or high-yield bond products tick up as investors continue to reach for yield. The data we gather from FINRA’s Trade Reporting and Compliance Engine, or TRACE, tells us that among retail investors, average daily trades in investment-grade corporate bonds have declined each year, while average daily trades in junk bonds continue to increase.

And while bonds aren’t necessarily complicated products, there are many complex and emerging issues that may not be apparent to the average investor, nor even to market professionals. As a regulator, we’ve spent a lot of time thinking about whether investors are sufficiently prepared for rising interest rates and whether they fully understand how the value of their investments may change when the Federal Reserve Bank begins to raise interest rates. And are market professionals and their systems prepared to maintain orderly trade amid a possible increase—potentially significant increase—in trading-environment volatility?

Understandably, FINRA and other regulators are concerned that investors are taking on risks that they either don't understand or cannot afford. So this afternoon, I want to spend my time with you talking about risk—specifically, why many complex products like structured retail products and private placements may pose a risk to investors, how FINRA is working to spot trends earlier and better protect investors, and the proactive steps firms can take to help their clients understand the risks they are taking on.

New and Emerging Complex Products

Given our ongoing concern about the evolving interest rate environment and the potential impact to investors, this afternoon I want to focus on interest rate-sensitive products, as well as structured products that embed fixed income securities or fixed income features.

With the continuing low-rate environment, issuers are becoming even more creative with the products they offer, and we continue to see more bells and whistles added to already complex products.

Among structured retail products, “steepeners,” for example, have seen a resurgence, with some firms adding new features to these offerings. “Steepeners” are fully principal-protected, longer-term notes that generally have fixed-to-floating coupons, with an initial, attractive rate followed by floating rates based on the spread between long- and short-term interest rates. The higher the spread, the steeper the yield curve. Issuers are adding a “trigger” linked to an equity index. The trigger serves as a downside buffer but once the buffer is breached, the investor could potentially lose principal.

”Range accrual notes” are another popular structured retail product. These notes offer potentially attractive yields that are linked to the performance of one or more market reference points, such as the S&P 500 Index or three-month LIBOR. The coupon on the range accrual is determined by the extent to which the reference point value stays in a fixed range during a given period. The greater the percentage of time it meets the criterion, the higher the coupon payment to the investor. Historically, these products offered full principal protection, but as with “steepeners,” we are seeing increased issuance of range accrual notes with principal at risk.

Another product that continues to cause us concern is alternative mutual funds, or Alt Funds. In the 12 months that ended May 2014, assets in these funds increased 45 percent to over $300 billion. These funds are marketed to investors as a way to invest in complex, actively managed strategies that will perform in any number of market environments. We have learned that some firms don’t vet these funds, especially if the firm already has an existing agreement with the fund company. We are concerned that reps may be selling these complicated products without understanding the underlying strategies or holdings.

Unconstrained bond funds have also increased in popularity because of their purported ability to potentially mitigate losses in a rising interest rate environment. Given the expectation of higher rates and the Federal Reserve’s reductions in its bond purchases, investors moved $70 billion into unconstrained funds in 2013, a 30 percent increase from 2012. We’re concerned that the complexity of the funds’ strategies may make it difficult for investors and registered representatives to understand how the funds may perform in various market conditions and may complicate representatives’ suitability determinations.

And we remain concerned about the products that primarily invest in floating-rate bank loans. Due to their high yields and the floating rate, products that invest in leveraged loans are attractive to investors chasing yield and looking to protect their portfolios from rising interest rates. Despite the lower interest-rate risk, these loans carry significant credit and call risk. These loans are also relatively illiquid, trade over the counter and can be difficult to value.

We are also concerned that firms are not adequately training their reps on the risks of floating-rate bank loans. Last year, for example, we fined two firms $2.15 million and ordered the firms to pay more than $3 million in restitution to customers for losses incurred from unsuitable sales of floating-rate bank loan funds. Brokers from the two firms, Wells Fargo and Banc of America, recommended concentrated purchases of floating-rate bank loan funds to customers who were seeking to preserve principal, or had conservative risk tolerances. The brokers made recommendations to purchase floating-rate loan funds without having reasonable grounds to believe that the purchases were suitable for the customers. FINRA also found that the firms failed to train their sales forces regarding the unique risks and characteristics of the funds, and failed to reasonably supervise the sales of floating-rate bank loan funds.

These are just a few examples the products we are concerned about.

Spotting Trends Earlier

Our goal is not to prevent the sale of products but to make sure investors know what they are acquiring. We also want to identify and quickly respond to risks that pose the greatest threat to investors and the markets. You have heard me speak before about the ongoing enhancements to our risk-based exam program, a program that is more data-driven and automated. We are collecting more information electronically and leveraging technology to manage and analyze the data. Overall, this data-driven approach allows us to better identify and prioritize the underlying risks associated with a firm's business model, and gain an understanding of the controls designed to manage those related risk exposures.

Our proposed Comprehensive Automated Risk Data System, or CARDS—which I’m sure you’ve heard about—is the next step in the evolution of our risk-based regulatory programs. CARDS will allow us to collect information in a standardized format across all firms on a regular basis, and manage the data so that we can quickly identify trends and product concentrations that are harmful to investors, including, for example, some of the complex products I just mentioned.

Having data in a standard format will also allow us to track product mix across firms and in branches of each firm, including changes to that mix. It will also help us monitor, on an ongoing basis, where firms consistently sell products that present higher risk to customers and, when compared to risk tolerance profiles, appear to be unsuitable for those customers.

Let me give you an example. Today, when we have concerns about a product—such as credit quality concerns related to Puerto Rican muni bonds or because of complexity with respect to an esoteric ETF—we have to triage a range of sources to identify firms that are most likely active in these products. Then, we send out wide-ranging sweep letters to begin narrowing down whether any firms' activities are of concern. With CARDS, we would already have the data to make these determinations. That means we could immediately zero in on the firms that are actively selling suspect products to retail investors and may have large, concentrated positions. Simply put, CARDS enables a more nimble, more focused and less arduous exam process and vastly improves the speed with which we can quickly intervene to protect investors.

CARDS can also help us more quickly identify patterns of transactions that could indicate bad behavior on the part of a particular broker-dealer, branch office or registered representative, monitor more effectively for problem areas such as pump-and-dump schemes, suitability, churning, mutual fund switching and concentrations of high-risk securities, and respond more quickly to stop those activities before more investors are harmed.

CARDS will also help us better understand the business profile of a firm and incorporate that understanding into FINRA’s examination, surveillance, cycle planning and risk assessment functions.

In addition, CARDS will improve our understanding of where a firm is taking on too much market risk in its proprietary trading or other risk-taking activities, and enhance our ability to identify potentially suspicious activity in accounts that may call into question the adequacy of a firm’s anti-money laundering program.

CARDS would also help firms better manage compliance, through more timely conversations with firms about issues we're spotting and data and tools that enhance firms’ ability to identify and address problem producers and actions. The feedback and report card approach has worked well in FINRA’s market regulation program and would be a valuable enhancement to FINRA’s member regulation programs as well.

CARDS is a work in progress. We continue to assess the economic impact of the program and meet with firms to further refine and develop the CARDS data specifications and overall rule proposal. And last month, we issued a second Regulatory Notice asking for comment on the proposed rule to implement CARDS. We want to be sure we get this right, so we encourage you to submit your comments by December 1.

Educating Brokers and Investors

Complex products will continue to present a number of challenges to firms, brokers and clients. While there’s no one-sized-fits-all approach to managing these products, I want to leave you with three steps firms can take to help their clients understand the risks they are taking on.

First, firms that are going to make complex products available to customers have a duty to make sure investors fully understand how the products operate and the risks of each product. That begins with brokers having a full understanding of the products they sell and receiving training on the features of the product as well as their firm's own suitability guidelines for the products. Brokers should understand whether a particular product is suitable for a particular client. When we examine firms, we also review the training provided to brokers to determine whether they understand the products they recommend. Having a full understanding of a product can help a broker conduct proactive conversations with his or her customer about product-specific risks.

Last December, we brought a case against a firm that allowed its reps to recommend complex ETFs without performing reasonable diligence to understand the risks and features associated with the funds. And the firm also failed to determine whether the ETFs were suitable for at least 27 customers, including retirees and conservative investors. As a result, many of the firm’s customers held leveraged and inverse ETFs for several months.

Second, from a supervisory perspective, having an effective process in place for vetting new products is also essential. Firms should conduct appropriate due diligence related to the issuer and the product's features, and should take into account whether the firm's existing supervisory procedures and systems are sufficient given the new product's features.

A firm’s supervisory procedures should also clearly specify how brokers and their supervisors should assess suitability of recommendations—including how the firm monitors for potential problems that relate to a specific product. The more effective supervisory procedures we have seen establish customer eligibility requirements for complex products.

Third, assess the quality of disclosure provided to your customers. In some cases, the challenge of understanding products may be exacerbated by ineffective disclosure practices. We have focused our examinations on how firms disclose material risks to investors and the policies and procedures surrounding those disclosures. We urge firms to make disclosures clearer and more effective for retail investors. Part of that includes a balanced discussion of the risks and potentially negative scenarios that might result in customer losses.

Before I close, I want to return to the issue of fixed income investments. Again, while corporate bonds, Treasuries and munis may not fall into the category of complex products, receding bond values amid rising interest rates could give rise to complicated problems, for firms, brokers and clients. It has been a long time since we have seen rising interest rates, and with a longtime low-rate environment widely expected to conclude, fixed-income investors may be facing perilous economics.

Our exam teams are very focused on interest rate-sensitive products, as well as structured products that embed fixed income securities or fixed income features. We’re also focused on products marketed based on yield or presented as bond equivalents.

Many firms have taken steps to educate both their registered representatives and their customers about the impact of rising interest rates. We’ve seen many good practices, including portfolio analysis tools that allow firms to use “what-if” scenarios to assess the effect of potential interest rate changes on customer portfolio values. Firms are also re-evaluating high-duration bond fund offerings and sending targeted communications to customers. In addition, they have increased their focus on ongoing suitability obligations relative to current sales of interest rate-sensitive products. There is no one-size-fits-all approach here. Each firm must address the issue in a way that makes sense for its business model and customer profile. But we feel strongly that it’s an issue firms must think about and take steps to mitigate, before interest rates rise. 

Thanks for listening.