SEC proposes tougher sales rule for exchange-traded products

The agency, concerned about consumer protection, says clients need a baseline understanding of product risk

Nov 26, 2019 @ 10:05 am

By Greg Iacurci

The Securities and Exchange Commission proposed a new rule Monday that would make it more difficult for registered investment advisers and broker-dealers to use leveraged and inverse exchange-traded products with clients.

The SEC, which has grown concerned about these products and their suitability for some consumers, is increasing sales practice and due diligence standards for intermediaries who wish to trade these securities on behalf of their clients or allow clients to trade them in self-directed brokerage accounts.

Leveraged and inverse exchanged-traded products, such as exchange-traded funds and exchange-traded notes, use derivatives and debt as a way to boost the returns of an underlying market index. Such securities can be extremely volatile.

"This is a daily trading tool for very sophisticated investors, to help them manage their daily trading risk," Tidjane Thiam, CEO of Credit Suisse Group, said last year after the implosion of the bank's VelocityShares Daily Inverse VIX Short-Term ETN. "You should not invest in it for any period of time superior to one day, because you risk losing all or a substantial portion of your investment."

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Under the SEC proposal, advisers and brokers could only approve a client account to buy and sell these exchange-traded products if they had a reasonable basis to believe a client is capable of evaluating the risks associated with these products. The rule was modeled after a Financial Industry Regulatory Authority Inc. rule covering options trading.

RIAs currently must adhere to a fiduciary standard, and brokers to a suitability standard, when recommending investment products like inverse and leveraged exchanged-traded products to clients. However, the SEC's proposal applies more broadly — advisers wouldn't be able to recommend such products without passing the upfront hurdle.

The proposal establishes the same due diligence requirements for RIAs and broker-dealers. They must, at a minimum, obtain certain information about a retail investor to approve or disapprove the investor's account for purchase of inverse and leveraged exchange-traded products, including: investment objectives and time horizon, employment status, estimated annual income, estimated net worth and liquid net worth, percentage of liquid net worth to be invested in leveraged or inverse investment vehicles, and investment experience and knowledge regarding such vehicles, options, stocks, bonds, commodities and other financial instruments.

"The commission's proposal recognizes the extensive changes that have taken place in our capital markets and the fund industry over the past several decades, including the importance of derivatives in effective portfolio management," Jay Clayton, chairman of the SEC, said in a statement. "Funds frequently use derivatives to gain exposure to certain asset classes more efficiently and to mitigate risks, but in certain cases derivatives can heighten risks to investors and markets, including risks related to leverage."

The public has 60 days to submit comments on the proposal.


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