Finra put broker-dealers on notice today that it is clamping down on sales practices and suitability obligations related to the sale of oil-linked exchange-traded products (ETPs).
Recent market volatility impacting the crude oil market and significant losses in a number of oil-linked ETPs in later April prompted Finra to issue the warning in the form of a new notice to members. The notice clarifies obligations for broker-dealers and advisors selling these complex products, which link performance to a variety of unfamiliar indices or reference benchmarks and even to daily price movements in crude oil futures contracts, “making them difficult for the average investor to comprehend,” Finra said in the notice.
The notice “should be taken as a blunt warning that Finra will be testing how well investment professionals understand the variety of complexities at play when dealing with oil-linked ETPs,” Tim Foley, an attorney in Alston & Bird’s financial services and products group in Washington, D.C., told Financial Advisor.
As U.S. crude oil prices dropped to below zero for the first time ever last last month, Finra said it saw evidence that retail investors and their advisors were betting on a price bounce by investing in oil-linked ETPs.
“Experience with similar complex products suggests that some retail investors and investment professionals recommending oil-linked ETPs, including commodity pools and ETNs (exchange-traded notes), may have mistakenly thought that these ETPs are a proxy for the spot price of oil, when in fact their investment objectives are to track oil futures contracts,” Finra said.
According to the self regulator, firms and advisors should consider whether less complex or less costly products could achieve the same objective for customers.
“Oil-linked ETPs are complex products that may not be suitable for some investors, such as retail investors with conservative investment objectives and long-time horizons. Given the heightened risks that these products raise, firms must be diligent in ensuring that their sales of these products are consistent with the requirements under the suitability, communications and supervision rules, and beginning on June 30, 2020, their obligations under Reg BI,” Finra said in the notice.
As lockdowns related to the coronavirus pandemic shut down transportation, oil demand declined precipitously along with excess storage capacity, pushing crude oil prices to record lows. This plunge in market value has significantly impacted ETPs tracking WTI futures.
“Leveraged and inverse oil-linked ETPs that seek to deliver multiples or the opposite of the return of an oil-linked index likewise have been extremely volatile during these market conditions,” Finra said.
Finra reminded firms that advisors must have a full understanding of the terms, features and risks of the product before making oil-based ETP recommendations to customers.
The regulator also said that both firms and reps must also have a reasonable basis to believe that a recommendation is suitable for a particular customer based on the customer's investment profile, including their investment experience, risk tolerance, liquidity needs, investment objectives and financial situation and needs.
For example, depending on the facts and circumstances, “an oil-linked ETP might be suitable for an experienced customer with a speculative investment objective, but it likely would not be suitable for a less experienced customer or a customer with a more conservative or a buy-and-hold investment objective,” the regulator said.