On May 15, 2020, the Financial Industry Regulatory Authority, Inc. ("FINRA"), in Regulatory Notice 20-14 (the "Notice"), discussed its concerns relating to sales of exchange-traded products ("ETPs") that provide exposure to the oil market.1 The price of oil, as we all know, has been extremely volatile lately, plunging to unprecedented lows. Consequently, oil-linked ETPs have experienced significant volatility, and some have lost a substantial percentage of their value.
CHARACTERISTICS OF THE MARKET
Oil-linked ETPs are not linked to the spot price of oil. Rather, they track oil futures, through an index of monthly futures contracts, in the case of exchange-traded notes ("ETNs"), or they actually hold a portfolio of futures contracts (or other commodity interests), in the case of commodity pools. One of the concerns raised by FINRA in the Notice is the lack of understanding by investors and sales representatives of the differences between these underlying assets and the spot price of oil. The Notice states that, based on experience with similar complex products, "some retail investors and investment professionals recommending oil-linked ETPs, including commodity pools and ETNs, 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."
Volatile markets and investor demand can cause both ETNs and commodity pool ETP shares to behave erratically, or "unhinge," from the value of the underlying commodity. For commodity pool ETPs, the example in the Notice was that due to investor demand, the ETP commodity pool reached the maximum number of shares available under its registration statement. Unable to issue new shares, demand exceeded supply, causing significant variations between the market price of the ETP's shares and the ETP's net asset value.
A similar situation occurred when an ETN issuer called its oil futures-linked ETN and stopped creations of new units. The issuer's press release noted that the issuance suspension could cause fluctuations in the trading value of the ETNs, and that, due to supply and demand, the ETNs had been trading at a premium to the closing indicative value.
Another aspect of oil-linked ETPs that retail investors or investment professionals recommending such ETPs may not understand is the effect of the regular replacement of the underlying expiring existing contracts with new contracts of the same maturity, in order to maintain that maturity in the index or portfolio. If a 3-month contract is being replaced at the end of its term with a new 3-month contract that is more expensive, the market is said to be in "contango," with the cost of purchasing the more expensive contract potentially causing a loss to the index or portfolio. If the new replacement contract is less expensive than the contract being replaced, the market is said to be in "backwardation," which may lead to gains. Over time, these losses or gains can cause the value of the underlying index or portfolio to significantly diverge from the spot price of the commodity.
FINRA'S SALES PRACTICES RECOMMENDATIONS
FINRA reiterated its concerns about recommendations of complex products to retail customers, citing Regulatory Notice 12-03, and reminded firms to consider whether to use the heightened scrutiny and supervision suggested therein for complex products. 2
Regarding suitability under FINRA Rule 2111 and satisfying the "customer-specific" prong of that rule, and the requirement that a recommendation be suitable for a particular customer based on the customer's investment profile, including risk tolerance, FINRA stated that "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 buy-and-hold investment objective."
Associated persons of dealers must understand what they are recommending – in this case, an understanding of the products' main features and associated risks, how oil-linked ETPs work, the effect of contango and backwardation, and how oil-linked ETPs may perform as opposed to the spot price of oil, particularly over long time periods. The associated person should also understand the difference between oil-linked ETNs and commodity pools, and the effect of a call on the ETNs or a suspension of issuance of an ETN or a commodity pool.
After June 30, 2020, firms should consider how any recommendation of an oil-linked ETP will comply with Regulation Best Interest.
Another concern raised by FINRA was compliance with Rule 2210 (Communications with the Public) in relation to communications regarding oil-linked ETPs. Such communications must, according to FINRA:
- Balance any discussion of benefits
with a clear explanation of the risks, which would include:
- The inherent fluctuations of oil prices;
- The speculative nature of futures investments; and
- A clear explanation that the ETP's price will not track directly the spot price of oil;
- Not omit any material fact or qualification that would cause such communication to be misleading;
- Explain the effect on the investment of contango and backwardation; and
- If the ETP is designed to achieve its investment objective on a short-term, such as daily, basis, explain that the ETP is not designed to track the underlying index or asset over a longer period of time.
FINRA specifically reminded member firms that having sufficient disclosure in a separate document, such as a prospectus, will not cure otherwise non-compliant sales materials, even if those sales materials are preceded or accompanied by a prospectus. In other words, the sales materials must stand alone under a Rule 2210 analysis.
Under the supervision requirements of FINRA Rule 3110, firms must act reasonably to ensure that their registered representatives and supervisors understand the risks presented by oil-linked ETPs. Registered persons of firms must be trained to understand the terms, features and risks of oil-linked ETPs, as well as the factors that would make such products either suitable or unsuitable for investors, particularly retail investors.
1 Regulatory Notice 20-14 is available at: https://bit.ly/2zAq94l.
2 FINRA Regulatory Notice 12-03 can be found at: https://bit.ly/3gvNZP8.
Originally published May 28, 2020.
Originally published in REVERSEinquiries: Volume 3, Issue
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