In a prior issue of this publication,1 we wrote about electronic structured note issuance platforms, and how these might be affected by U.S. securities regulations. FINRA’s March 2016 report2 on “robo-advisors” provides a framework for considering the effect of its rules and regulations on possible platforms of this type.
An electronic structured notes issuance platform may be created for a variety of purposes. For example, it could be used to show investors a broker’s current new offerings, or to show securities available for sale in the secondary market, providing (or not providing) an opportunity to place a purchase order. Some have envisioned a system in which an investor could “design” a structured note, for example, selecting from certain pre-established selections different potential reference assets, and different parameters for buffers, caps, participation rates, maturities and other terms. Some market participants have proposed systems in which structured products would be a tool used in an electronically created portfolio. In each case, such a system could conceivably be accessed directly by investors or used as a tool by financial advisors.
Is the System a “Digital Advice Tool”?
A system of this kind likely would be a “digital advice tool” of the type contemplated by the report. A system of this kind would fit into FINRA’s views of digital advice tools in the report if it supported one or more of the following functions: customer profiling, portfolio selection and trade execution. Depending on its use, it could be a “financial professional facing” tool, or a “client facing” tool, depending upon how it is incorporated into the sales process.
A system of this type could be used as a tool to obtain key information about customers, including their risk tolerance, investment goals and familiarity with structured products and other complex securities. If the system permits investors to design and/or purchase structured products, the system could be designed to deny access to these functions to individuals who do not appear sufficiently experienced, or for whom such products are not consistent with their stated investment profile. It is also possible that some conservative products offered by a broker may be within an investor’s risk tolerance, while other, more complicated products may not be. A system would need to be designed with an appropriate mechanism for making these determinations.
A system that enables investors or financial advisers to design products will need to have parameters that ensure that the products offered satisfy FINRA’s reasonable-basis suitability standard. For example, can such a system offer a product that can have a capped return or an interest rate that is too low to provide an investor with a reasonable return? Changing market interest rates, and changing volatilities, should in principle change the terms of the products that are offered.
According to FINRA’s guidance in the report, a system of this kind should be tested carefully prior to use, and monitored regularly in order to ensure that it produces results consistent with its purpose.
The Perfect System – And a Financial Adviser’s Role
A system may perform perfectly as intended, and produce recommendations that are, in and of themselves, consistent with FINRA’s suitability standards. However, if a system is designed for use by a registered representative, that representative must have sufficient knowledge of the relevant securities to satisfy the rules; that is, a registered representative cannot use such a system as a substitute for having the requisite knowledge about the relevant products offered or about the customer who may purchase them. Registered representatives who use such a system must be properly trained as to its use, and any of its limitations.
Portfolio Construction and Rebalancing
A system of this kind may be used to suggest structured products that would help constitute the investor’s portfolio allocation in a certain sector or security type. A system could be configured to periodically make recommendations to an investor as to structured products that could be used to enable the investor to maintain the recommended allocation, and could even conceivably be configured to automatically effect transactions to do so. Such a system would need to allocate the types of structured products that would be most appropriate, or in some cases, inappropriate, for different portfolios. Of course, if any transactions are recommended or effected automatically, the system would need to be constructed carefully in order to ensure that its output is consistent with the firm’s strategies and outlook, and that any conflicts of interest are appropriately mitigated or otherwise addressed.
An electronic structured note system would face a variety of challenges in complying with FINRA’s rules and guidance. The March 2016 report provides a useful framework for analyzing how a particular system would need to be designed and operated in connection with these regulations.