February may be sweeps month for television ratings, but FINRA sweeps happen all year round. And make no mistake, these sweeps have big stakes. As a result of the current interest rate environment and volatility in the equity market, many investors seek alternative investments, some of which may be risky. It comes as no surprise that FINRA has its sights set on complex and structured products. As many know, FINRA does eventually get around to discussing its targeted examinations (aka sweeps), but not typically at their outset. We have been hearing of Targeted Examination Letters being issued to several firms nationally in what appears to be a new sweep.
Recently on FINRA’s radar are two structured products: cliquets and steepeners. The latter follows the shape of the yield curve, the returns of which are linked to the difference between long-term and short-term interest rates. The “steeper” the curve, the greater the return. Cliquets are extended options that have periodic settlements that reset its strike price at the level of the underlying price level.
Often, these structured products are appealing alternatives to investors during volatile market conditions. However, despite their appeal, cliquets and steepeners pose potential problems that can be curtailed with proper supervisory procedures. One problem arises when the performance of these products differs from originally anticipated. This can create further issues, as the product continues to be offered under outdated performance expectations. One way to avoid this potential problem is to set up a system for monitoring the data underlying these investments. Product review should be a cornerstone of any supervisory procedure when dealing with structured products. For example, steepeners often feature fixed rates up front that will convert to floating rates and create illiquid secondary markets. Reviewing the performance of a steepener will enable a firm to assess the product’s appropriateness, or lack thereof, where no secondary market exists. If the anticipated liquidity of a steepener begins to change, so can its appropriateness for retail investors. A periodic review of its performance will spot this issue.
While product review is important, training your staff in selling cliquets and steepeners is vital. Knowing the risks associated with a product is just as important as understanding the rewards of the product. Historical performances of a product such as a cliquet may better equip a registered representative to assess the product’s appropriateness for specific customers. Lastly, supervisory procedures should be in place that can prohibit the sale of structured products such as cliquets to certain groups of customers, which can help avoid regulatory issues in the future. For example, where a retail investor’s account has not been approved for options trading, cliquets may not be an available choice for the sales force when working with that particular customer.
Establishing proper supervisory procedures can avoid many issues in the future. From how the product is vetted to how it is offered for sale, cliquets and steepeners can be rewarding products and remain that way so long as proper procedures are in place. Let’s see what happens with FINRA’s latest activities.