FINRA used a misselling case to remind member firms of certain fundamentals, including the importance of implementing a new product approval process, reasonable diligence processes prior to making recommendations, suitability policies, training, supervisory procedures, and monitoring sales materials to ensure that these are fair and balanced.

In Regulatory Notice 17-32, FINRA takes a "back to basics" approach to sales of exchange-traded products ("ETPs") designed to track futures on the Chicago Board Options Exchange Volatility Index ("VIX"). FINRA focused on unsuitable sales of complex products to retail investors who may have purchased ETPs linked to VIX futures as "buy and hold" investments.1

FINRA has characterized ETPs linked to VIX futures indices as complex products.2 FINRA again reminded firms that "recommendations [of complex products] to customers must be based on a full understanding of the terms, features and risks of the product, sales materials must be fair and accurate and firms must have reasonable supervisory procedures in place to ensure that these obligations are met."3

Complexities of VIX-Linked ETPs

There are several characteristics of ETPs linked to VIX futures indices that may not be well understood by a retail investor. Instruments linked to VIX futures indices are different than instruments linked to the performance of the VIX Index. While the VIX Index tends to rise while the stock market falls, thus possibly being useful as a hedge against a falling equity market, ETPs linked to VIX futures indices may behave differently. This is because, in the process of rolling off expiring short-term contracts and replacing them with newer contracts with a later maturity date in order to maintain a constant maturity for included contracts, the VIX futures indices may pay more for the replacement contracts than the ones being sold. This cost to the VIX futures index results in a negative roll yield, lowering the index level. A futures market in which it costs more to replace a futures contract on the VIX with one of the same maturity is said to reflect a futures market in "contango."4

In a contango market, a VIX futures index will not correlate with the VIX Index. Consequently, an investor seeking the protection against a falling equity market associated with the VIX Index may not understand that an ETP linked to an index of VIX futures will not provide that protection. As an example, FINRA notes that "over a recent 12-month period, while the VIX was down around six percent, one volatility ETP tracking the short-term VIX futures index lost more than 70% of its value."5

FINRA's Expectations

FINRA reiterated its concerns with respect to complex products, asking member firms to consider the following with respect to recommendations and sales of ETPs linked to VIX futures indices:

  • Are the guidelines for the heightened scrutiny and supervision for complex products discussed in Notice 12-03 being followed?
  • Has the firm performed reasonable diligence such that the firm can make a suitable recommendation of the ETP? Is there a reasonable basis for believing that a recommendation of an ETP linked to a VIX futures index is suitable for a particular customer?
  • Is the associated person recommending the product to the customer capable of explaining, at a minimum, the product's main features and associated risks?
  • Are the sales materials fair and balanced?
  • Does the firm have in place supervisory systems reasonably designed to achieve compliance with applicable securities laws and regulations, including the applicable FINRA rules?
  • Have the registered representatives and supervisors been trained to understand the terms, features, and risks of the ETPs, as well as the factors that would make those products suitable or unsuitable for certain investors?6

Conclusion

Notice 17-32 is a loud and clear statement that FINRA will be on the alert for unsuitable recommendations of complex products, including sales of ETPs linked to VIX futures indices. Firms recommending and selling these products should ensure that they perform reasonable diligence on these products so that they can fulfill their obligations in respect of complex products outlined in FINRA Notice 12-03.7