Have you ever considered the idea of investing in a 2x leveraged inverse ETF? While most traditional buy-and-hold investors would shy away from such a notion, these funds remain an attractive option for traders looking to capitalize on short-term market volatility, often linked to individual stocks.
Recently, an advisory panel to the Securities and Exchange Commission has recommended implementing new regulations requiring brokerage firms to assess whether self-directed investors should be allowed to engage in trading complex products like leveraged exchange-traded funds (ETFs). This proposal mirrors existing regulations concerning options trading, where brokerages must determine whether investors are qualified to engage in such activities.
The SEC’s Investor Advisory Committee, recognizing the widespread availability of high-risk, complex products, adopted this proposal to ensure investors fully comprehend the risks before engaging in transactions. Christine Lazaro, a committee member and law professor at St. John’s University, emphasized that this initiative stems from concerns over whether the current regulatory framework sufficiently protects individual investors from potential pitfalls.
Although merely a recommendation—with no mandatory action required from the SEC or the Financial Industry Regulatory Authority (FINRA)—there is notable support among commissioners for extending the gating process used in options trading to include other complex financial products. Commissioner Jaime Lizarraga advocated for this at a recent committee meeting, suggesting that brokers should verify the suitability of such trading activities for their clients, similar to the vetting process for options trading.
Part of this recommendation involves urging the SEC or FINRA to establish a clear definition of what constitutes a complex product, enabling brokerage firms to identify which offerings would necessitate enhanced investor scrutiny.
Moreover, the committee advises that the SEC or FINRA should promote best practices for brokerages intending to offer complex products and emphasize the importance of investor education in this area. Additionally, they recommend implementing trading process disclosures that caution investors about the risks associated with these complex instruments. These disclosures might include prompts that encourage investors to pause and reconsider their decisions at critical trading junctures, thus reinforcing the gravity of their investment choices.
However, should these recommendations lead to formal regulatory changes, opposition from brokerage firms and fund companies is anticipated, mirroring the pushback seen with the introduction of the options trading rule. Critics, such as James Andrus, vice president of sustainability global markets at Franklin Templeton and a committee member, argue that such regulations might inhibit product innovation and restrict market participation.
Despite potential industry resistance, proponents argue that additional safeguards are necessary due to the intricate and high-risk nature of these products. Brian Hellmer, assistant secretary of the committee and chief investment officer at Mendota Financial Group, highlighted the importance of ensuring that investors are genuinely aware of the risks before committing to such financial instruments.
In light of the ongoing debate and feedback, the committee also seeks to align the language of FINRA’s Rule 2360 with Regulation Best Interest, a higher standard of conduct introduced in 2020. This alignment would reaffirm that options trading should only be permitted when in the best interest of the investor.
The committee also calls for stricter enforcement actions against firms that fail to adhere to due diligence requirements under the options trading rule, further emphasizing the regulatory commitment to protecting investor interests in the face of increasingly complex financial markets.
