Concerns among regulators arise from the potential of retail traders exceeding their capabilities.

Would you like to trade options, leveraged and inverse ETFs, and structured notes, Mr. Retail Trader?

The demand for complex investment products has surged recently, especially among self-directed investors who have been trading from home due to Covid.

Regulators are concerned that you may be making reckless investments, so they are considering implementing additional safeguards to prevent you from making poor decisions. They may also require you to pass a test to demonstrate your investment knowledge.

The market volatility is increasing regulators' anxiety.

FINRA is sending a warning signal

The Financial Industry Regulatory Authority (FINRA) issued a regulatory notice to its member brokerage firms, reminding them of the risks associated with complex financial products and their legal obligation to ensure that their investors are invested in products that are suitable for them.

FINRA noted that the number of accounts trading in complex products and options has increased significantly in recent years. However, regulatory concerns arise when investors trade these products without fully comprehending their unique features and associated risks.

Reg BI, adopted in 2020, mandates that FINRA members act in the “best interest” of their clients when making investment recommendations. This entails brokers explaining the nature of the product, the potential risks and rewards, and determining if the investment is “suitable” for the client.

FINRA seems to want broader rules on these products

FINRA is seeking comments on whether the current regulatory framework is sufficient to safeguard investors, as the old rules were established when most financial products were purchased through financial professionals, while now many of these products are bought and sold through self-directed trading platforms such as Robinhood or other online brokers.

Dave Nadig, a financial futurist at ETF Trends, stated that the given information is evidently an attempt to set the stage for new regulatory measures.

Nadig stated that the SEC is worried about the lack of education among new retail investors.

The proposal to create a new class of products called 'complex' is not solely a response to retail investing in options, but it encompasses a broader range of products. These complex products would include everything except for plain vanilla stocks and bonds.

‘Complex’ products could include your crypto ETF fund

FINRA defines a complex product as one that has features that may make it challenging for a retail investor to comprehend the product's fundamental characteristics and associated risks, such as the payout structure and how it may behave in various market and economic conditions.

These include leveraged and inverse exchange-traded products, volatility-linked ETPs, structured products, and defined outcome ETFs, which provide exposure to market index performance with downside protection and an upside cap on potential gains over a specified period.

Cryptocurrency futures are employed by mutual funds and ETFs.

FINRA stated that the complexity of these products' features may make it challenging for retail investors to comprehend their essential characteristics and associated risks.

When retail customers purchase products through a self-directed platform without the help of a financial professional, their concerns may intensify due to the lack of explanation of the product's key features and risks.

FINRA is not only cautioning about these products but also questioning if extra safeguards are required to safeguard investors.

Are self-directed platforms growing at an alarming rate, and do they require additional safeguards?

Should retail traders be required to take tests?

FINRA appears to require retail investors to possess a greater understanding of the products they are purchasing.

Should retail customers be required to complete a knowledge check and, if they fail, complete a learning course and additional assessment to demonstrate their understanding of the common characteristics and risks of complex products?

FINRA is proposing a requirement for retail traders to pass a test prior to trading certain products.

FINRA is also worried about plain-vanilla options trading

The increase in listed options trading volume has raised concerns among regulators. FINRA reports that daily trading volume has surpassed 38.6 million contracts, a 30% increase from 2020 and a 100% increase from 2019.

FINRA advised that retail investors who trade options without comprehending their vocabulary, strategies, and risks may face similar risks as those involved in transactions of complex products. It is crucial for members to assess whether investors are aware of the various risks associated with trading options.

There are already rules in place: Do we need more?

FINRA has implemented various safeguards for investors looking to trade options, futures, and warrants, such as suitability requirements and assessing whether customers possess the necessary knowledge and experience to assess risks.

A former SEC attorney, Thomas Gorman, believes that FINRA has a legitimate reason for concern.

While FINRA is concerned about the retail trader's lack of education, they are also concerned about the brokers' lack of education. Some of these products are so complex that even a PhD in economics may not fully comprehend them.

Gorman supported FINRA's efforts to improve broker education and client communication.

What is the warning shot for self-directed accounts without a financial advisor?

Gorman stated that platforms have a responsibility to investors, even if they are not financial advisors with a fiduciary duty, to prevent people from purchasing whatever they want on their platform.

Amy Lynch, president of FrontLine Compliance and a former SEC compliance official, concurs but adds that it brings up a fresh batch of issues.

She informed me that they are indirectly exerting pressure on self-directed trading platforms. Will these platforms be held liable for losses incurred by retail investors who engage in bad trades? If a person loses a significant amount of money while trading options on Robinhood or Schwab, who is responsible?

Should retail investors have access to certain products? Are some products too risky for the average investor? Who should decide? It's a delicate balance: Where should the line be drawn?

FINRA may propose new rules after the public comment period ends on May 9.

The SEC is worried about these complex products, too

FINRA, which regulates brokerage firms and exchanges under SEC oversight, has announced that it will coordinate its response to a request for comment from the SEC on complex products with the development of its regulatory approach to this topic.

FINRA and the SEC are collaborating to intensify regulation of retail trading, as stated by Gorman.

The SEC has instructed FINRA to investigate Gensler's efforts to safeguard investors and his previous discussions on protecting against intricate financial products.

Thomas Gorman and Dave Nadig will discuss the SEC's and FINRA's push for more regulation on ETF Edge Monday at 1 PM.