The SEC is making a concerted effort to tap into industry data to hone its examination and enforcement activities to ensure brokers and advisors are making appropriate recommendations to their clients.
In the broker-dealer arena, the commission has set its sights on the sale of complex products. It is scrutinizing the operational policies and procedures that firms have put in place and then evaluating how well branches are complying with those rules.
The SEC's concerns about complex products aren't entirely new, but they continue to grow as more exotic investment instruments enter the market, and brokers and advisors introduce those products to retail clients.
"One of the areas we're spending a lot of time thinking about is the sale of complex financial instruments, particularly as they're sold to retail investors," said Stephanie Avakian, deputy director of the SEC's Division of Enforcement. She outlined the commission's efforts to become a more data-driven regulator during remarks at an event hosted by the Practicing Law Institute.
"There really has been a tremendous uptick in the complexity and diversity of products that are sold to retail investors in recent years."
Avakian explains that the commission is casting a wide net in its review of complex products, including alternative mutual funds, leveraged and inverse exchange-traded funds, equity indexed-annuities, and "other types of securities that have derivatives embedded within the product."
To take one example, Avakian says that there are on the order of $40 billion to $50 billion in structured notes registered with the commission each year.
"Many of the sales here are to relatively unsophisticated retail investors," she says. "And the performance of structured notes is often tied to highly complex baskets of securities, commodities, indexes, and we're increasingly seeing complex proprietary algorithms and indexes being embedded in these products."
One of the SEC's overarching concerns is whether the recommendations to invest in these complex products are consistent with the duties of care that brokers and advisors owe their clients.
Avakian says that the SEC's enforcement division has been working closely with the Office of Compliance Inspections and Examinations to cull through large volumes of trading data to identify the firms that are engaged in the heavy movement of complex products.
Through that analysis, SEC officials are trying to uncover patterns of excessive trading, excessive markups or simply of high-fee trades that might not deliver commensurate value to the client.
"In doing this, we're look for potentially problematic trading patterns or practices that could be indicative ... of purposeful wrongdoing," Avakian says.
"This is the kind of activity that could result in additional cost to an investor without increased benefits, particularly where there's no analysis as to whether it actually makes good financial sense to make a trade like that," she adds. "Or it could be indicative of less nefarious conduct, like potential failures within a broker-dealer to fully implement its compliance program and the policies and procures effectively."
The work Avakian's division is doing to harness data to get a better sense of how the industry is handling complex products is complemented by the SEC's broker-dealer task force. Through that initiative, launched two years ago, officials have been exploring new regulatory approaches to better supervise the brokerage sector, including the analysis of raw trade data from clearing firms that has helped identify broker-dealers who appear to be engaged in excessive trading known as churning. That effort, Avakian explains, has helped flag individual firms for closer scrutiny and potential enforcement action, and has identified emerging industry trends that can inform the examination process.
Avakian notes that many of the SEC's concerns of complex financial instruments aren't necessarily the result of any malicious intent from advisors or brokers, but rather stems from the exotic nature of the products.
"In addition to concerns about trading practices, effective policies and procedures, we're also concerned about the potential gap between the sophistication of the average retail investor and the complexity of some of these products," she says. "Because they're so complex, it's important that broker-dealers and registered reps fully understand the products before recommending them to clients."
Too often, advisors themselves don't appreciate all of the risks or fees associated with the complex products, she says, so it is incumbent on practices to conduct their own training and due diligence to ensure that staffers understand what they are putting in front of their clients.
"I think part of the takeaway," Avakian says, "is that firms should strive to do their own and similar analysis on this sort of data where they can to uncover and address potential wrongdoing, problem with trading practices, determine whether policies and procedures are being followed, see if folks who are selling these products have a full understanding of the products they're selling."
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