The Financial Industry Regulatory Authority (Finra) is launching a review into the due diligence and possible unsuitable sales of volatility products in the wake of February’s sell-off that saw a number of these funds run into trouble.
The agency has set out plans to investigate firms’ supervisory processes and sales practices related to recommendations of funds and ETFs linked to the Chicago Board Exchange Volatility index (VIX).
The investigation will include, but not be limited to, unsuitable recommendations, misrepresentations, and appropriateness of any required disclosures to customers.
Finra will initially gather information from October 1, 2017, through February 28, 2018, and assess firms’ controls for product vetting, testing, and due diligence for VIX-linked products.
The review is focused on sales to retail clients rather than institutions.
The exam will scrutinize firms' operations and how they identify and mitigate risks related to recommendations to non-institutional purchasers of VIX-linked products.
The review will look at more than 20 firms with customers who traded these VIX-linked products during the review period, according s Finra spokesman. 'Finra's focus is closely linked to market fluctuations in 2018,' he said.
The move comes after several strategies plunged in early February as their bets against a spike in volatility backfired. The ProShares Short VIX Short-Term Futures ETF (SVXY) fell 88% and halted trading after the dramatic spike in the VIX, while LJM Partners’ Preservation and Growth fund shut completely after losing over 80% in two days.
'The sweep is part of Finra’s continuing focus on the suitability of sales of complex products, including leveraged and volatile products, to retail customers,' the same Finra spokesman said.
Firms included in the review will be required to provide detailed documents outlining the product due diligence process, a list of VIX-linked products recommended to non-institutional investors, disclosures and representations to customers, gross commissions generated and any restrictions of purchases of VIX-linked products.
The exam will also assess how firms test VIX-linked products on their approved platform under various market conditions, what measures they took to address risks and pre-and post-trade settlement controls of VIX-related options.
In October 2017, Finra ordered Wells Fargo to pay more than $3.4 million in restitution to customers who were recommended volatility-linked exchange-traded products by registered representatives who did not fully understand their risks and features. Finra found that Wells Fargo failed to implement a reasonable system to supervise sales of these products.