FINRA is concerned that complex products are being sold to retail investors who don't understand what they're buying, and have little or no idea as to their essential characteristics and risks.  To address this suitability issue, FINRA earlier this year offered guidance on how firms may best supervise sales of complex products to retail investors.

What's a "complex product?" It may include a security or investment strategy with novel, complicated or intricate derivative-like features, and can include such products as:  structured notes, inverse or leveraged ETFs, hedge funds, ABSs and other securitized products.

What's an effective way to deal with complex products? FINRA recommends that firms adopt a 2-step process:

Step One - identify whether a product is "complex."  [Discussed below, in this post.] Step Two - implement heightened supervisory and compliance procedures for sales of those products identified in Step One  as "complex." [See Part Two is separate BTN filing.]

FINRA Staff Contact. Direct questions to:   Tom Selman, EVP, Regulatory Policy, at (202) 728-6977.   To access the source document, go to:  [FINRA RegNote 12-03, January 2012]. Part One Continued After The Jump. Identifying Complex Products by Their Characteristics. Any product with multiple features that affect its investment returns differently under various scenarios is potentially complex - probably "over the heads" of average retail investor.  Take for example the characteristics of these difficult-to-understand securities: 1.  Products Secured by a Pool of Collateral. Products secured by a pool of collateral - e.g., mortgages, payments from consumer credit cards or future royalty payments on popular music. With these securities, the creditworthiness of the underlying borrowers or the existence of prepayment risks, though critical to the evaluation of the product, may not be readily apparent to retail investors - e.g., asset-backed securities (ABSs).  [Similarly, unlisted REITs may present liquidity and valuation issues for a retail investor.] 2.  Products With An Embedded Derivative Component. Products that include an embedded derivative component may be difficult to understand where or when ...

• repayment of principal or payment of yield depends upon a reference asset, when information about the performance of the reference asset is not readily available to investors.   [e.g., structured notes with an embedded derivative for which the reference asset is a constant maturity swap rate.]

• different stated returns are provided throughout the lifetime of the product.  [e.g., “steepener” notes typically offer a relatively high teaser coupon rate for the first year, after which they offer variable rates determined by the steepness of a yield curve.  Similarly, some firms have offered structured notes with payoffs contingent on whether one or more reference asset performs within a certain range.]

• the investor might incur a capital loss as a result of the fall in the value of the reference asset without being able to participate in an increase in its value.  [e.g., so-called “reverse convertible notes” may fall into this category.]

• a change in the performance of the reference asset can have a disproportionate impact on the repayment of capital or on the payment of return. [e.g., “knock in” or “knock out” features associated with reverse convertible notes, in which a drop in the value of the reference asset to a pre-defined level, can affect determination of an investor’s gains or losses.]

3.  Products with contingencies in gains or losses. And, particularly applicable with those that depend upon multiple mechanisms, such as the simultaneous occurrence of several conditions across different asset classes - e.g., range accrual notes for which the return of principal can depend upon the value of two or more reference assets on certain pre-defined dates. 4.  Structured notes with “worst-off” features. These provide payoffs that depend upon the worst performing reference index in a pre-specified group.  These notes can limit the return of principal at maturity if either the reference index falls by a stated percentage -e.g., 30% - or if any of the reference indices decline in value since the date of issue. 5.  Investments tied to the performance of markets. These may not be well understood by many investors  -- e.g., some exchange-traded products offer retail investors exposure to stock market volatility.  Some also provide inverse or leveraged exposure.  The investable form of volatility may be in the form of futures on the CBOE Volatility Index (VIX) that reflect the market’s expectation of volatility. 6.  Products with principal protection. Such protection can be conditional or partial, or it can be withdrawn by the product sponsor upon the occurrence of certain events. Notes that can lose their principal protection based upon a stated event represent an example of a product with this feature. 7.  Product structures that can lead to performance significantly different from what an investor may expect. Such products may have leveraged returns that are reset daily.  Leveraged or inverse exchange-traded funds exemplify this feature. Many leveraged and inverse ETFs “reset” daily, meaning that they are designed to achieve their stated leverage or inverse objectives on a daily basis. Their performance over longer periods of time can differ significantly from what might be expected based on their daily leverage or inverse factor. 8.  Products with complicated limits or formulas for calculating investor gains. Some structured notes have a payout structure that tracks the upside performance of a reference asset one-for-four, but if the reference asset’s performance exceeds a specified threshold the payoff is reduced to a much lower, pre-set level, regardless of how it performs afterward. FINRA's Concluding Note. Many other products don't possess the above characteristics, but may nevertheless require heightened compliance and supervisory procedures because of the risks they present.  That said, firms generally will not go wrong referring to the above general characteristics when establishing policies and procedures to identify products that are sufficiently complex to warrant enhanced oversight. The key point for firms is, "when in doubt, err on the side of caution." That is, if a product has features of complexity that resemble any of the above - e.g., embedded derivative-like features, or a structure that produces different performance expectations according to price movements of other financial products or indices - then firms should err on the side of applying their procedures for enhanced oversight to the product.