Alarmed at a set of conditions that could invite sales abuses and eventually a market correction, the Financial Industry Regulatory Authority enters 2013 with a warning to investment advisors that the group plans to keep a close eye on the industry and hold advisors accountable to its new suitability rule.
As a starting point, FINRA explains that the current market conditions of slow growth and low interest rates have created new vulnerabilities for retail investors, who, while chasing safer investments, could actually be exposed to new risks as they shift holdings from equity to debt markets, which FINRA warns could be inflated.
"Investor appetite for yield, among other factors, has bid up market prices on investment-grade and high-yield debt, putting pressure on upside growth potential and creating significant downside risks," FINRA said in a letter outlining the group's regulatory priorities for the coming year.
"In this environment, FINRA is particularly concerned about sales practice abuses, yield-chasing behaviors and the potential impact of any market correction, external stress event or market dislocation on market prices."
FINRA said that it plans to closely scrutinize broker-dealers and registered representatives who recommend "complex or high-yield products" to ensure that both advisors and clients have a full understanding of various risk factors involved with those investments, such as the volatility of holdings that are sensitive to interest rates, liquidity concerns and credit risk exposures that are out of synch with the client's risk tolerance.
Under FINRA's suitability rule, which the SEC approved in 2010 and took effect last July, advisors are required to offer advice on transactions or investment strategies that they believe to be in the best interest of their clients. Then in December, FINRA issued a revised set of guidelines narrowing the scope of terms like "customer" and "investment strategy" as they are incorporated in the rule. Those revisions were meant to offer clarity to investment advisors, many of whom had objected that the terms were overly broad. Following the implementation of the suitability rule, FINRA's enforcement activity spiked, and the group is now promising that it will remain vigilant as it heads into 2013.
In its regulatory outlook, FINRA identified an array of emerging products that it deems "potentially unsuitable" for retail investors based on a variety of risk factors, including business development companies, leveraged loan products and commercial mortgage-backed securities.
FINRA examiners will also continue to scrutinize advisors who steer clients toward a set of investment products that it has warned about in the past, including high-yield debt instruments, exchange-traded funds and notes, non-traded REITs, municipal securities and variable annuities.
"Our examiners will focus on the suitability of recommendations, the brokers' level of product-specific knowledge, the level of due diligence in assessing the risk tolerance and liquidity needs of the customer when making investment recommendations, the manner in which material risk exposures are disclosed to customers and the impact on broker compensation associated with competing investment alternatives," FINRA said.
Aside from stepped-up enforcement of its suitability rule, FINRA plans to evaluate financial firms' defenses against cyber attacks, which the group warns have been increasing in frequency and sophistication.
"Our primary concern is the integrity of firms' policies, procedures and controls to protect sensitive customer data," FINRA said. "FINRA's evaluation of such controls may take the form of examinations and targeted investigations."
FINRA identified insider trading and firms' anti-money laundering practices as additional areas of concern. Along with the SEC and law-enforcement authorities, FINRA strives to curb insider trading at the firms that it oversees and urges risk controls such as information-barrier policies, training and monitoring employee trading activity both inside and outside the firm.
On the money-laundering front, FINRA said that its own examinations have uncovered a growing number of foreign currency conversion transactions through which foreign financial firms purchase U.S. bonds with their local currency through a U.S.-based broker-dealer, with the proceeds eventually transferred offshore.
"In this regard, U.S. broker-dealers that act as intermediaries in these transactions may receive foreign bonds or other securities worth millions of U.S. dollars without knowing who or how many underlying customers may be involved," FINRA said. "Reviews of this business have raised concerns regarding the level of due diligence performed by firms and inadequate reviews for potential suspicious activity."
FINRA also warned about some firms' casual sales practices concerning risky and speculative microcap and low-priced OTC securities, advising stricter oversight of traders involved with those assets, due diligence to ensure balance in any research dealing with microcap and OTC securities, and monitoring customer-outreach efforts such as telemarketing and promotional emails.
Additionally, FINRA expressed concerns about the increase in the use of software to produce automated investment advice, margin-lending practices and firms' policies for supervising branch offices.
FINRA also warned of market disruptions caused by algorithmic trading, high-frequency trading and alternative trading systems, signaling that it plans to closely monitor firms engaging in those practices in 2013.
