Remarks at SEC Speaks: Increasing Product Complexity: What’s at Stake?

Good morning. Thank you, Bill [Hinman] for that kind introduction.

As always, it is a pleasure to be with you today at SEC Speaks.

Before I continue, I will remind you that the views I express here today are my own and may not necessarily reflect those of my fellow Commissioners, or of the staff of the Commission.

It’s my understanding that this is the 47^th year of SEC Speaks. Much has changed in our capital markets since 1972. Computers now allow investors to access a myriad of investment options from common equity to complex financial instruments within minutes. Both large and small investors have more investment options at their fingertips—and I mean that literally—than ever before. Computers also allow financial products to be developed and sold more quickly than ever before. This high rate of financial innovation and engineering can be beneficial, but it also can present challenges. I still remember the ashen faces of the Secretary of the Treasury and the Chair of the Federal Reserve when they came to the Senate Banking Committee seeking authorization for a massive federal government intervention during the financial crisis. Financial engineering of complex institutional investment products (such as credit default swaps and collateralized debt obligations) were at the heart of the financial crisis.

Now, over a decade later, we live in the ‘era of the possible.’ Advances in financial innovation and engineering have enabled the development of new and even more complex financial products. These advances have also allowed the rapid proliferation of these products into the hands of retail investors.

We know we can build products that take advantage of our technological and engineering capabilities. But the question should not be: “Can we develop and sell to investors a product that does XYZ?” The question ought to be “Should we develop or sell to investors a product that does XYZ?”

Allow me for a moment, to take you back in time more than 100 million years—to the Jurassic and Cretaceous periods—when dinosaurs roamed the earth. You can imagine that these remarkable forms of life looked spectacular from a distance, but up close they were probably quite frightening. Steven Spielberg’s movie, Jurassic Park, paints the picture well.[1] To the park guests, the prehistoric animals were jaw-droppingly majestic, at least from a distance. Up close, however, some of the dinosaurs were unpredictable, if not outright scary. The scientists that created them did not fully understand their capabilities, the unintended effects, or the collateral damage that would inevitably ensue. The scientists failed to control the park because of what boiled down to a misunderstanding of their highly engineered breeding process. As Dr. Alan Grant noted in the movie, “life found a way.”[2]

By referencing Jurassic Park, I am not suggesting that every complex product is equivalent to a tyrannosaurus rex or velociraptor—that is, something scary, dangerous, and unpredictable. All investments have at least some risk. And I recognize that there is a sliding scale of complexity. But what I would like to do is ask whether certain products are appropriate for all investors? How are these products being sold, particularly to retail customers? Even if the disclosure is perfectly clear, does it appropriately inform investor decision-making? If the Jurassic Park guests really understood what could go wrong, do you think they would go on the tour?

Although strategies involving derivatives may date back to at least the 6^th century B.C., when the Greek philosopher Thales bought options on olive presses,[3] they have gotten much more esoteric and complex since then.[4] Products, strategies, and structures using derivatives can range in complexity now, from covered call strategies on the “simpler side” to the far more exotic. Things like straddles, strangles, iron condors, iron butterflies, twin-win notes, worst of notes, and buffered super track notes come to mind. It seems like the more odd the name, the more complex the product.

Of course, derivatives in general can be risk-moderators and even necessary tools for businesses and financial professionals. Some would say structured products or derivatives give certainty to financial risk.[5] Others would say they are “financial weapons of mass destruction.”[6] While both may be true in their own right, I would ask: Should certain complex and esoteric products or strategies be targeted to retail investors? In today’s world, virtually anyone—retail investors alongside financial professionals—has access to any number of different products, services, strategies, and exposures.[7] And if they can’t get direct access, there’s sure to be a vehicle that gets them there indirectly.

Take, for instance, over-the-counter structured notes linked to bespoke indices.[8] The index methodologies on which these products are based often involve some form of calculus or advanced math.[9] The imbedded fees can be mind-numbingly complicated. Notably, the underlying investments can include instruments that would not be available to a retail investor directly. Despite this, these products are often sold to retail investors by financial professionals who make a lot of money by selling complex products. What’s more, it’s not even clear that all of these financial professionals fully understand the products they are selling.[10]

Complex products are also readily available to retail investors in the form of exchange traded products. We all have read the headlines about the VIX futures-based products over the last few weeks.[11] The VIX, as you know, is an index that seeks to measure implied stock market volatility. Investors can gain exposure to the VIX in several ways, including through futures. The VIX-based products in the headlines are based on an index of futures.[12] And that index of futures is based on a second index, which is the VIX. The VIX, in turn, is derived from the price of options referencing a third index whose components are domestic equities. So, the values of these exchange-traded products are based on a combination of futures, options, and three indices. Quite the maze.

What troubles me, is that often-times complex products fall into the hands of people who don’t fully understand them. For certain of these products, the intention may be to market them to only institutional investors.[13] And maybe the products often work as intended.[14] But how does this play out in practice? Do retail investors have access to these products? Do their brokers sell these products after a frank discussion about the potential outcomes and the risks?[15] Do investors understand that the products are trading tools and not long-term investments? Are investors aware they bear credit risk by purchasing these products?[16] Or that the exposure they are getting might not actually reflect the exposure they seek?[17] Is it even possible to have disclosure that adequately describes how these products work?[18]

We also have seen a rise in leveraged[19] and complex passive investment strategies.[20] While index investing traditionally has been seen as rather bland, its rise in popularity has been a cattle call to financial engineers.[21] So, index investing has gone from tracking broad-based indices like the S&P 500 to the new frontier in innovation. With nearly one-third of investment company assets under management,[22] many of these funds track indices reflecting much more than the traditional methodologies that we are all familiar with. Today, indices have bespoke algorithmic methodologies and frequent rebalancing. They can look more like active management than a purely passive instrument.[23] Complexities abound. Do investors know these funds are subject to more than just market risk? Are they aware of the added complexities?

Investors can lose money, or even a lot of money, but that’s not the issue. What concerns me is the disconnect between what investors actually understand and what they really need to understand in order to have a fighting chance at using these products the way they are designed to be used.

A big part of the Commission’s mission is to protect investors. Even after issuers improve disclosure, is that disclosure enough?[24] Do investors really understand what they are getting into? As I have said before, disclosure may only be one piece of the puzzle.[25]

Unfortunately, study after study has shown that many retail investors lack basic financial literacy.[26] One response has been to try to improve financial education.[27] This is a noble pursuit, and we should certainly continue to serve the public in this way. Anecdotally, some studies have shown that financial education, when given close in time to an investor’s decision, can have some impact.[28] However, other studies have shown that attempting to improve general financial literacy often does not work to improve outcomes or subsequent behavior.[29] This is an area we should continue to understand and strengthen.

The Commission has also brought enforcement actions relating to the purchase and sale of complex products. For example, in one case, the Commission charged a large financial institution for supervisory failures related to the sale of reverse convertible notes to retail investors.[30] In another, the Commission charged a different large financial institution for misleading retail investors when selling structured notes.[31] Furthermore, the Commission and FINRA have brought a number of enforcement actions related to the sales practices of inverse and leveraged ETFs.[32] However, the Commission continues to see abuses relating to the purchase and sale of complex products.

So, how do we deal with this multifaceted problem? I think there are several answers.

First, the Commission, FINRA, and the Exchanges need the ability to understand the full impact of these complex products on investors and our markets. We certainly must finalize the consolidated audit trail—the CAT—the Commission’s Hubble telescope into the securities markets. The CAT will be a critical tool for overseeing the capital markets and will better allow the Commission and the self-regulatory organizations (SROs) to catch up with the industry’s rapidly evolving technical sophistication. To date, there have been many hurdles that have delayed the development and deployment of the CAT. However, it appears that progress is being made by the SROs. I remain hopeful that progress will soon be tangibly observable. There should be no doubt that completion of the CAT is imperative.

In addition, the Exchanges that list complex products must be able to effectively surveil for problems.[33] If they are unable to do so, should they even be listing the products in the first place? And if there is a problem with a product they listed, shouldn’t we require them to have the equivalent of smoke detectors and fire extinguishers, and to keep the exit doors clear?

Finally, part of the solution must come from industry professionals and gatekeepers.[34] This includes lawyers, accountants, exchanges, investment advisors, broker-dealers, and others. Gatekeepers are on the front lines. They are charged with advising clients on their investments or how to comply with the law. Or perhaps they are listing products with the public interest in mind. All gatekeepers need to remember that there are real people behind each account number, who are saving for college, retirement, or any number of financial goals. Gatekeepers should be part of the solution, not part of the problem.

I will leave you with one last quote from Jurassic Park. It comes at the point in the film when the guests are debating the validity of what John Hammond, the park’s owner, has created. Dr. Ian Malcom forcefully explains to Hammond as follows:

I’ll tell you the problem with the scientific power that you’re using here, it didn't require any discipline to attain it. You read what others had done and you took the next step. . . . You stood on the shoulders of geniuses to accomplish something as fast as you could, and before you even knew what you had, you patented it, and packaged it, and slapped it on a plastic lunchbox, and now . . . . you’re selling it . . . .[35]

John Hammond replies to the criticism by saying “I don't think you're giving us our due credit. Our scientists have done things which nobody’s ever done before,” to which Dr. Malcolm responds, “yeah, but your scientists were so preoccupied with whether or not they could that they didn’t stop to think if they should.”[36]

The question should be the same here—

not can we create complex and esoteric products,

but should we?

Let’s stop and think, before we repeat the mistakes of the past.