FINRA Warned of Volatility-Linked ETNs Before February Stock Market Plunge

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A CNBC report traced the source Wall Street's recent rout—including a single-day Dow Jones loss of over 1,000 points—in part, to volatility-linked exchange-traded notes (ETNs) that FINRA previously warned investors about.

In October, FINRA ordered Wells Fargo to pay $3.4 million to customers who purchased volatility-linked exchange-traded products (ETPs)—including ETNs—that FINRA says were unsuitably recommended. In the associated AWC, investigators wrote that some of the Wells Fargo representatives who marketed the Volatility ETPs and ETNs did not fully understand their risks and features when recommending them, improperly marketing them as a long-term hedge on equity positions in the event of a market downturn.

This faulty recommendation strategy conflicts with a 2012 Investor Alert concerning exchange-traded notes. The alert warned consumers that ETP unsecured debt instruments associated with the performance of certain indexes, such as the DJIA or S&P 500, could prove disastrous for risk-averse investors. Since then, the SEC in 2015 warned that volatile complex exchange traded products (ETFs, ETNs) may be unsuitable for low-risk or long-term investors, while FINRA issued a 2017 Regulatory Notice concerning volatility-linked ETPs, writing that "many volatility-linked ETPs are highly likely to lose value over time" and are "unsuitable for certain retail investors."

Furthermore, as evidenced by FINRA's 2017 discipline of JP Morgan Securities broker Todd Jason Jones for unauthorized exercise of discretion in customer accounts, some investors might not even be aware they possess complex ETNs in their accounts. In its report, FINRA wrote that Jones had used discretion without written authority to purchase the leveraged ETN known as VelocityShares 3x Crude Oil (UWTI) in 12 firm customers' accounts without written authority.

As we wrote when FINRA first issued its alert, "One or two bad market days can shred an investor's holdings in a leveraged ETN."

Such a drastic loss befell Credit Suisse this month, as the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) lost most of its value on Monday, February 5, when the market took a plunge. By Tuesday, the VelocityShares ETN was down 94% (it opened at $129.35 on Friday and closed at $7.35 on Tuesday), while other exchange-traded securities saw their trading halted on Tuesday after a Monday night collapse.

For instance, by the time ProShares Short VIX Short-Term Futures resumed trading Tuesday, it was down 90%.

Said one XIV trader, "I've lost $4 million, 3 years worth of work, and other people's money." Credit Suisse on Tuesday announced it will liquidate XIV on February 21.

Thus, when FINRA wrote in October that Wells Fargo reps incorrectly believed the complex products could be used as a long-term hedge on equity positions in the event of a market downturn, it might have taken until February to understand the consequences of the firm's inaccurate assessment: a 90% loss in value is likely not a wise long-term hedge.

This isn't FINRA's first time disciplining Wells Fargo for improper ETP sales, either. In 2012, FINRA ordered Wells Fargo to pay over $2.7 million in fines and restitution for a series of suitability and supervisory violations related to sales of non-traditional exchange-traded funds in 2008 and 2009 (coincidentally, the last time the market experienced such a downturn). Some of the non-traditional ETFs cited in the 2012 action included leveraged, inverse, and inverse-leveraged ETFs, while FINRA additionally sanctioned Wells Fargo for failing to adequately train its representatives and supervisors regarding non-traditional ETFs.

FINRA concluded its allegations by writing, "Certain firm registered representatives made unsuitable recommendation of non-traditional ETFs to certain customers with conservative income or conservative growth & income investment objectives and/or risk tolerances."

If you have invested with a broker or financial adviser who has recommended a complex exchange-traded product, such as volatility-linked exchange-traded notes or inverse/leveraged ETFs, and these unsuitable recommendations, given your objectives or risk tolerance preferences, have proven harmful to your investments or interests, please call The Law Offices of Jonathan W. Evans & Associates at (800) 699-1881 for an investigation and consultation.