By Mark S. Nelson, J.D.
SEC Chair Gary Gensler issued a public statement in which he said he had directed Commission staff to review the rules applicable to exchange-traded products (ETPs) with respect to the risks such products pose to both retail investors and sophisticated investment managers. Gensler said in his public statement that the review was part of a “broader look” at ETPs.
“Though the listing and trading of these products, including the listing and trading of the two ETPs that the Commission voted to approve last Friday, can be consistent with the Exchange Act, that doesn’t mean the products are right for every investor,” said Gensler. “I encourage all investors to consider these risks carefully before investing in these products. I believe that potential rulemaking could strengthen the investor protections around these products.”
Gensler’s public statement focused on risks associated with investments in ETPs, which are designed for very short-term investments but which many investors may mistakenly hold for longer periods of time because they lack adequate knowledge about how ETPs function, their purposes, and their risks. Gensler also mentioned that some ETPs have features that can amplify an investor’s gains or losses by significant multiples.
For example, a basic explainer available on the website of the Financial Industry Regulatory Authority Inc. describes the several types of leveraged ETPs. First, a “leveraged” ETP would seek to deliver a gain/loss that is a multiple of some index (e.g., 2x or 3x). Second, an “inverse ETP” would seek to deliver the opposite gain/loss of some index. A “leveraged inverse ETP” would seek to deliver a multiple of the opposite of the gain/loss of some index.
“Most geared ETPs ‘reset’ every day, which means they are only designed to accomplish the stated leveraged or inverse objective on a daily basis—these ETPs don’t make any promises as to how their returns will compare over a longer period, which can make the products risky long term—or even medium-term—investments,” said the FINRA document.
ETPs also typically have a complex structure centered around a trust arrangement. The trust may issue baskets of shares and then only authorized participants can create or redeem baskets.
With respect to virtual currencies, the SEC has yet to approve an ETP because of concerns about fraud in underlying virtual currency markets, among other things. It is unclear from Gensler’s public statement whether virtual currency-themed ETPs are part of the staff review. Other Commissioners, such as Commissioner Hester Peirce, have previously called for the SEC to approve virtual currency ETPs while also questioning whether these proposed ETPs have been treated differently by the Commission than older ETPs focused primarily on more traditional investments such as precious metals.
Gensler has recently suggested that the Investment Company Act might be the proper legal regime for virtual currency-themed ETFs, a subset of ETPs. “When combined with the other federal securities laws, the ’40 Act provides significant investor protections for mutual funds and ETFs,” said Gensler in remarks a few days ago. “I look forward to staff’s review of such filings.”