Continuing the trend of increased scrutiny of exchange-traded
products ("ETPs"), the Financial Industry Regulatory
Authority ("FINRA") issued an Investor Alert on July 10,
2012 titled "Exchange-Traded Notes—Avoid Unpleasant
Surprises" (the "July 10 Alert"). The July 10 Alert
details the unique features and risks of exchange-traded notes
("ETNs"), which are unsecured debt obligations of an
issuer usually linked to a market index or other benchmark that
trade on exchanges. The July 10 Alert outlines the similarities and
differences between ETNs and exchange-traded funds
("ETFs") as well as more traditional debt instruments
like bonds, thus exposing ETN investors to the market risk inherent
in the underlying index (as with ETFs), but also the credit risk of
issuer default (as with bonds). Unlike ETFs, however, ETNs are not
registered investment companies subject to the same regulatory
requirements, and they do not buy or hold assets in order to track
the performance of an underlying index or benchmark. Unlike bonds,
ETNs do not pay interest, but rather make a
"distribution" at maturity determined by the performance
of the underlying index.
The July 10 Alert expressly identifies seven risks associated
with ETNs: (1) credit risk; (2) market risk; (3) liquidity risk;
(4) price-tracking risk; (5) holding-period risk; (6) call, early
redemption, and acceleration risk; and (7) conflicts of interest.
It also encourages investors to do their own homework before
investing in ETNs and sets out questions to which investors should
know the answer before making an ETN investment, including the
identity of the issuer, the index or benchmark the ETN tracks, if
the ETN is callable by the issuer, if the ETN offers leveraged or
inverse exposure to the underlying index or benchmark, the fees and
costs associated with the ETN, and the tax consequences of the
ETN.
As with earlier ETP-related FINRA alerts focused on the risks
related to leveraged and inverse ETFs, the July 10 Alert highlights
special concerns related to leveraged, inverse, and leveraged
inverse ETNs, particularly the holding period risk. Leveraged ETNs
seek to pay a multiple of the index or benchmark they track, and
inverse and inverse leveraged ETNs seek to pay an inverse of the
index or benchmark (or, in the case of inverse leveraged, a
multiple of the opposite of the performance). FINRA cautions about
the importance of distinguishing leveraged and inverse ETNs that
"reset" daily from ones that have monthly resets or no
resets. Leveraged and inverse ETNs that "reset" daily are
susceptible to the effects of compounding that can cause the
ETN's performance to deviate from the ETN's underlying
index or benchmark, thus making them more of a short-term trading
tool not intended for buy-and-hold investing.
The July 10 Alert also details how unique features related to
the creation, redemption, and trading of ETNs, such as the ability
of issuers to suspend creation of new shares of the ETN, can lead
to large disparities between the indicative value of an ETN and the
market price at which that ETN is actually trading in the secondary
market. FINRA cautions that it is a good idea to compare an
ETN's closing and intraday indicative values with the market
price and explains there are variety of reasons for price
deviations. Without identifying the ETN, FINRA offers up a recent
incident, which we can only assume to be the VelocityShares Daily
2x VIX Short-Term (TVIX), as an example of how an ETN can trade at
a premium to its indicative value if the issuer suspends issuance
of new shares. After the suspension of new shares, the ETN traded
at a premium of nearly 90 percent. When the creation of new shares
resumed, the ETN dropped by more than half in two days.
While the highly publicized pricing disparities in TVIX may have
been the immediate impetus for the July 10 Alert, it should be
viewed as part of a larger pattern of increased scrutiny on the ETP
industry as a whole in the United States and Europe. This scrutiny
has resulted in calls for heightened supervision and regulatory
reform of the ETP industry, regulatory action against ETPs, and
investor lawsuits. Given the explosive growth of the ETP industry
and the proliferation of new and exotic ETPs, it is unlikely this
scrutiny will end any time soon.
A copy of the July 10 Alert is posted
here. FINRA's press release regarding the July 10 Alert is
posted here.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
Specific Questions relating to this article should be addressed directly to the author.
In November 2012, the U.S. District Court for the Eastern District of New York preliminarily approved a settlement agreement in the In re Payment Card Interchange Fee and Merchant Discount Antitrust Litigation.
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