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FINRA Investigating Exchange-Traded Notes

The U.S. regulator that oversees the sale of investment products to investors is investigating how companies are marketing exchange-traded notes, a niche category that gained some notoriety when one ETN experienced a huge loss this year.

A spokeswoman for the Financial Industry Regulatory Authority said on Thursday the regulator is "looking at the events and trading" activity surrounding a sharp plunge in the price of an exchange-traded note designed to track stock market volatility.

FINRA began its inquiry after the Credit Suisse-managed VelocityShares Daily 2x VIX Short-Term exchange-traded note, or ETN, lost half its value in just two days earlier this month.

But FINRA's review is not limited to the VelocityShares volatility ETN, the spokeswoman said.

"We have a review under way looking at a host of issues relating to ETNs and other complex products," the spokeswoman said.

Exchange-traded notes are debt securities issued by banks. ETNs were first brought to market in 2006 as a way for sophisticated traders to make bets on different parts of the market. But recently, retail investors have begun trading ETNs as one way to get exposure to popular segments of the market like silver, gold and natural gas.

To be sure, the dollar value of ETNs is small, roughly $18 billion. The VelocityShares volatility ETN, known as TVIX for its ticker and managed by Credit Suisse, for instance, had about $700 million in assets at its peak.

In contrast, the dollar value of better-known exchange-traded funds, or ETFs, is $1.2 trillion.

ETNs and ETFs are often lumped together because they both track the performance of an index, a commodity or a sector and trade like a stock.

But ETNs differ from ETFs in that they are not portfolios of investments. Instead, the ETNs - or exchange-traded notes - are contracts in which the issuers agree to pay investors returns that are equal to the investments they aim to track.

The number of ETN offerings has grown rapidly in recent years. Today, there are 212 ETNs available on the exchanges, representing slightly less than 15 percent of all exchange-traded products, which includes ETNs and ETFs.

The increased popularity of ETNs has raised concerns from regulators that retail investors, and even financial advisers, may be buying these products without understanding them.

"A month ago, I didn't believe that these kinds of products needed special labeling. But what's gone on over the past few months has made me somewhat concerned that investors are getting into these products without knowing what they are buying," said Tom Lydon, president of Global Trend Investments, a registered investment adviser and editor of ETFTrends.com.

Massachusetts' top securities regulator is also looking into problems with the VelocityShares volatility ETN, a spokesman for Secretary of the Commonwealth William Galvin confirmed. Galvin has sent a letter to Credit Suisse, giving the firm until April 5, which is next Thursday, to respond to a series of questions.

A Credit Suisse spokeswoman said the firm "is cooperating with regulatory authorities."


In the aftermath of the big plunge in the VelocityShares volatility ETN, concerns have grown about bizarre trading in other exchange-traded notes that are selling at a premium to their net asset value.

The next TVIX, some traders say, is the iPath Dow Jones-UBS Natural Gas Total Return Sub-Index ETN. The ETN, issued by Barclays Capital, is designed to track the performance of natural gas futures.

The natural gas ETN, which has a market cap of about $36 million, plunged 22 percent this week, following a 24 percent drop in the previous week.

Paulo Santos, an independent trader, said the issue with ETNs isn't just that they sometimes trade at a premium to the net asset value, but the products in some cases are "structurally flawed."

He pointed to the natural gas ETN as an example. He said since it tracks a futures contract, the ETN loses value each month when those futures have to be rolled over.

"Even if GAZ was trading at fair value, it would not be advisable to buy it," Santos said.

A spokesperson for Barclays said no one was available to comment.


Concerns about ETNs began to grow earlier this year when the VelocityShares volatility ETN, which aims to double the daily price moves in an index tracking short-term VIX futures, began experiencing big swings in value.

On Feb. 21, Credit Suisse stopped issuing new shares of the VelocityShares ETN, or the TVIX, after investors started trading the fund more heavily. The halt caused the ETN's price to begin trading at a large premium to its net asset value, which is the end-of-the-day calculation of a portfolio's value.

The VelocityShares ETN ended at $17.01 on Feb. 21 and gradually fell to $14.43 by the close of trading on March 21.

The next day, March 22, the VelocityShares volatility ETN dropped 29 percent and trading in the note nearly quadrupled to 30 million shares. After the market closed, Credit Suisse announced it would begin creating shares in the ETN, causing some industry observers to question whether some traders knew about the investment firm's announcement beforehand .

The problem, traders say, is that it appears that there is a small circle of traders who have information on what is going on with these products and the ETN issuers completely control how they are going to trade, said Jamie Lissette, an independent trader who lost a couple of thousand dollars trading TVIX. Lissette is also the founder of the Hammerstone Group, a Westport, Connecticut-based operator of online discussion forums for investors.

Like the VelocityShares volatility ETN, the Barclays-managed natural gas ETN trades at a premium to its net asset value. That has led some industry observers and savvy traders to begin scouting for other ETNs that trade at a premium.

Some ETNs that fit that profile, according to experts, are the UBS E-TRACS Long Platinum ETN and the VelocityShares 3x Long Silver ETN.


The recent problems with ETNs are causing some analysts and investor advocates to say regulators need to do more to protect retail investors.

"There is no barrier preventing the average investor from stumbling in these ETNs," said Samuel Lee, an ETF analyst at Morningstar Inc.

BlackRock Inc which is the biggest manager of ETFs, has called on regulators and legislators to take steps to require investment firms to clearly explain to investors the risks involving ETNs.

"The current discussions around ETNs provide us another opportunity to go back to regulators and try to move our agenda forward," said Jennifer Grancio, global head of business development at BlackRock's iShares unit.

Morningstar's Lee said it's also hard for investors to discern the fee structure with ETNs. The mutual fund ratings company said fees for ETNs can range anywhere from 50 to 535 basis points.

ETFs, meanwhile, have set fees and must alert investors if those fees change.

But many ETNs have fees that can change day by day, depending on the historical performance of the funds, Lee said.

(Reporting By Jessica Toonkel, Angela Moon; Additional Reporting by Emily Flitter; Editing by Chizu Nomiyama and Jan Paschal)

Copyright 2010 by Reuters. All rights reserved.

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