ETN Sponsors’ ‘Double Dip’ Hurts Shareholders

by ETFguide | April 17, 2012 2:00 pm

The $17 billion exchange-traded note (ETN) is in the midst of a public relations nightmare, as several notes like the VelocityShares 2x VIX Short-Term ETN (NYSE:TVIX[1]) and the iPath Dow Jones UBS Natural Gas Subindex Total Return ETN (NYSE:GAZ[2]) have not performed as they were designed.

For lack of a better description, we’ll simplify the complicated mess by calling it “ETN-gate.”

What’s gotten much less attention is that Credit Suisse (NYSE:CS[3]) and Barclays  (NYSE:BCS[4]) have been double dipping by lending out ETN shares to traders that short them, while simultaneously collecting fees from ETN investors that are long these very products.

Barclays began lending out shares of GAZ earlier this year even though the ETN was closed to new retail investors, according to a Reuters report. This counteractive move contributed to a more than 40% decline in GAZ shares, badly damaging ETN investors who were attempting to go long natural gas. Because Barclays wasn’t creating new GAZ shares, but merely lending shares from its own inventory, it wasn’t required to notify GAZ note holders beforehand that new shares would flood the market.

Likewise, Credit Suisse offered ETN shares for lending to its affiliates.

By “double dipping,” Credit Suisse and Barclays Bank were both able to charge higher lending fees (just like a loan shark) because shares in the ETNs were in short supply due to the fact both sponsors ceased issuing new shares. Traders that shorted TVIX or GAZ made money, while shareholders in both notes got creamed.

Why would ETN sponsors lend out shares they knew were in short supply to the detriment of their shareholders? Why didn’t financial regulators prevent it from happening?

The SEC should be ashamed of itself for even allowing such an unsavory practice to occur. Either regulators don’t have a clear understanding of the ETN market or they are asleep at the wheel — or maybe both.

The fact that ETN sponsors would risk their reputations and their businesses to loan shark supports what I’ve been saying all along:  ETN issuers, particularly European ones — are badly undercapitalized and desperate for cash.

ETNs are debt instruments linked to the performance of a single security, currency or basket of securities. While ETNs are less popular than their bigger cousins — exchange-traded funds or ETFs — they trade in similar fashion.

ETNs, unlike ETFs, carry the added dimension of credit risk. If the ETN issuer becomes insolvent or goes bankrupt, the investor can lose their entire investment.

Currently, ETNs are under investigation by the Securities and Exchange Commission and state regulators from Massachusetts.

  1. TVIX:
  2. GAZ:
  3. CS:
  4. BCS:

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