NEW YORK (Reuters) – U.S. regulators examining whether the exchange-traded note market is harming investors have another reason to be concerned — the sellers of these products are helping traders bet against them, sometimes at the expense of retail investors.
ETNs, which make up just 1.5 percent of all exchange-traded products, have been in the spotlight in the last few months as they have become more popular with traders.
What’s gone less noticed is that banks — Credit Suisse and Barclays Bank PLC in particular — have been lending out shares to investors looking to short these products, even though the ETNs are closed to new retail investors.
That’s caused massive declines in the value of the ETNs in question at the expense of investors holding the funds.
Credit Suisse made headlines when its VelocityShares 2x VIX Short-Term ETN dropped nearly 30 percent in value a few hours before the bank began issuing shares again, sparking regulatory probes into whether hedge funds were tipped off ahead of time.
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But Credit Suisse said its offering of new shares was done on a “limited basis,” into inventory of its affiliates to make the ETNs available for lending.
Similarly, earlier this year Barclays Capital began lending out shares of its iPath Dow Jones UBS Natural Gas Subindex Total Return ETN even though the ETN was closed to new retail investors, causing the portfolio to drop in value almost 42 percent, at the expense of investors in the fund. Since the bank was lending out shares from its own inventory, and not creating new shares, it did not notify investors beforehand that new shares would be going on the market.
Credit Suisse and Barclays made money by lending out ETN shares, and were able to charge higher fees for lending out these shares because they had closed them to the public, thus making them hard to find. Funds who successfully shorted the shares made money, but any investor already in the fund saw the value of their portfolio plummet.
“I don’t know why this is legal,” said Dominic Salvino, a VIX specialist on the Chicago Board Options Exchange floor for Group One Trading. “It gives significant advantage to one set of market participants over another.”
Barclays and Credit Suisse declined to comment.
GROWING CONCERNS
ETNs, which are debt securities issued by banks were first brought to market in 2006 and only have $18 billion in assets — a fraction of the $1.2 trillion exchange-traded product market.
The Securities and Exchange Commission, the Financial Industry Regulatory Authority and the Massachusetts Attorney General are taking a closer look at ETNs as a result of the trading swings in TVIX .
But industry observers believe that regulators also should look into how banks continue to lend out shares to hedge funds, thus generating revenues for themselves, after they halt new issuances for the general public.
“The ability to do this aligns the issuers’ interests with the entities who want the price of the ETN to go down,” said Dave Nadig, director of research at IndexUniverse LLC.
The issuers also make money from it. Barclays, Credit Suisse and other banks that engage in this practice can also make higher fees lending out shares on closed ETNs than if these shares were available to everyone.
In general, firms that lend securities that are hard to find, such as closed ETNs, can charge more than easily available securities.
On average, firms can lend out securities for 0.10 percent to 0.15 percent, but hard-to-find securities can bring in fees anywhere from 1 percent to 7 percent, said Josh Galper, managing principal of Finadium, a specialist research firm.
“This really sheds light on how these companies are making money and brings up the question of whether things go awry because they are structuring trades only for hedge funds,” Weisbruch said. “Where does that leave the small investor?”
Implications for Investors
The drop in value that the Barclays iPath Dow Jones-UBS Natural Gas Total Return Sub-Index saw in February demonstrates how investors can get hurt by ETN issuers giving hedge funds preferential treatment.
In August 2009, Barclays announced it was temporarily suspending issuing new shares of its GAZ ETN.
The halt caused the ETN’s price to begin trading at a premium to its net asset value, which is the end-of-the-day calculation of a portfolio’s value. On average over the past 12 months ending March 29, GAZ traded at a premium of 14.12 percent, according to IndexUniverse.
But from February 1 through March 29 of this year, 666,500 new shares of the ETN became available on the market. The ETN’s value rose as high as $6.02 on February 19, and then collapsed to $3.51 on March 29, according to IndexUniverse.
“If you were an investor that was long the ETN and realizing the benefits of the product trading at a premium, you would have been caught completely off-guard,” said Paul Weisbruch, vice president of ETF/options sales and trading at Street One Financial, which executes trades for institutional investors.
The reason this happened is that Barclays keeps an inventory of the ETN shares, which it can lend out as it sees fit, according to people familiar with the situation.
A review conducted by Reuters of the 11 closed ETNs out of 212 ETNs available did not unveil any other jumps in shares outstanding.
Barclays discloses in its prospectus that supply from its inventory can affect the value of the ETN shares, but investors have no way of knowing when a flood of shares are going to hit the market.
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“It’s terribly unfair but it’s in the prospectus and companies have the right to do terribly unfair things that are in the prospectus,” said Michael Shaoul, chief executive officer of Oscar Gruss & Son Inc in New York.
(Reporting By Jessica Toonkel; Angela Moon; Editing by Bernard Orr)