Can ETNs Be Trusted?

Barclays Capital 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 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.

Through such double sipping, Credit Suisse and Barclays Bank were able to charge higher lending fees because shares in the ETNs were in short supply as a result of 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?

That ETN sponsors would risk damage to their reputations and their businesses to lend shares strongly suggests that ETN issuers, particularly European ones, are badly undercapitalized and desperate for cash. Does that sound like the type of entity to which you would gladly entrust money?

 Will Regulators Step Up?

The ETN industry, like a celebrity in the midst of public scandal, has said very little about the operational problems of its products, instead opting for cryptic behavior and website statements.

Meanwhile, the Securities and Exchange Commission, along with state securities regulators from Massachusetts, are investigating ETNs. Could it be the ETN market is out of control because securities regulators have allowed it to become that way?

The SEC should take clues from the U.S. Food and Drug Administration: When medications available for public consumption don't perform as they should — or worse, when they hurt people — the protocol is to pull those drugs from the market immediately. And so long as ETN issuers are incapable of preventing their products from trading at massive premiums and discounts or suffering from other operational difficulties, the SEC has a strong case for pulling them from publicly trading markets.

"ETNs don't necessarily complicate asset allocation, but they may complicate the related process of risk management," says Fox. "They're not ETFs, so often they are less liquid than ETFs and they are more likely than ETFs to use complex derivatives."

Moreover, the very name "ETN" probably doesn't reflect all of the financial risks these types of products contain. A more apt description for ETNs might be "Debt or Credit Linked Derivatives."

What should policymakers do? At the very least, a temporary ban would allow regulators to reassess the true risks of these very complicated products.

What should financial advisors do? As the aftermath of GAZ and TVIX sorts itself out, advisors should view these products with high alertness and caution