• FINRA Issues Investor Alert Regarding Risks of Exchange-Traded Notes
  • July 25, 2012 | Authors: Kelly A. Carrero; Lee Ann Russo; Jayant W. Tambe
  • Law Firms: Jones Day - New York Office ; Jones Day - Chicago Office ; Jones Day - New York Office
  • 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.