Finra's alert on ETNs signals strong regulatory focus on those products, lawyers say

By Emma Trincal

New York, July 10 - The Financial Industry Regulatory Authority's new investor alert about exchange-traded notes is the latest illustration of the regulator's heightened scrutiny of these securities in a market that has seen a couple of products go sour, although it's "nothing new," according to lawyers.

Titled "Exchange-Traded Notes - Avoid Unpleasant Surprises," the new alert was released Tuesday and is designed to remind investors of the risks associated with ETNs, especially on two issues: pricing discrepancies and complex ETNs with inverse or leveraged exposure, said Courtenay Myers Lima, an attorney with Latham & Watkins LLP.

The issue of leveraged and inverse ETNs is not coming up for the first time, she said, pointing to a prior alert jointly released in 2009 by the Securities and Exchange Commission and Finra but pertaining to exchange-traded funds and not ETNs.

Recent events

"What's interesting is that they're highlighting what they put out before. It was in the context of ETFs, but it applies equally to ETNs. It's clearly still an issue for Finra ... the fact that the compounding can have some unanticipated results if held over a long period of time. That's something they want investors to pay attention to," she said.

The alert warns investors that the performance of a leveraged or inverse ETN may differ substantially from the return of the underlying benchmark following the same parameters.

"Given the daily resetting of its leverage factor, an ETN that is set up to deliver twice the performance of a benchmark on a daily basis will not necessarily deliver twice the performance of that benchmark over longer periods such as weeks, months or years," the alert said.

Headlines

The first two words in the alert offer context as Finra mentions "recent events" that have "placed a spotlight" on the market for ETN products.

A lawyer said that the unnamed "recent events" are not hard to identify and pointed to two of them.

The first, he said, involves Credit Suisse AG, Nassau Branch's VelocityShares Daily 2x VIX Short-Term ETNs listed under the NYSE Arca ticker symbol "TVIX." In February, the issuer suspended the creation of new ETNs, which caused the price to trade at a premium to the indicative value. But a month later, the issuer began to create new ETNs again, which soon precipitated losses.

A similar situation happened with Barclays Bank plc's iPath Dow Jones - UBS Natural Gas Subindex Total Return ETNs listed under the NYSE Arca ticker symbol "GAZ."

Barclays suspended the ETNs temporarily in August 2009, causing an imbalance of supply and demand in the secondary market and leading to a "persistent" premium in the trading price of the ETN on the exchange in relation to its intraday indicative value, as Barclays acknowledged in a press release in May.

"I think because of what happened with TVIX and also GAZ, several people say that the SEC is looking at ETNs. That may have caused Finra to look at it too," the lawyer said.

Price deviations

Myers Lima said that Finra's alert focuses in particular on the possible gaps between indicative value on the one hand, or the price computed by the issuer based on the benchmark's performance, and the market price on the other hand, which reflects the trading price on the secondary market.

"That is what's driving the alert. They want investors to be aware that the market price can trade at a discount or premium to the indicative value. The market price is not just a function of the performance, it's also a function of supply and demand for shares and other external factors," she said.

"You should kind of wonder why would anybody buy it if the price is much higher. If there is a price discrepancy between the market price and the indicative value, people should pay attention to it and understand what drives the gap. That's what this alert is about mainly. It's their main focus.

"But otherwise, all they're doing is making sure people understand what they're purchasing by mentioning things that are already disclosed in the pricing supplement documents. Credit risk, market risk, liquidity risk, all of that is already out there.

"It's a reminder for investors to do their homework. The issuers make those announcements. The information is public. They put investors on notice. I don't think they're saying anything new besides that."

The lawyer agreed, saying that the document offered a "good description of ETNs" but "it's a little bit old news," referring to the 2009 preceding alert.

He said that the alert should be placed in the context of a rapidly growing market.

"It makes sense because when ETNs started in 2006 with the original iPath, they were very straightforward. Over the years though, they picked up inverse; they picked up leverage, they picked up some of the characteristics of the ETFs.

"We now have a lot of complicated products, inverse ETNs, leveraged ETNs. Finra points out that those are more useful for traders than for mom and pop.

"But the problem is that when something is listed on an exchange, it becomes much easier for retail to have access to it," he said.

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