* Retail investors see values drop as a result
* Banks reap higher fees from hard to find shares
By Jessica Toonkel and Angela Moon
NEW YORK, April 12 (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.
But Credit Suisse said its offering of new shares was done
on a “limited basis,” i nto inventory of its affiliates to make
the ETNs available for lending.
Similarly, e arlier 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. Sinc e 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 Feb. 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 Feb. 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.
“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)
