The breathtaking collapse of major ETNs linked to natural gas and the VIX index has captured the fancy of adults and schoolchildren everywhere. It's also raised bothersome question about why the Securities Exchange Commission (SEC) failed to prevent a totally preventable fiasco.
The VelocityShares Daily 2X VIX Short-Term ETN (NYSEArca:TVIX - News) lost 60% of its value over the past week, while the iPath DJ-UBS Natural Gas ETN (NYSEArca:GAZ - News) has followed a similar path. (Pun intended.)
Like the Pink Panther's Inspector Clouseau, the SEC has been notoriously late and clueless in solving the ETN mystery.
Here are the key reasons the SEC has failed to properly supervise the ETN marketplace:
A day late and dollar short: Why didn't the SEC immediately open up an investigation when Credit Suisse stopped issuing TVIX notes back on February 21? Why didn't the SEC investigate the iPath DJ-UBS Natural Gas ETN (NYSEArca:GAZ - News), three years ago, when Barclays stopped issuing shares in August 2009?
From what I've observed, the SEC's market timing is awful and it's partially due to the agency's super tight knit relationship with Wall Street. Friends regulating friends doesn't serve the investing public.
Lack of understanding: If the SEC truly understood the ETN market, they would've immediately recognized that ETN issuers can blindside ETN investors whenever they create or redeem notes. Did the SEC not realize the February 21 stunt by Credit Suisse would create instability in TVIX shares? Did the SEC not know huge distortions between an TVIX's share price and its underlying assets would likely be triggered? Did the SEC not read the prospectus?
Unfortunately, Wall Street has done such an outstanding job of manufacturing confusing financial paraphernalia, it seems securities regulators themselves don't understand the very products they are responsible for supervising.
Selective Enforcement: Maybe the real problem with the SEC is how they pick and choose what securities rules they'll enforce, not necessarily what should be enforced. Of what value is a litany of securities rules if they're never enforced? And which rules did the SEC fail to uphold? The ETN market is out-of-control, because the SEC has allowed it to become that way.
The Right ETN Game Plan
ETN issuers have not been able to prevent their products from trading at massive premiums or discounts and they too share in the blame. Cleary, Barclays and Credit Suisse, as top ETN issuers, have flunked in executing their prospectus stated objective for GAZ and TVIX by making sure their products closely stick to their underlying benchmarks.
If you are investing or trading in ETNs with substantial premium/discount distortions, be forewarned: You are not making a directional trade based upon the ETNs underlying benchmark or index, but rather an arbitrage trade. If you're anything but an institutional investor with the toolkit to make arbitrage trades, you're swimming with sharks.
Long before this ETN crisis struck, I've been warning readers about the dangers of ETNs.
On September 13, 2011, I wrote "ETN Market Primed for Disaster." The article was published at ETFguide.com and Yahoo Finance.
That piece was followed up by another controversial article I wrote on November 30, 2011 titled "Are you ready for the Great ETN Meltdown?" Then again, on February 13, 2012, I followed up with "Credit exposure for ETNs not going away."
In the December 2011 edition of the ETF Profit Strategy Newsletter, I asked "Which ETNs Will Blow Up First?" In this research piece, I provided a list of the top 15 ETNs by assets and 15 alternatives. I gave readers plenty of advanced warning, which shows that fiercely independent research and going against the Wall Street consensus is a winning formula.(Incidentally, TVIX was one of the ETNs I advised against.)
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