Traders in the $6.8 trillion exchange-traded product universe just got a rude lesson on the importance of the “exchange-traded” component.
The 6,150% price surge and subsequent liquidation of a Credit Suisse note known as DGAZF shone a harsh spotlight on what happens when these products move to over-the-counter trading. It’s ringing alarm bells over the roughly $2.4 billion worth of ETNs that still inhabit this purgatory in the U.S.
While the money held in delisted ETNs is a fraction of the overall exchange-traded market, industry analysts warn those billions could be time bombs. What would have been merely a short-squeeze in DGAZF turned calamitous because market makers couldn’t create new shares in the note.
“Once ETNs are relegated to the OTC markets, all bets are off,” said Nate Geraci, president of investment-advisory firm The ETF Store. “OTC markets are akin to the Wild West, where standard rules of engagement seem to fly out the window.”
The leveraged natural-gas product may be an extreme example, but investors in other delisted ETNs face the same risk, said Geraci.
Even after Credit Suisse’s announcement that it would effectively shutter DGAZF, eight of the nine ETNs the bank delisted in July still trade OTC, including the $451 million VelocityShares Daily 2x VIX Short Term ETN. Barclays and Deutsche Bank have a combined total of 48 ETNs trading over-the-counter, according to Bloomberg Intelligence data.
“Like a company having filed for bankruptcy, an unsupported ETF or ETN should not be permitted to trade,” said James Pillow, managing director at Moors & Cabot.
Spokespersons for Credit Suisse, Barclays and Deutsche Bank declined to comment.
ETNs can be a risky proposition even when they’re listed. Unlike ETFs, the notes are unsecured debt obligations issued by banks that are backed by the issuer rather than the assets the product is linked to. They’re often used as a way to invest in hard-to-access assets, and frequently use derivatives to amplify returns or deliver the inverse performance of whatever they track.
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A combination of GLD’s higher fees and an almost relentless demand for the yellow metal have catapulted it from fourth on the revenue leader board in 2017.
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If approved, the firm would be able to issue its own ETFs, although they haven’t registered any individual funds yet.
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There has been increased demand for havens amid a resurgence in coronavirus cases, flaring political tensions and a weaker dollar.
July 23
Delistings Multiply
While the notes can be risky for buyers, they can also cause headaches for issuers, who have liquidated or delisted a near-record number this year. Violent swings in leveraged products amid the coronavirus-fueled turmoil have drawn increased scrutiny from regulators.
When they delist, banks typically prevent market makers from creating new shares — meaning prices can go haywire. Another OTC-traded commodity note, the VelocityShares 3x Inverse Silver ETN, ticker DSLVF, closed with a 92% premium to its indicative value last Monday.
Reasons vary for keeping a note alive off-exchange. Some issuers find themselves unable to liquidate because the product’s documentation makes it difficult. One compelling justification to keep a note trading is fees, according to James Seyffart, a Bloomberg Intelligence analyst. DGAZF had only $36 million in assets, but it charged an expense ratio of 1.65% a year, high by industry standards.
Mysterious Surge
The risk is drama on the order of last week’s price surge, for which no clear catalyst has emerged. A number of odd-lot trades hit the tape in the run-up to the closure, including 25 shares that changed hands at $4,999 each on Monday, according to data compiled by Bloomberg. The small sizes likely point to algorithmic or high-frequency trading, Seyffart wrote in a report Wednesday.
“The risk of trading manipulation absolutely increases” over the counter, said Geraci. “DGAZF is exhibit A.”
After short-sellers took to Twitter last week, Credit Suisse announced that investors would be paid out at an average of the note’s indicative value over several days before it closes. That was $93 on Monday morning in New York versus a closing market price of $15,000 on Wednesday.
If clients “looked just three months ago, these numbers would be glaringly different,” an expert says.
That may have saved short-sellers who hadn’t yet covered their positions, but it’s unclear what happens to those forced to buy back shares at inflated prices. And there’s little to prevent the same scenario from playing out again.
“There are plenty of ways for speculators to lose money,” said Pillow. “A liquidated ETN should not be one of them.”
