The financial industry is no stranger to fraud, and it seems one particular area of rising contention is Exchange Traded Notes (ETNs). These high-risk derivatives aren’t a new creation since they’ve been around for over a decade. However, after a track record of billions of dollars being lost by investors and banks like Credit Suisse generating enormous profits, some analysts have kinned these products to fraud.

Despite this, the Securities & Exchange Commission has not banned them. And they remain highly popular amongst both retail and sophisticated investors. So, what exactly are Exchange Traded Notes? And where does the fraud come into play?

What is an Exchange Traded Note (ETN)?

Exchange Traded Notes are highly complex financial instruments. The average prospectus length that explains how an ETN works is usually around 200 pages long. But in oversimplified terms, these derivatives are a form of unsecured debt obligations, similar to a bond.

These products are supposed to track the behaviour of an underlying index and provide returns accordingly. However, unlike a bond, no interest is paid. Instead, at the maturity date, the issuer will pay out the performance of the underlying index minus fees. 

Barclays was the first bank to issue an ETN. And later on, other banks like Credit Suisse and Citigroup started issuing their own ETNs with leveraged and inverse variations. These are effectively products built to allow expert traders to speculate on the performance of an index.

A conflict of interest arises

Banks that issue ETNs create a conflict of interest immediately with their customers. Why? Because these institutions only make a profit if the price of the exchange traded note goes down. Whereas investors obviously profit when the price goes up.

And this is where things get dubious because the issuer wants the price to fall as fast as possible. An ETN is actually intentionally designed to fall to zero over time. At least that’s how Credit Suisse described their ETN products:

“The long term expected value of your ETNs is zero. If you hold your ETNs as a long-term investment, it is likely that you will lose all or a substantial portion of your investment.”

The fraud starts creeping in

Having a product designed to fall to zero over the long term is not in itself an issue. This is because ETNs are meant to be used as a short-term trading instrument rather than a long-term investment. But the problem arises when banks start getting very aggressive with reserve splits.

A reverse split is the same thing as a stock consolidation for equities. The issuer can merge shares of an ETN together to reduce the number of shares outstanding. While the overall net asset value of the product hasn’t changed, the price is artificially inflated.

For example, let’s say an ETN has a net asset value of $100 with 100 shares outstanding. The issuer then decides to do a 10:1 reserve split. That means every 10 shares becomes one share. The net asset value is still $100, but the price per share has jumped from $1 to $10.

Why would an issuer want to inflate the price? Because now, they can issue new shares for the ETN at an elevated price, allowing for even more profits when the price inevitably starts falling. And when the price drops too low, the reverse split process is repeated, continuing the cycle.

In 2010, Credit Suisse launched the VelocityShares Daily 2x VIX ETN at a net asset value of $2.5bn. In July this year, the ETN was delisted at a price of $112.36. That’s a 99.99% drop. And during that time, 25 million shares were converted into one!

The balance of risk… what balance?

As these products are designed to fall to zero over the long term, banks have zero risks in issuing them. The risk is entirely held by the investors. And those who owned shares of another Credit Suisse ETN, VelocityShares Daily Inverse VIX, know this all too well.

This exchange traded note follows the inverse performance of the CBOE Volatility Index. This index is used as a proxy for gauging the level of uncertainly within the market. In 2018, the Dow Jones Industrial Average fell by 1,600 points in a single day, causing the volatility index to jump up in price. Consequently, the inverse ETN dropped off a cliff by 92% and $1.6bn of investor capital was wiped out in a single day.

Investors lost a fortune, while Credit Suisse, the ETN issuer, reported an enormous profit just before delisting the product. This is why analysts are beginning to use the F word to describe ETNs.

The call for the regulation of Exchange Traded Notes (ETNs)

I think it’s fair to say that a derivative is borderline fraudulent when other financial institutions start pushing for more regulatory oversight. BlackRock, the world’s largest asset manager, has openly spoken out against ETNs, saying that a new classification system needs to be implemented to ensure investors are aware of the risks.

Meanwhile, Paul Gambles, the Co-Founder of MBMG group, has actively criticised Credit Suisse, saying, “Stamping a boilerplate warning that nobody reads or understands doesn’t amount to disclosure”.

The Securities & Exchange Commission has begun handing out fines to ETN issuers that sold these instruments to unknowing investors using distributors. But they haven’t issued a ban. And in the meantime, this predatory approach to selling ETN products continues. Platforms like Robinhood allow unsophisticated retail investors the ability to buy ETNs offering no more than a similar boilerplate risk warning.

Final thoughts

As a long-term stock investor, exchange traded notes have no interest to me personally. But to a short-term trader, they can be an excellent source of profits. The problem is these instruments are intended for financial experts. And yet, it appears the vast majority of customers are actually amature retail investors.

With billions of dollars being wiped out each day and ETN issuers reaping the profits, the question becomes: Should this practice be allowed to continue?