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March 01, 2013 at 10:10 AM
It’s been almost one year since the historic collapse of the VelocityShares Daily 2X VIX Short-Term ETN (TVIX). Within a matter of days, TVIX lost around 60% in value, wiping out traders who were making bullish bets on the VIX.
What went wrong?
Besides a depressed VIX taking down TVIX, its problems were stoked when its issuer, Credit Suisse, stopped creating shares. This almost immediately triggered further instability in the note’s share price.
Is another blow-up in the ETN market possible?
ETNs Are Not ETFs
Although ETNs and ETFs may resemble each other, they are far from the same.
Shareholders in an ETF have a claim on the assets, whereas ETNs are unsecured debt obligations. That means if the institution who issued the ETN goes bust, it’s likely the ETN will follow suit. This is what’s referred to as “credit risk.”
What about the comparisons of ETNs to traditional bonds?
Unlike bonds, ETNs do not generally distribute any interest payments to investors.
Instead, the issuer promises to pay the ETN owner an amount that’s determined by the performance of the underlying index or benchmark on the ETN’s maturity date (usually two or three decades from issuance), minus any specified fees. As a result, the money invested in ETNs gives issuers a cheap source of capital, since they don’t have to pay noteholders for assuming credit risk.
No wonder financial institutions prefer raising capital via ETNs versus traditional bonds!
Other Risks
ETN credit risk is just the beginning of potential shareholder risks.
