Dislocations highlight risks of commodity ETNs

Notes face scrutiny after problems with Barclays’ OIL and GAZ products

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ETNs provide investors with access to commodity markets, but may have structural issues

  • In several recent cases, banks have halted creations of exchange-traded notes (ETNs) linked to commodity prices, leading to deviations between the market price of the notes and their underlying index.
  • Critics of ETNs say they are less robust than exchange-traded funds (ETFs) or exchange-traded products (ETPs), which hold actual assets, such as futures, to connect their value to the underlying commodity, and which have multiple authorised participants that control supply and demand.
  • ETNs, in contrast, are uncollateralised debt securities that can be redeemed for a value tied to a particular index.
  • Regulation around ETNs tends to be looser than for ETFs and ETPs. European Union rules have generally encouraged the use of ETPs rather than ETNs, making ETNs a mostly US phenomenon.
  • Some market observers say there is an emerging trend in which banks have been closing down ETNs, possibly as a way to reduce credit exposure.

Early this year, strange things started happening to one of Barclays' popular exchange-traded notes (ETNs) for tracking the price of oil. The iPath S&P GSCI Crude Oil Total Return Index ETN – better known as OIL, its ticker on the NYSE Arca exchange – started trading at a huge premium to its underlying index. In the three weeks from December 31 to January 20, the index plunged 35% while the market price of OIL fell just 12%.

It is unlikely that most investors noticed the dislocation, though, until Barclays released a statement on January 20 explaining what had happened. As it turned out, the ETN had begun trading at a premium to the index after the bank had limited the creation of shares. That, in turn, had impacted the creation-redemption mechanism that keeps the ETN in line with its underlying index.

"Due to the current market dynamic in the sale by the issuer of ETNs from inventory, there are likely to be continued fluctuations in this premium if strong interest from exchange participants in purchasing the ETNs continues," Barclays said in the statement.

"The secondary market premiums for the ETNs have been volatile, however, and investors should not assume that the ETNs will continue to trade at a premium in relation to their intraday indicative value," it added.

Indeed, the premium narrowed sharply after the statement came out and market participants realised what had happened. From January 20–22, the note's indicative value jumped 21% to $4.49 and its traded market value fell 12% to $4.83, according to data from Barclays and NYSE Arca (see figure 1).

figure-1-oil-dislocation

Such incidents have drawn attention to the quirks of ETNs, which offer fewer regulatory safeguards than their close cousins, exchange-traded funds (ETFs) and exchange-traded products (ETPs). With both ETFs and ETPs, entities called ‘authorised participants' buy or sell securities as needed to keep the price of the instrument in line with its net asset value. But with ETNs, only one entity can perform this task: the issuer of the note. That means the risk is entirely concentrated in one spot, and if the issuer decides to halt creations, the note's price can become detached from the index it is designed to track.

"When you do that, you seriously distort the price of the note," says Towsend Lansing, London-based head of exchange-traded commodities at asset management firm ETF Securities. "ETNs, unlike ETPs, have a built-in capability of shutting down this creation mechanism."

Barclays declined to comment, but Lansing suggests the bank halted creations of OIL because of an unwillingness to put more risk on its books. "It's possible this sort of thing happens when the desk is struggling to create exposure," he says.

The ABCs of ETNs

An ETN is an unsecured debt obligation of its issuer, typically a bank. In contrast to ETFs or ETPs, which actually hold securities or futures contracts that tie them to the underlying markets they track, ETNs stay in line with their underlying markets because of the issuer's willingness to redeem them for their so-called ‘indicative value', which is calculated and published each day.

There are pros and cons to such a structure, experts say. Among the negatives, investors can expect to lose all their money if the issuer goes under, due to their uncollateralised nature. Positives, meanwhile, may include favourable tax treatment under US law.

"From an investment standpoint, one of the distinguishing characteristics of an ETN is that the holder of an ETN is exposed to the credit of the issuing bank," says Brian McCabe, a Boston-based partner at law firm Ropes & Gray. "ETNs may also be more efficient from the standpoint of US income taxation, as ETNs are not required to pay interest or dividends."

As long as the issuer is willing to create and redeem notes to keep the supply of ETNs in line with demand, ETNs can track their underlying index smoothly. But if the issuer throws in the towel, imbalances between supply and demand can emerge, leading to price distortions.

In June 2015, for example, Goldman Sachs closed its GSC Connect S&P GSCI Enhanced Commodity Total Return Strategy Index ETN to creations. The note, which trades under the ticker GSC, tracks a variant of the S&P GSCI – one of the oldest indexes for commodity investing, formerly called the Goldman Sachs Commodity Index, based on a weighted average of 24 commodities. In the year since Goldman stopped creations of GSC, the instrument has experienced intermittent distortions in which its indicative value and market prices have deviated by 1–3%, usually for no longer than a day or two at a time, according to data from Chicago-based research firm Morningstar.

A more dramatic example of an ETN dislocation involves another Barclays product, the iPath Bloomberg Natural Gas Subindex Total Return ETN, which tracks an index of front-month US natural gas futures. Barclays halted creations of the note – known by the ticker GAZ – in August 2009. Subsequently, the note began trading at massive premiums to its index, in episodes lasting for months at a time. On March 16, 2012, for instance, the market value of GAZ hit $5.91, a premium of 233% over its indicative value of $2.53. Barclays released a statement in May that year warning the notes were "currently not suitable for most investors".

ETNs: a history

Commodity ETNs have existed for a little over a decade. One of the oldest and largest is the iPath Bloomberg Commodity Index Total Return ETN, launched by Barclays in 2006. The note offers exposure to the Bloomberg Commodity Index – another broad, multi-commodity index, formerly called the Dow Jones-UBS Commodity Index – and trades under the ticker DJP. It has about $806 million in assets under management (AUM).

Other ETNs that have been around for some time include Goldman's GSC, which was launched in 2007 and has some $115 million in AUM, and Barclays' OIL, which was launched in 2006 and – despite the problems it experienced in January – has $761 million in AUM.

Commodity investing experts describe ETNs as relatively simple for banks to launch. Unlike ETFs or ETPs, they do not require the creation of a special-purpose vehicle (SPV) to hold the underlying assets. They also face lighter regulation.

Lansing, at ETF Securities, says ETNs came into being because banks wanted to get access to commodity investor flows – so they just put them on their balance sheets. "Launching an ETN is easier than pulling together an ETP, which has stricter rules around collateralisation," he says. "Buying an ETN also offers easier access for some investors. Distribution is also easier in some cases. The market is large enough that there are enough clients out there who want to invest in ETNs."

The looser rules mean ETNs are easier to bring to market, says Sal Gilbertie, president, chief investment officer and co-founder of Teucrium Trading, a Vermont-based issuer of ETPs linked to agricultural commodity prices. "Generally, there just needs to be permission from all parties involved to issue the debt, as opposed to ETFs, which have a much more rigorous regulatory process to go through because they are considered separate entities," he says.

Commodity ETNs are predominantly a US phenomenon. In the European Union, the rules governing which funds may be distributed across the EU – called Undertakings for Collective Investments in Transferable Securities (Ucits) – do not cover ETNs. That has kept ETNs a relatively limited part of the commodity investment landscape in Europe and encouraged the development of ETFs and ETPs instead, market participants say.

"In Europe, most ETFs are Ucits, which provides strong rules on structure and selling, but ETNs aren't covered by Ucits," says Hector McNeil, co-chief executive at WisdomTree Europe, a London-based ETF sponsor and index developer.

Still, Europe has a few ETN success stories. McNeil points to the ETFS Brent 1mth (OILB) and ETFS WTI 2mth (OILW) notes, which were designed to provide exposure to North Sea Brent and West Texas Intermediate crude oil prices, respectively. Crafted by ETF Securities and structured as unsecured debt securities of a subsidiary of Royal Dutch Shell, OILB and OILW were among the first oil ETNs to be listed and are still among the most actively traded in Europe, McNeil says.

Looser rules

In the US, ETNs face a lighter regulatory regime than ETFs and ETPs, even though investors may be only dimly aware of the differences between them.

The gold standard for US securities regulation is the Investment Company Act of 1940, which governs mutual funds and many stock-market ETFs listed on US markets. Often called the '40 Act, the law includes a variety of disclosure and governance provisions, enforced by the US Securities and Exchange Commission (SEC). Commodity-linked ETFs and ETPs, however, generally do not fall under the '40 Act. Instead, they will typically register with the US Commodity Futures Trading Commission (CFTC) as commodity pools, a structure in which multiple investors combine their funds to trade futures.

Meanwhile, ETNs are neither registered investment companies under the '40 Act nor commodity pools. The main regulatory safeguard for ETN investors is that ETN listings must be carried out in compliance with the Securities Exchange Act of 1934, which governs secondary trading of securities.

"The SEC looks at ETNs differently than ETPs," says Lansing at ETF Securities. "When [issuers] tried to launch ETPs, they were taken to the SEC as an SPV, but because the structure of the ETP fell between the ETN space and the futures space, the SEC wasn't completely comfortable. Hence the US still has ETNs, while Europe has ETPs."

Besides the different regulatory treatment, the structure of ETPs includes various safeguards that ETNs lack. ETPs are structured as debt issued by an SPV. The SPV's sole purpose is to issue the ETPs, and the only assets the SPV holds are the derivatives used to provide the ETP performance and the collateral held for counterparty risk management. The SPVs also tend to have a trustee who acts on behalf of the ETP holders as another layer of protection.

WisdomTree's McNeil characterises ETPs as the modern version of ETNs. "They are both debt products, but ETPs have developed to provide more information from a regulatory standpoint, particularly at the prospectus level," he says. "The most robust ETPs don't rely on a company's balance sheet alone; instead they use orphan SPVs and are collateralised to further guard against counterparty risk."

Closing down

Lately, some banks seem to be pulling back from the ETN business. In June last year, Royal Bank of Scotland (RBS) closed down 13 of its ETNs, including its entire offering in the US and seven commodity ETNs. In a statement, the UK bank described the move as "a consequence of [its] exit of the structured retail investor products business".

Then on January 20, UBS announced the mandatory redemptions of two of its ETNs linked to master limited partnerships (MLPs), after distress in the MLP sector triggered "acceleration events" in the structure of the notes. The MLP structure is most commonly used in the US energy sector, particularly among midstream companies.

"There appears to be an emerging trend where uncollateralised ETNs are being closed, especially in the US," McNeil says.

Gilbertie at Teucrium attributes the trend to regulatory pressure. "One of the problems in the market now is that regulations are forcing banks to treat all credit obligations on their balance sheets differently, so some banks are scaling back their ETN operations," he says.

Would the disappearance of ETNs be such a bad thing, though? Gilbertie thinks there are better ways to provide investors with access to commodity prices. "This lack of collateralisation means that the ETN is a debt obligation and the products are not transparent," he says. "You don't know what the bank is hedging against. It's totally non-transparent."

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