The Securities and Exchange Commission (SEC) recently uncovered two new parts of rule-making proposals aimed at trimming risks in exchange-traded funds (ETFs). These proposals could drive investors into less well-regulated products such as exchange-traded notes (ETNs). Investors in ETNs can take on significant credit risk. The first proposal aimed to address liquidity concerns for the ETFs, mandating that no more than 15% of a fund’s holdings take longer than seven days to liquidate without moving the market. Exchange traded funds are investment funds traded on stock exchanges, much like stocks, and tracks and trades its net asset value over the course of the trading day. They are not typically meant to be held for a long period of time. The proposal requires mutual funds and ETFs to implement liquidity risk management programs and enhance disclosures regarding fund liquidity and redemption practices. This will mean it could be difficult for the funds to hold certain financial classes.
The second proposal unveiled by the SEC in December aimed to address derivatives usage by limiting the leverage in funds. It would limit funds’ use of derivatives and require them to put risk management measures in place which would result in better investor protections. This proposal could put a majority of levered ETFs in violation, therefore driving investors to invest in alternate ETNs. ETNs are senior, unsecured unsubordinated debt securities issued by an underwriting bank. They also have a maturity date and backed only by the credit of the issuer. Although ETNs are an alternative to an ETF, they can be just as risky for investors. ETNs are regulated under a less stringent Securities Act and are unsecured debt obligations carrying a large amount of risk. There is also always a risk that the issuer could default and investors would lose some or all of their investments, as ETNs are not required to physically hold collateral. Some of the past defaults of ETNs include those sold by Lehman Brother. Many investors only recovered 9% of their investment following the crash and demise of the firm in 2008.
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