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Outrage Over the TVIX Trounce: Greenberg

Sabine Scheckel | Stone | Getty Images

Forget too big to fail. The recent trouncing of VelocityShares Daily 2X VIX Short-Term ETN, better known by its symbol — the TVIX — is too complicated for most people to care.

What a shame.

This levered electronically traded note (ETN) is tied to the S&P 500 VIX futures, which measure the implied volatility of S&P 500 index options.

The very nature of what it is, as a derivative of a derivative, makes it too complicated for comfort. Add in the arcane nuances of ETNs, not to be confused with exchange-traded funds , you get full glazing over of the eyes.

That’s even after the TVIX’s trounce, which has caused its share price to fall by 60 percent in recent days — the biggest disconnect from reality (or “premium discount spike,” as the pros put it) of an ETN that anybody can remember.

Surely this must have sparked concern by the Securities and Exchange Commission.

Hardly, which gets to my outrage.

First a little background: The TVIX was created by Credit Suisse to give investors a chance to make a super-turbocharged bet on the VIX. It was generally doing what it was supposed to do until Feb. 22. That’s when Credit Suisse, without explanation, issued a terse press release saying that it would temporarily stop issuing new shares in the TVIX.

One of the hallmarks of exchange-traded notes and funds, if all goes well, is that there won’t be any interruption in the creation or redemption of shares to meet market demand. When Credit Suisse turned off the share spigot, the TVIX suddenly looked more like a closed-end mutual fund, with the price of its shares rocketing to a premium of its net asset value. (Which, of course, is not what its investors were buying.)

When that happened, the share pricing got out of equilibrium — until last Thursday, when it started collapsing. As the share prices fell, losing 30 percent on the day, Credit Suisse announced post-close that the company would temporarily start issuing shares again.

Rumors about the timing of the Credit Suisse announcement (who knew what when?) started swirling — as did people wondering why the shares continue to trade — and where the SEC was in all of this?

Or as I wanted to know: Why did the SEC approve this fund (and any like them) in the first place? After all, among the disclosures in the TVIX is this doozy, bold-faced and underlined in the prospectus: “The long term expected value of your ETNs is zero. If your ETNs are a long-term investment, it is likely that you will lose all or a substantial portion of your investment.”

This is where it gets good: An SEC spokesman, in response to my questions, said that “from the Securities Act standpoint, we don’t have the authority to weigh in on the merits of any particular offering or security; we are not merit regulators, so we don’t approve or disapprove offerings.”

Besides, the spokesman added, the TVIX, like all ETNs, is a debt instrument issued as a shelf registration by a “well-known, seasoned issuer.”

A debt instrument issued as a shelf registration by a “well-known, seasoned issuer”?! Ah, so the banks are using ETNs merely as some kind of esoteric way to raise cash for general corporate purposes?

That’s what it say in its prospectus, but as you might have guessed by now: It’s not quite that simple.

If you read on, the TVIX (and other ETNs) also say the cash may also be used “to hedge our obligations under the ETNs of the applicable series.”

What does that mean? Credit Suisse declined comment and Barclays Capital, another active issuer of ETNs, referred me to the prospectuses.

So I turned to David Nadig, head of research at Index Universe, who probably knows more about ETNs than most investors who buy them (he has a staff of 10 that actually reads the prospectuses.)

According to Nadig, the amount of cash raised is less about raising cash and more “to earn the fee...on the asset they collected.”

So, in effect, the banks are creating ETNs to raise cash that will generate fees. And they’re getting it done under the guise of plain vanilla shelf debt registrations with no questions asked because they are considered “well-known seasoned issuers”?

“They do skate through and live in a loophole,” Nadig says.

Nice!

And there lies my outrage: They’re gaming the system, and the SEC just turns its head because ETNs “are notes, and notes are debt instruments” and these banks are “well-known seasoned issuers.”

Why do I suddenly feel like it’s 2008 all over again — and that once again the regulators will turn a blind eye until after something bigger than the TVIX occurs?

Hard to say what bigger event may occur. It may be nothing more than the blowup of naive registered investment advisor or financial planner who used a leveraged ETNs as a way to hedge a client’s portfolio. Or perhaps something more systemic.

Whatever it is, this much is clear: The SEC will likely be the last to know — or at least to do something about it.

Questions? Comments? Write to HerbOnTheStreet@cnbc.com

Follow Herb on Twitter: @herbgreenberg

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Disclaimer

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