On June 12, 2015, the SEC issued a Request for Comment on Exchange-Traded Products (ETPs).12 The request addresses legal standards and other regulatory positions relating to the trading of ETPs, securities exchange listing standards, market pricing and arbitrage mechanisms. In the press release announcing the request, SEC Chair Mary Jo White noted the growing complexity of ETPs and that public input is being requested “to inform our evaluation of how they should be listed, traded, and marketed to investors, especially retail investors.”13 The request also invites comments on “how market professionals sell ETPs, especially to retail investors, and on investors’ understanding of the nature and use of ETPs.” The bulk of the request relates to exchange-traded funds, but there are some requests relating specifically to exchange-traded notes (ETNs), the key aspects of which are summarized and discussed in this article.
Arbitrage and Market Pricing
The request discusses the role of arbitrage by various market participants in generally keeping the market price of the ETP from diverging significantly from the value of the underlying asset. In an orderly market, ETN arbitrageurs accomplish this through redemptions, when the ETN is trading at a discount to its indicative value, or by selling the ETN in the secondary market, when the ETN is trading at a premium to its intraday indicative value.
The effect of arbitrageurs’ actions in minimizing any premium or discount between the trading price of an ETN and the value of the underlying asset (as reflected in its indicative value) is extremely important in understanding the regulatory relief that makes ETNs permissible. Issuers of ETNs are regularly “creating,” or issuing, new ETNs, and reselling ETNs that have been previously redeemed or repurchased. Due to the ongoing creations, the “restricted period” of the ETNs, for purposes of Regulation M, does not end until the ETN is called or matures. The affiliated broker-dealers of ETN issuers engage in market-making activities in the ETNs, constantly purchasing and selling ETNs in the market. Absent regulatory relief, redemptions by the issuer and market-making bids and purchases by the affiliated broker-dealer during an ongoing distribution (the restricted period) would constitute impermissible market manipulation under Regulation M.
In order to address these Regulation M issues, in 2006, Barclays Bank plc received the iPath no-action letter from the Division of Market Regulation, under which the SEC staff granted relief from Rules 102 and 101 of Regulation M for the redemption of ETNs by the issuer and the market-making activities of its affiliated broker-dealer.14 In the iPath Letter, the staff agreed that the availability of real-time pricing information for both the ETNs (due to their NYSE listing) and the underlying reference asset (index levels being publicly available in real time), plus the ability of arbitrageurs to redeem ETNs and purchase new ETNs, would prevent any significant differences between the trading price of the ETNs and the value of the underlying reference asset. Counsel for Barclays noted, however, that the arbitrage mechanism might not be effective for short periods of time due to, among other factors, supply and demand for the ETNs.15
Request number eight asks about arbitrage as it relates to ETNs. Among other items, that request asks “[h]ow is arbitrage affected by ETN issuers’ ability to suspend and restart issuances of notes at their discretion? How are arbitrage opportunities affected when an issuer suspends the issuance of its ETNs?”
The first part of this request begs the question as to why, in light of recent ETN litigation, an issuer would suspend and then restart issuances of its ETNs (unless the issuer enjoys dealing with plaintiffs’ lawyers).16 One ETN issuer, due to internal position limits, temporarily suspended issuances of its ETN. Within a few days, the issuer restarted issuances. Due to supply and demand, the ETN began trading at a significant premium to its indicative value. Once issuances were restarted, trading prices then quickly converged with the indicative value. Some investors sued, claiming that they were not adequately informed of this possible situation. The issuer prevailed in court, due, in part, to sufficient risk factor disclosure about this very possibility.
In response to the first question quoted above, the answer may be that a professional arbitrageur would likely be able to take advantage of this temporary premium due to a suspensin of issuances, but a retail investor might suffer great loss by purchasing at a premium and then being caught holding the ETN when the premium disappears. If an inexperienced ETN investor were to redeem its ETN at a time when a temporary premium exists, the redemption price would not reflect the premium.
Some issuers have temporarily suspended issuances of their ETNs and have not restarted them. Those issuers have issued several press releases warning that due to an imbalance of supply and demand in the secondary market for their respective ETN, the ETN either was trading, or might begin trading, at a significant premium to its indicative value. Typically, these issuers, in their press releases, have stated that they expect the premium to continue and to fluctuate. Consequently, the ETN would be unsuitable for most investors because the ETN will not track the price of the underlying reference asset in a consistent manner. The reason for this type of communication is most likely to warn away retail investors from the ETN.17 Arbitrageurs, however, are better equipped than retail investors to trade in this situation.
Whether during a temporary suspension of an ETN issuance followed by a resumption of issuances, or during a long-term suspension of an ETN issuance, the normal effect of arbitrageur’s activities in keeping the trading price and the indicative value close will be disrupted. Consequently, although arbitrageurs may be able to work the market to their gain, they will not be able to achieve price parity between trading prices and indicative values when an issuer is not creating new ETNs.
Request number 11 asks if investors or other market participants use intraday or closing indicative values for ETNs, and, if so, for what purpose. How does the intraday or closing indicative value differ from the market value of an ETN or its redemption amount?
The intraday and closing indicative values, which are issuer-calculated values of the ETN based on intraday and closing underlying reference asset values, respectively, and take into account the applicable investor fees at the time of calculation, are used by market participants as a close approximation of the redemption value of an ETN. Indicative values are one of the tools used by arbitrageurs and other investors in determining whether to hold, sell, purchase or redeem an ETN when there is a price differential between the trading price and the indicative value.
In February 2014, the Division of Corporation Finance, Office of Capital Market Trends, sent a “sweep” letter to various ETN issuers in which issuers were asked to improve their disclosure relating to, among other things, intraday indicative value, how intraday indicative value is calculated, why it is valuable to investors, and the relationship between intraday indicative value, the trading price and the redemption price. The sweep letter asked issuers to include a risk factor about the potential for the ETN trading at a premium or discount in relation to the intraday indicative value or redemption price of the ETN.18
Partly in response to the ETN sweep letter, ETN prospectuses clearly disclose the differences between the trading price, intraday indicative value and redemption price, and warn investors that they may not be able to take advantage of, and may actually lose money with respect to, price disparities between the trading price and indicative value. Investors are also warned that they are subject to market risk when they redeem their ETNs, because the redemption price will be set at the close of the trading day after their redemption request is accepted. Accordingly, if the ETN is trading at a discount (the trading price is less than the indicative value) and an ETN holder exercises its redemption right, if the trading price increases during the day after the redemption request is accepted, the ETN holder will have lost the opportunity to take advantage of the discount.
Exchange Act Exemptions and No-Action Positions
Request 19 focuses on the Regulation M relief provided by the iPath Letter, and if there are situations in which that relief should be limited.
The request asks about how the Regulation M relief should apply when the issuer has suspended ETN issuances, causing price disparity, as discussed above. The answer is simple – if issuances are suspended, there is no Regulation M restricted period and issuer redemptions and affiliated broker-dealer market making activities would not be in violation of Regulation M.
The request also asks whether the Regulation M relief should “be limited to ETNs where there is a clear, independent index, where there is no limitation on issuances or redemptions, or where an ETN’s secondary market price does not vary substantially from the relevant reference index? What effect would such a change have?”
The standards for an index or any other permissible reference asset underlying an ETN are set out in the listing rules of the relevant national securities exchange.19 Those rules set forth the minimum requirements for the underlying reference asset. In the case of an equity index, for example, the NYSE Arca Equity listing rules cover the minimum number of index components, minimum market value for each index component, minimum monthly trading volume, weighting limitations and component issuer Securities Exchange Act reporting requirements, among others. The listing rules also require that firewalls be maintained to generally prevent interference by broker-dealer personnel with personnel maintaining and calculating the index and that procedures be in place to prevent the misuse of material, non-public information. The rules do not prohibit linking an ETN to an index sponsored or calculated by an affiliate of the ETN issuer.
Given that ETNs must satisfy the NYSE Arca Equity Rules, and that the liquidity provided by an exchange listing was one of the key elements underlying the Regulation M relief provided by the iPath Letter, one wonders what the Division of Market Regulation means by a “clear, independent index” and what this proposed additional requirement could mean.
ETN issuers that are subject to an internal position limit include in the ETN prospectus disclosure about that limit, and related risk factor disclosure of how the trading price of the ETN may be affected if issuances are suspended due to reaching the internal limit. This is viewed as good disclosure, a clear warning to investors that, in the future, premiums or discounts to the indicative value may exist. Excluding these ETNs from the Regulation M relief would not only keep many ETNs out of the market, but also would cause existing ETN issuers that have reached their disclosed position limits to be forced to issue ETNs in order to continue to maintain parity between the trading price and the indicative value.
The suggestion that Regulation M relief should not be available to an ETN for which the secondary market price varies substantially from the relevant reference index is potentially unworkable. Not all ETNs trade at a premium or discount as a result of a temporary issuance suspension. ETNs with small market capitalizations may be partially illiquid, causing their trading price to deviate from their intraday indicative value. For example, in mid-March of this year, it was reported that one ETN traded at a 13% discount to its net asset value on March 16, 2015. That ETN had $6.49 million in assets at that time, and had only traded seven days in 2015 up to that date.20 If the Regulation M relief was denied to that ETN and others with sparse trading, the issuer would be punished for issuing an ETN that was not trading well.
The request casts a very wide net and, with respect to ETNs, seems to cover some of the same ground as the ETN sweep letter. Industry participants should respond to the requests and highlight how some of the suggested changes could be potentially damaging to the ETN market.