September 01, 2006

Exchange - Traded Notes

Barclays Bank PLC, a division of Barclays PLC, won approval from the Securities and Exchange Commission (SEC) to launch a new kind of security that straddles the line between structured debt and ETFs. Dubbed " i Path ETNs," the new products trade like ETFs but use a debt-based struct u re that changes the tax implications, risks and arbitrage opportunities on the funds.

So far, Barclays has rolled out three ETNs: one tied to the total return version of the Goldman Sachs Commodity Index (ticker: GSP), one tied to the total return version of the Dow Jones AIG Commodity Index (ticker: DJP) and one tied to the Goldman Sachs Oil Total Return Index (ticker: OIL). The funds trade on the NYSE.

In a traditional ETF, share holders own a stake in the underlying assets, and if you hold enough shares, you can (through an Authorized Participant) redeem those shares directly from the fund for the corresponding value of said assets.

That is decidedly not the case with the iPath ETNs. The iPath ETNs are debt instruments. When you buy an ETN, you are buying a senior debt note from Barclays PLC, where b y B a rclays promises to pay you the exact return of the underlying commodity index-minus an expense ratio of 75 basis points per year.

The primary functional difference between ETFs and ETNs lies in the different kinds of risk that investors take on when they buy the products. With ETFs, investors take on "tracking risk"-the risk that the underlying assets will not accurately track the intended benchmark. With ETNs, Barclays guarantees that the ETNs will track their benchmarks, so there is no tracking risk. Instead, investors take on "credit risk"-the risk that Barclays won't pay up on its promises.

There are other important differences that investors must consider. For instance, there is no guarantee that there will be a liquid market for the ETNs, although Barclays says it will engage in "limited trading" to support the notes. (Investors should keep a close eye on spreads.)

One further uncertainty for the notes involves their tax status. According to Barclays, "[t]he United States Federal income tax consequences of an investment in the iPa t h ETNs are uncertain." Barclays believes that investors will only pay capital gains taxes when they sell the funds, with no possibility for distributions in the interim. That would be quite attractive ... if it holds up at the IRS.

It's not clear how Barclays plans to separately market its ETNs and ETFs, particularly when they cover the same product. For instance, as we went to press, Barclays received approval for an ETF linked to the Goldman Sachs Commodities Index. It's not clear how Barclays will distinguish that product from the existing ETN linked to the same index.

Baker To SEC: Get Moving

Rep. Richard Baker (R- La.) has a message for the SEC: Get moving on ETFs, or the ETF industry will get moving overseas.

The blunt-speaking congress man, who chairs the Congressional Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, has a history of prodding the SEC on competitive issues. He famously called Regulation NMS "the worst public policy I have seen in my nearly two decades in Congress."

In his latest move, Baker told the SEC that it needed to develop stand a rdized rules on approving ETFs, and to create a dedicated staff whose only focus is on the ETF industry.

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