ETN Double Dipping With GAZ?

April 03, 2012

Is it fair game for issuers to loan their own ETN? Apparently so.


When TVIX reopened for creations last week, quite a few of us noticed an odd feature of the press release.

Instead of just opening the window, they were going to initially make shares available to an affiliate, who would then loan those securities out to short-sellers. Theoretically, this additional selling pressure would help keep TVIX from trading at too much of a premium.

This got us to thinking. How much money could an ETN issuer make by loaning out shares, rather than making them truly available, and why would any ETN issuer actually do this? It turns out, we already had a great example of this to dig into—and we mean dig. That example is GAZ, the iPath Natural Gas ETN (NYSEArca: GAZ).

GAZ has been closed since the fall of 2009, presumably because Barclays was hitting—or worried about hitting—position limits on its natural gas exposure.

Remember, that’s because GAZ, like TVIX, is an ETN. It doesn’t “own” anything. It’s just a promise to pay a pattern of returns that looks just like a long position in front-month natural gas futures. To hedge that risk, ETN issuers back up each dollar of each ETN they issue with a dollar of exposure to the actual underlying—if they can.

So GAZ closed, because Barclays wasn’t comfortable—or wasn’t capable—of managing the hedge. Over time, the shares outstanding of the ETN declined slightly, as authorized participants redeemed shares, putting the actual shares outstanding below their peak.

They pretty much remained below that peak until a few weeks ago, when the premiums in GAZ went nuts.

Curious Creations in GAZ

The top blue line in the chart above is the shares outstanding. From the first of the year, positive flows have been some 680,000 shares in a fund that’s theoretically closed for creations.

If, for instance, the normal process had been in place, a third party could have shown up with cash for fair value, and then sold its shares at a greater-than-100-percent premium, pocketing enormous instant profits. But with the window closed, supposedly, nobody could do that.

Except, it turns out, Barclays Capital, the issuer.

A spokeswoman from BarCap declined to comment on activity surrounding GAZ.

But officials familiar with the ETN said that the creations implied by the rising share counts were in fact shares issued—effectively—to BarCap itself.

Now, BarCap didn’t sell these and profit the way an AP would. Instead, it loaned these shares out to short-sellers, who would then profit should the premium collapse (and let’s be clear, premiums pretty much always collapse eventually.)

For an ETN issuer, this is essentially a riskless transaction. After all, if BarCap holds the shares in its own account, it doesn’t need to hedge it, as it would only owe itself the ETN’s returns!



The most altruistic person might say that by making these shares available to loan, they’re helping collapse the premium, which in general is a noble goal. Most investors want their ETFs trading at fair value. Of course, if you’re a holder of GAZ at these premiums, you really, really don’t want the premium to collapse.

A less charitable person might look for a deeper motive here. Say, a profit motive.

When securities are loaned out, the borrower has to pay something to borrow those shares, generally known as the loan or rebate rate. If a security is hard to borrow—like GAZ, ever since it hit the Securities and Exchange Commission’s threshold list on Feb. 16—that rate can be quite high.

Here’s what the average rebate rate was on GAZ:

Average Rebate Rate on GAZ


What this means is that for every dollar of GAZ loaned out, somewhere between 2 and 8 cents would be earned by the lender over the course of a year. So BarCap is collecting a fee somewhat like this for the shares it shorted from its own inventory.

The numbers above come from a Wall Street source, and represent an average of existing reported loan positions.

By our math, the excess shares created by BarCap for their own account right now are worth roughly $2.4 million—not an enormous position by Wall Street standards.

That said, on that $2.4 million position—valued at the inflated market price—BarCap is earning vastly more in fees than it’s earning from its management fee on GAZ, or 0.75 percent, which is assessed on net asset value.

To put things in perspective, here’s the difference in cumulative fees that would be collected on this loaned position.


Theoretical Loaned Position on GAZ


A few things to note: First off, we are not talking about large dollars here. Nobody’s buying yachts on the management fee or the loan fees on a few hundred thousand shares of anything.

But what’s curious here is the bizarre misaligned incentives.

Generally speaking, we expect our investment managers to be on our side. We imagine green-eyeshade portfolio managers investing right along with us.

But in this case, it would actually be better for BarCap to have its ETN at an enormous, short-inducing premium, and continue to issue shares to itself to loan. Not only are there no hedging costs, because it owns both the asset and the liability, but there’s quite literally no downside for BarCap: If the ETN premium collapses, short-sellers will simply return the borrowed shares. If the premium doesn’t go away, it will collect the fees indefinitely.

The only people in this equation who can really make out like bandits are the short-sellers.

By inventorying and loaning shares to short-sellers, issuers like BarCap and Credit Suisse, and presumably others, are indeed helping suppress premiums, but they’ll also be profiting from the shareholder losses of their long holders while enriching the short-sellers.

Is this illegal? While I’m not a lawyer, I seriously doubt it. Companies maintain inventories of their own products all the time.

I do find the alignment of incentives here, however, to be curious, and honestly, a bit troubling.


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