Is ETN investment a prevented fiasco?

By Lee Kyung-min

Leveraged crude oil exchange-traded notes (ETNs) are emerging as a risky financial investment to be monitored, following a near 14-fold increase in the net purchase of the derivative products in only about two months, Friday.

Buyers of the notes, a type of unsecured debt security that tracks an underlying index of securities, are seeking windfall gains from the difference in crude price between the current record low and a level they hope it will recover to.

The product is designed to pay buyers twice the price difference between purchase price and sell price.

Korea Exchange (KRX) data showed individual investors bought a net 380 billion won ($314 million) in U.S. West Texas Intermediate (WTI) ETNs in March, soaring more than five-fold from 70.2 billion won a month earlier.

The March figure is a near 14-fold increase from January when the amount was 27.8 billion won.

They were sold by four brokerages ― Shinhan, Samsung, Mirae Asset Daewoo and NongHyup (NH).

The oil price tanked in February and continued to fall through March to the record low, falling below 20 dollars per barrel due to an economic feud between two global oil powers ― Saudi Arabia and Russia.

Brent crude dropped to $22.58 a barrel, March 30, its lowest level since November 2002, while the price of WTI fell below $20 a barrel, close to an 18-year low.

The feud began after Russia rebuffed a production cut proposed by Saudi Arabia, the de facto leader of the Organization of the Petroleum Exporting Countries (OPEC). Saudi Arabia retaliated by slashing its April official selling prices and pledged to dramatically ramp up production, to which Russia instead of showing signs of compromise said it would “make their own decisions on what to do.”

Taking this as a sign of a prolonged conflict, many investors bought the derivative.

Yet, the short-term spike in sales has led to a liquidity shortage-triggered extremely high “disparate rate,” an industry term meaning a difference between the net worth of the product and the market value. This is measured by the difference divided by net worth times 100.

A liquidity provider, or a company that hopes to make a profit on the bid-offer spread by quoting both a buy and a sell price, usually manages the rate below 6 percent.

But as of Wednesday, the rate recorded by the four brokerages was between 35.6 percent and 95.4 percent, a figure “preposterous” to market watchers.

This prompted the Financial Supervisory Service (FSS) to issue its strongest warning on the product, the first of its kind since the agency implemented its three-level warning system as part of efforts to enhance consumer protection in June 2012.

“Despite the unreasonably high disparate rate, some people keep buying the risky products, jacking up the trading volume thereby causing a further spike in the already high rate,” the FSS said.

“The investor profit will be determined by net worth, not market value. Those bought at a price higher than the net worth price therefore are likely to see losses.”

Starting April 13, the FSS plans to sell the product whose rates are above 30 percent as of Friday, and therefore deemed far off the normal trading range. They will be sold at a preset price every 30 minutes.