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European investors seem to be now discovering that exchange-traded notes (ETNs) offer a fresh twist on portfolio enhancement. But what is behind the growth of these new products?
The rise of ETNs in Europe
Exchange-traded notes are unsecured debt securities issued by financial institutions that promise to pay the return of a specific index or benchmark. Unlike exchange-traded funds (ETFs), ETNs do not own the underlying assets they track. Instead, they are a promise from the issuer to pay the holder the index’s return minus fees.
This structure allows ETNs to offer exposure to a wide range of assets, including commodities, currencies, and even complex investment strategies that might be difficult to replicate through traditional means.
Earlier this year, the London Stock Exchange allowed the listing of cryptocurrency exchange-traded notes (ETNs) to meet growing investor demand for regulated, secure exposure to digital assets. These ETNs integrated cryptocurrencies into traditional European financial markets, reflecting the increasing institutional interest in these assets. The move by the London Stock Exchange followed similar earlier moves by the Frankfurt Stock Exchange and the Vienna Stock exchange.
In all cases, the goal was to provide the markets with a structured, transparent investment vehicle, ensuring compliance with regulatory standards and offering a familiar platform for investors to engage with investment styles that they otherwise would not have been able to engage with. Cryptocurrencies only happen to be the most popular recent choices; current global trends go toward offering innovative financial products that cater to the evolving needs of all investors, and the flexible nature of ETNs helps to achieve this goal.
The ETN issuance process
Before limited to major banks, the process to issue ETNs is now open to practically any type of company. As CEO of a technology company venturing into the financial sector, Fabio Dias undertook the complex process of establishing a Special Purpose Vehicle (SPV) to facilitate innovative investment products.
The first step involved setting up the SPV as an independent entity, ensuring it had a distinct legal and operational structure. Recognizing the importance of regulatory compliance, Dias navigated the rigorous process of registering the SPV as an alternative investment manager with the UK Financial Conduct Authority (FCA).
This required extensive documentation, including detailed business plans, risk assessments, and compliance frameworks. Dias’ role was pivotal in coordinating these efforts, liaising with regulatory bodies, and ensuring that all operational protocols met the stringent standards required by the FCA.
To further advance the company’s strategic goals, Dias spearheaded the issuance of an exchange-traded note (ETN), choosing the Vienna Stock Exchange for its favorable listing conditions and growing reputation in the financial markets. This initiative necessitated a thorough understanding of the Austrian regulatory landscape, prompting a crucial trip to Austria.
During his visit, Dias engaged with a local legal expert to discuss the specific legal and regulatory requirements for listing on the Vienna Stock Exchange. These discussions covered topics such as disclosure obligations, investor protection measures, and compliance with European Union financial regulations. Dias’ leadership was instrumental in aligning the SPV’s operations with these requirements, ultimately leading to the successful listing of the ETN and expanding his company’s footprint in the European financial market.
Why European investors are turning to ETNs
According to Dias, European investors are attracted to ETNs for several compelling reasons. First, ETNs offer access to markets and strategies that might otherwise be difficult or costly to invest directly. For example, an ETN tracking a basket of rare earth metals provides exposure to this niche market without the hassles of physical ownership.
Secondly, ETNs’ tax efficiency in many jurisdictions makes them an attractive option for investors looking to optimize their after-tax returns. In most jurisdictions, ETN profits are taxed as capital gains, normally attracting a more favourable tax rate than dividends, which are taxed as income.
“One of the major advantages of ETNs is their potential for precisely tracking the underlying index. Without the need for the investor to hold and manage a portfolio of assets, ETNs can minimize tracking errors and provide investors with returns that closely mirror their chosen benchmark,” Dias shares.
Finally, gaining leveraged or inverse exposure to various indices allows for more sophisticated portfolio management and hedging strategies. That said, these benefits come with significant risks that investors must consider carefully.
Some ETNs, particularly those offering leveraged or inverse returns, can be highly volatile and may not be suitable for long-term holding as they have a high cost of carry. Market liquidity is another concern, as some ETNs may have limited trading volumes, potentially impacting an investor’s ability to enter or exit positions at desired prices.
Credit risk
Despite the stated benefits, if not planned correctly, the ETN structure also introduces credit risk, as the performance of an ETN is dependent on the issuer’s ability to meet its obligations. The choice of an SPV by Dias allowed the investors’ funds to stay legally segregated from his company’s main business and mitigate contagion risk, which was a very real concern for investors in ETNs issued by the now defunct Credit Suisse.
According to David Meyer from Meyer Wilson, a renowned national investor claims and class action law firm in Ohio, “the value of exchange traded notes is backed solely by the financial institution that issues them. This means that the safety and returns of your investment depend heavily on the creditworthiness and reliability of the issuer.”
“If the issuer faces financial trouble or goes bankrupt, the value of the ETN could be negatively impacted, regardless of how the underlying index performs. Therefore, knowing the issuer and their financial health is key to making an informed investment decision.”
ETNs as alternative investment vehicles
Technological advancements in the financial sector have accelerated the adoption of ETNs in Europe and other parts of the world, and this popularity is changing how people invest by offering investors a convenient way to gain exposure to various assets without direct ownership. However, ETNs carry credit risk, as they are unsecured debt obligations of the issuing entity. This means that if the issuer defaults, investors may lose their principal investment regardless of the performance of the underlying asset.
Understanding these risks is crucial for investors considering ETNs as part of their portfolio. “There is no doubt about it. ETNs can offer many benefits, but thorough research and careful due diligence are still needed when incorporating these into an investment strategy,” Dias concludes.
