A high drama is currently playing out in a small corner of the financial markets, perhaps the last place that any ordinary investor – as a Hollywood producer – might think to see.
While many of the details are knee-jerk in financial market jargon, from short coverage to triple charges with exchange traded notes, some observers think it’s a pretty simple story to tell about the dangers for investors in unregulated segments of ‘ the market – especially when combined with risky trades.
In this case, a wrong way that might have worked out in a few weeks or months, ran out – or was forced – out of time. About $ 2 billion has been lost, according to one estimate. And one observer thinks that much of the situation was manipulated, perhaps by someone taking revenge.
At the center of it all is an arcane product called a note with exchange. Notwithstanding the agreement in name with exchange-traded funds, ETNs are essentially bonds, mostly issued by banks. This particular note, the VelocityShares Daily 3X Inverse Exchange Traded Note DGAZF,
, was issued by Credit Suisse, and represented a bet on natural gas. It attracted investors who thought the price would go up, and those who thought the price might go down: short sellers.
DGAZF publisher Credit Suisse decided in mid-July to withdraw several of its ETNs from the stock exchanges where they trade. That step is not too unusual, said Dave Nadig, chief investor and director of research at ETF Flows. Being listed on an exchange – for DGAZF, it was the New York Stock Exchange – requires paying a certain amount in fees, being responsible for certain administrative and regulatory tasks, and so on.
But if an ‘exchange-traded product’ is no longer, well, traded on an exchange, it may prove to be problematic for investors. That’s because any trading product that is not on an exchange is fully marketed, Nadig told MarketWatch, a process he calls “dragging a product that represents liquidity and transparency into the wild, wild west of financial markets.”
There are currently about 30 ETNs trading over the counter.
When ETNs are removed, their value generally declines considerably, reflecting their new lack of liquidity and tradability. Still, the infrastructure of the market maker that supports the exchange of the exchanged product world usually manages to collect many of the excellent shares and return them to the issuer in an orderly manner.
But when Credit Suisse wrote off DGAZF, things got complicated. That’s because at the time it happened, there was a remarkably short position of 130,000 shares.
Short sellers who believe that the price of an asset will drop make their bet by borrowing shares of that asset from someone else. If the thesis is correct and the share price decreases, the short seller can buy shares at the new, lower price and pocket the difference. But when the price goes up, the short seller gets “pressed:” he or she then has to buy back shares at a higher price.
When DGAZF was delisted, Nadig believes, someone knew who had the excellent short position on DGAZF, and decided to squeeze them.
“If you have 100,000 shares short and someone knows that, and they can manipulate the price on the OTC, then they can force a margin call on you,” Nadig said. And indeed, “someone” was willing to manipulate the price.
DGAZF Awards, Thanks to Dave Nadig / ETF Flows
Over the course of a few days, the price of an ETN share rose from $ 125 to $ 25,000.
This happened on trading of only a handful of stocks, with extremely thin volume, and for Nadig that seemed suspicious. “The only scenarios I can think of are just algorithms, say a momentum model that buys and sells for no good reason – or a man with a vendetta against a short seller.”
If that sounds damn good, one confirmation for Nadig’s theory – and he’s coming down hard on the “broken man”, not “broken algo” – is that the higher price for the notes represents an opportunity for anyone who really invests in a long position to get money out of a product that will only lose its liquidity and value as the trade continues to decline.
In fact, trade will not just disappear. On August 12, Credit Suisse announced that they would call the note at the end of August. This means that trade will stop altogether and ETN holders will receive fair value with effect from August to August. Meanwhile, the regulator responsible for such trade, FINRA, has stopped all trade.
Creidt Suisse declined to comment for this article. FINRA confirmed that “DGAZF was stopped on 8/12 at 4:01 am according to FINRA Rule 6440 / extraordinary event stopping provision and factors considered”, but further comment declined. The SEC, the regulator responsible for exchanges, and the New York Stock Exchange both declined to comment.
Observers of financial markets and exchanged products have taken to Twitter in recent days to express wonder – and anger – about what is happening.
In a research note published on Friday, I3 Dusaniwsky, S3 Analytics, noted that the more than 2000% share price short sellers cost about $ 2 billion in mark-to-market losses. DGAZX is the 15th most-short exchange-traded product, Dusaniwsky said.
“Perennial volatile stocks like Tesla TSLA,
and sudden volatile stocks such as Kodak KODK,
and DGAZF highlight the need for strong risk management when shorting equities, ”said Dusaniwsky. The price movements seen in DGAZF “were potential widow-makers. While a long-term shareholder can only lose what they invest or borrow, a loss of a short-term investor can be technically infinite. As we see in DGAZF and KODK, these losses can be sudden and massive. ”
“If you were a long-time keeper, this is great,” Nadig said. ‘But if you were long, you already had a chance to sell more. If it is suspended for trading over the next two weeks, we have some interesting questions. If I’m short and I can not buy it, I literally have no structural way to cover my short. And I have no idea what the (heck) happens then. Around the street, 130,000 shares are being recalled, none of which can be recalled because there is no way to buy back the shares. ”
What’s the takeaway? “It’s just bananas,” Nadig said. “It would be illegal for a patent to send an exchanged product to an unregulated market. It should be illegal to stop a mention. Writing it down should mean that you call the note. ”
Next read:Are ETFs safe … for retail investors?
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