Subject: Derivatives - Exchange Traded Notes

Last-Revised: 18 July 2010
Contributed-By: Vincenzo Desroches of Forex Charts

Exchange Traded Notes (ETNs) are a derivative issued by banks to track the performance of some market index. Like a stock or exchange-traded fund, an ETN trades daily on an exchange. These derivatives were first issued in 2006 by Barclays Bank and now are issued by many different banks. An ETN has some similarities to an Exchange Traded Fund (ETF) as well as significant differences.

This security resembles a bond in that it is a promise to pay at some future maturity date, but any further similarity stops there. The fund does not actually own any underlying security, as with an ETF. The ETN is a prepaid contract that tracks its underlying index minus an annual management fee. There are no payments or distributions until maturity. Since appreciation is accumulated based upon an index, share values in the notes do not fluctuate with market interest rates as with bonds. Much like a bond, the value of the security depends heavily on the issuer.

The IRS has yet to rule on these securities, but it has been taken for granted that, due to the prepaid nature of the security, gains at

maturity will be capital gains, generally subject to more favorable tax rates compared to ordinary income. ETFs, on the other hand, must make annual distributions of dividends and any capital gains realized when the fund is re-balanced must also be passed through to the investor. Owners of ETN shares may defer tax impacts until maturity or whenever their shares are sold in the market. However, if the IRS were to change their present position, then share values could also be impacted.

ETN shares also trade daily as with ETFs, but in this case, the issuer of the security is the buyer of record. Also, large institutional positions of material size may only be liquidated weekly. There is also something called "tracking error" that relates only to ETFs. Since underlying assets must be bought and sold continually for ETFs, there may be a small difference between market-based and actual return. These amounts may be in the 1% range, but they do not exist with ETNs.

There is one downside that must be considered. Just as currencies fluctuate on forex charts due to credit fundamentals, share values in ETN's will react to changes in the credit worthiness of the underwriter. These changes may result from formal credit rating changes or from any market perception of increased risk. Barclays Bank, the original issuer of ETN's, may be safe, but the banking crisis of 2008 demonstrated that no one is too big to fail.

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