A high drama is playing out in a small corner of the financial markets right now, in perhaps the last place any ordinary investor — or Hollywood producer — might think to look.
While many of the details are knee-high in financial markets jargon, from short covering to triple leveraged exchange-traded notes, some observers think there’s a fairly straightforward story to be told about the dangers for investors in unregulated segments of the market – especially when coupled with risky trades.
In this case, a wrong-way bet that might have worked itself out over a few weeks or months ran — or was forced — out of time. About $2 billion has been lost, according to one estimate. And one observer thinks much of the situation was manipulated, perhaps by someone seeking revenge.
At the center of it all is an arcane product called an exchange-traded note. Despite the similarity in name to exchange-traded funds, ETNs are essentially bonds, usually issued by banks. This particular note, the VelocityShares Daily 3X Inverse Exchange Traded Note , was issued by Credit Suisse /zigman2/quotes/202835784/composite CS +1.97% , 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’s issuer, Credit Suisse, decided in mid-July to pull several of its ETNs from the stock exchanges on which they traded. That step isn’t too unusual, said Dave Nadig, chief investment officer 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 when an “exchange-traded product” is no longer, well, traded on an exchange, it can wind up being problematic for investors. That’s because any tradable product that isn’t on an exchange winds up on the over-the-counter market, 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 delisted, their value generally drops considerably, reflecting their new lack of liquidity and tradability. Still, the market-maker infrastructure that underpins the exchange-traded product world usually manages to gather much of the outstanding shares and redeem them back to the issuer in an orderly fashion.
But when Credit Suisse delisted DGAZF, things got complicated. That’s because at the time it happened, there was an outstanding short position of 130,000 shares.
Short sellers who believe the price of an asset will go down make their bets by borrowing shares of that asset from someone else. If the thesis is correct and the share price declines, the short seller can buy shares at the new, lower price and pocket the difference. But if the price goes up, the short seller gets “squeezed:” he or she must then buy back shares at a higher price.
When DGAZF got delisted, Nadig believes, someone knew who had the outstanding short position on DGAZF, and decided to squeeze them.
“If you’re 100,000 shares short and someone knows that, and they can manipulate the price on the OTC, they can force a margin call on you,” Nadig said. And indeed, “someone” was willing to manipulate the price.
Over the course of a few days, the price of a share of the ETN surged from $125 to $25,000.
That happened on trades of just a handful of shares, with extremely thin volume, and for Nadig, that seemed suspicious. “The only scenarios I can imagine are just runaway algorithms, say a momentum model that’s buying and selling for no good reason — or a human being with a vendetta against a short seller.”