VelocityShares Daily 2x VIX Short-Term ETN (NYSEArca: TVIX) was down as much as 30% at one point in afternoon trading Thursday. The volatility-linked exchange traded note was sharply lower even as the CBOE Volatility Index, or VIX, was up roughly 5% in the final minutes of trading.

The divergence between the 200% leveraged ETN and the VIX initially puzzled some market observers and traders because the product is designed to rise along with Wall Street’s fear gauge.

However, as ETF Trends reported last month, the issuer for TVIX, Credit Suisse, halted new share creation. [Credit Suisse Suspends Volatility ETN Issuance]

Credit Suisse warned the temporary suspension of further share creation in TVIX “may cause an imbalance of supply and demand in the secondary market” for the ETN, which may cause the ETN to trade at a premium or discount in relation to indicative value. [Volatility ETF Trading Volume Jumps After TVIX Suspends Issuance]

Basically, TVIX has been trading similar to a closed-end fund since the halt of new share creation. The ETN has been trading to a premium to indicative value. Therefore, it is susceptible to swift drops like the one seen Thursday if the premium erodes. In other words, the ETN can be influenced by factors outside the movement of VIX futures.

Premiums or discounts are determined by demand – buying or selling pressure on the shares. For example, a natural gas ETN that suspended the creation of new shares, iPath Dow Jones-UBS Natural Gas ETN (NYSEArca: GAZ), is trading at a massive premium. [Natural Gas ETN Premium]

ETFs and ETNs have a complex “arbitrage mechanism” that typically keeps the price of a share in line with the net asset value. However, the feature breaks down when a fund isn’t creating new shares, so premiums and discounts can appear.

Thursday’s plunge in TVIX could bring more negative attention to ETNs. Earlier this week, investment researcher Morningstar published a strong warning on hidden ETN fees and risks. [Morningstar Sounds Alarm on ETNs]

Credit Suisse halted further creation of new TVIX shares in February due to internal limits on the size of the ETN.

Unlike exchange traded funds, ETNs are debt instruments issued by financial institutions that promise to pay the return of an index. Therefore, they introduce credit risk.

TVIX and other volatility-linked products are designed to track VIX futures contracts — not the spot price.

These funds can be hurt by so-called contango in VIX futures markets. [VIX ETFs: Beware Contango]

TVIX is linked to 200% of the daily performance of the S&P 500 VIX Short-Term Futures Index, minus fees. TVIX’s market cap was hovering around $400 million on Thursday afternoon following the steep decline, according to MarketWatch data.

ProShares Ultra VIX Short-Term Futures ETF (NYSEArca: UVXY), an exchange traded fund with a similar goal as TVIX, gained 2% on Thursday and has seen trading volume rise in recent weeks.

VelocityShares Daily 2x VIX Short-Term ETN

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