As Deutsche Bank faces regulatory scrutiny, with some observers warning that results could trigger the next Lehman Brothers event, investors who utilize exchange traded products, namely exchange traded notes, should be aware of the potential risks they face.
ETNs are not ETFs. Similar to index-based exchange traded funds, ETNs also track some sort of index as part of their investment strategy. However, an exchange traded note, like the name implies, is a type of debt note that pays the return on the underlying portfolio and trades on an exchange.
ETNs are debt securities issued by financial institutions that promise to pay the return of an index, minus fees and taxes. Consequently, investors are exposed to the credit risk or the possibility the underwriting bank goes bankrupt. The note can be vulnerable if the issuer gets into financial trouble, otherwise known as a default. With an ETN, an investor can lose some or all of their investment if the ETN issuer goes under.
In the case of Deutsche Bank, 20 DB ETNs, including the $347.9 million Deutsche Bank FI Enhanced Global HY ETN (NYSEArca: FIEG) and the $143.6 million DB Gold Double Long ETN (NYSEArca: DGP), could be in trouble. If Deutsche Bank goes under, then DB ETN investors would lose out on their original investment and could be left with little or nothing.
While not that big of a problem in the U.S. markets, Deutsche Bank’s Europe-listed synthetic ETFs, or Undertakings for Collective Investments in Transferable Securities (UCITS), could also cause investor’s headaches if the bank topples. UCITS hold securities that are unrelated to the benchmark index through derivatives or swap agreements with one or more counterparties who have agreed to pay the return on the benchmark to a fund. Essentially, returns are backed by a counterparty instead of the individual components out of a benchmark index.
Consequently, if a counterparty becomes unable to pay, the investor of the synthetic ETF could also lose money.
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