Barclays is a British bank with over $1.7 Trillion in assets and is regarded as one of the most prestigious firms in the financial world.
They do everything from advesing on mergers and acquisition, underlying IPOs and operating a global franchise of consumer and corporate banking services. In this article, we are going to focus on their structured products division specifically their exchange traded notes (ETNs) under the iPath brand name. ETNs are very similar to ETFs .
Over the years Barclays have built a very successful bussiness of FTNs which have more than $100 Billion in asset under management (AUM). One of their most popular ETNs is the $VXX which tracks the prices of short term VIX futures. This product is very porplar among investors who wants gain exposure to the VIX either for hedging purpose or as a pure speculation. Barclays makes money by charging a 0.9% fee to holders of the ETN.
This a usually considered a very safe business, As it doesn't matter whether the ETN goes up or down in value either way Barclays collect their fee, So you might be surprised to hear that they recelty announced a 450 million-pound ($591 million) hit from their ETN division. This loss is so catastrophic that they are forced to suspend their pre-planned share repurchase plan as they have to instead divert cash to cover this loss. You would think that these unexpected losses are the result of recent market volitily but No, it was purely the result of gross incompetence on the part of the bank's employees.
To understand more deeply, Let us first understand the difference between ETFs and ETNs. ETNs are structured products that are issued as senior debt notes, while ETFs represent a stake in an underlying commodity. ETNs are more like bonds in that they are unsecured. ETFs provide investments into a fund that holds the assets it tracks, like stocks, bonds, or gold.
Because ETFs are backed by hard assets there's pretty much no risk of defaulting. But an ETN function very differently the issuer in this case Barclays promises to pay you cash at some future date the cash payment is linearly related to the performance of some index. As long as everything is functioning properly an ETN and ETF would be completely identical because they both target the exact same market exposure. From the issuer side an ETF is an asset and an ETN is a liability.
In the case of $VIXX, it is meant to track the performance of short-term fixed futures basically Barclays is promising to pay holders of $VIXX a cash payment based on the value of an index of short-term Vix futures in normal times. If the index goes up the payment it has to make to the holder's increases to hedge this risk so they go into the futures market and buy vix features exactly equal to the value of their liability if the futures increase in value their liability from the vxx etn increases but their portfolio of fixed features increases by the exact same amount this way they have a net zero position so for all practical purposes it's completely safe however let's say there's another financial crisis like 2008 and the bank is pushed to insolvency due to risk it took on from other parts of its business if barclays were to go bankrupt you could theoretically get a situation where they have to liquidate all their assets and they may not have enough money to make good on their obligation to vxx holders his goes back to the point of etns being liabilities, not assets.
Because of this the SEC requires issuers like Barclays to register beforehand how many shares of the etn they plan to issue this requirement to register with the SEC is where the problem arises over the past couple years the $VXX ETN has grown in popularity, As more investors want to buy in Barclays issues new shares as the number of shares grows they're supposed to increase their registration with the SEC as it turns out Barclays did not increase their registration and the number of shares exceeded the allowed amount there's no obvious reason that they didn't increase their registration the bank is well-capitalized and the SEC almost certainly would have approved the increase it appears that their employees were probably just lazy and completely forgot to file the necessary paperwork so what does that mean for the bank under U.S securities laws when they issue an ETN without properly registering it the buyer of the ETN has a so-called right of rescission this means that Barclays is obligated to buy back the ETN at their original price of issue.
The $VXX has not been doing very well recently at the current market price:
The worst part about this was it was completely avoidable there wasn't anything wrong with the product itself it was purely the result of incompetence on the part of Barclay's employees once they found out about the problem they froze the issuance of new shares in an attempt to stop the bleeding.