Schwab May Issue Warning on Exchange-Traded Products

Discount brokerage Charles Schwab Corp is reviewing whether to add a warning when a customer is about to trade certain exchange-traded products, in one of the strongest warnings yet for retail investors about these esoteric securities.

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The move follows the sudden plunge in an exchange-traded note called VelocityShares Daily 2X VIX Short-Term ETN, or TVIX, which lost 60 percent of its value in a short span of March.

"It is under review, primarily because of the risk we saw in things like the TVIX. No one knew that those kind of things were going to happen," said Randy Frederick, managing director of trading and derivatives at the Schwab Center for Financial Research in Austin, Texas.

The warning would be similar to one that pops up when investors trade options related to volatility, which are more complex than stocks.

The note, which pops up at the final verification stage of a trade, will serve as "a last warning to say, 'Hey, make sure you know what you are doing. If not, call us and we will explain to you,'" Frederick said.

Schwab's review and consideration of a warning for investors is significant because it comes at a moment after federal and state regulators have zeroed in on volatile trading and other activity involving exchange-traded notes.

REGULATORS CIRCLING ETNs

The Financial Industry Regulatory Authority, the U.S. regulator that oversees the sale of investment products to investors, is investigating how companies are marketing exchange-traded notes. A FINRA spokeswoman told Reuters on Thursday that the regulator is "looking at the events and trading" activity surrounding a sharp drop in the price of the TVIX, an exchange-traded note designed to track stock market volatility.

Massachusetts' top securities regulator is also looking into problems with the TVIX, a spokesman for Secretary of the Commonwealth William Galvin said.

The U.S. Securities and Exchange Commission is conducting a preliminary review into the volatile trading of the ETN, The Wall Street Journal reported on Thursday, citing people familiar with the matter.

Credit Suisse, the issuer of TVIX, stopped creating new shares a month ago as investors scrambled into this and other volatility-linked securities to bet on an increase in more market gyrations down the road.

The price of TVIX dropped about 60 percent in just two days last week on news that Credit Suisse would start issuing shares again, bringing it back in line with its expected value.

A Credit Suisse spokeswoman said on Thursday the firm "is cooperating with regulatory authorities."

MAKING RISKS CLEAR

Another major online brokerage Fidelity Investment has had a system for warning investors about the risks of trading ETNs since 2009. An investor who wants to trade an ETN has to sign an investor agreement, and every time an investor makes a trade, a screen pops up warning them of the risks of ETNs.

Fidelity also does not make leveraged and inverse ETNs and ETFs easily accessible when investors use its "ETF Screener."

A spokesperson for discount broker TD Ameritrade said they have not decided to add a warning on trading these products.

A representative from E*Trade Financial, another discount broker, did not respond to a request for comment.

Exchange-traded notes have been attracting higher investment inflows alongside their exchange-traded-fund cousins. But experts caution that investors need to educate themselves before trading these exchange-traded products, or ETPs.

ETNs have brought in $2.4 billion in net inflows so far this year, a 71 percent increase from 2011, according to Morningstar.

"Even as a full-time trader, this is a product that is very hard to understand. You type in TVIX and all you get is that the profit is two to three times the volatility index, so people are thinking 'Oh yeah, this is great.' The problem is, these ETNs are designed to fail. They are broken products," said Jamie Lissette, an independent trader, and also the founder of the Hammerstone Group, a Westport, Connecticut-based operator of online discussion forums for investors.

"Unfortunately, I traded TVIX during the plunge last week, and lost a couple thousand in a short time frame," Lissette said.

Angry investors, some who have lost in the "six-digit figures" trading TVIX are gearing up for a lawsuit against Credit Suisse. They claim Credit Suisse misled investors by not providing sufficient information about the product.

Some are also questioning the timing of the announcement on re-issuing shares, which came just a couple hours after a 30 percent plunge in TVIX on March 22, as investors had started to bet the shares would fall. The product's price fell another 30 percent the following day.

Moulton & Arney, LLP, a boutique law firm based in Houston, is one of a handful of firms gathering investors who have lost money in the product. It is investigating the circumstances surrounding the decline in TVIX, and has received almost 200 calls from investors.

The law firm said on its website that it "has been retained by a client who suffered a six-figure loss in TVIX on March 22 to investigate and pursue potential claims against Credit Suisse to recover his loss."

Some large full-service brokerage firms already restrict their brokers from selling exchange-traded notes. For example, Bank of America Merrill Lynch only allows its more than 17,300 brokers to sell ETNs to clients with at least $10 million in assets – and only if they specifically ask for them.

Raymond James Financial has prohibited its 5,400 brokers from selling 53 ETNs since October 2010, including the volatility ETNs and three-times leveraged ETNs. Clients who want to invest in available ETNs have to sign an affidavit that states they understand the risks inherent in these products.

(Reporting By Angela Moon and Jessica Toonkle; Editing by Jan Paschal)