Exchange traded industry shows fractures Market participants are calling it the exchange traded note, or ETN, that barked. Last month the TVIX, an ETN marketed by VelocityShares, diverged dramatically from the volatility index it was meant to be tracking. Its issuer, Credit Suisse, had suspended the creation of new units due to its own internal risk limits, inhibiting the market from keeping the note's value in check. IN Exchange Traded Funds While this particular ETN appears to have briefly spun out of the Swiss bank's control, these market participants say it is still a good illustration of the hidden benefits that many big banks can reap from the alphabet soup of exchange-traded products that they host on behalf of big and small investors. Importantly, say analysts, banks generate more than just basic management fees from exchange traded products, which have grown over the past dozen years into a $1.8tn market sold to both big and small investors. The products can help banks fund their own vast portfolios of securities and trading positions, or be used to offset the risks they incur from their daily business. Adam Sussman, partner and director of research at Tabb Group, a financial industry consultancy says: "It's just a very effective tool for them to recycle risk or manage liquidity." Exchange traded funds, or ETFs, seek to replicate the returns of an index or asset class while trading on exchanges like stocks. ETNs also trade on exchanges but are actually bank-issued debt securities. But cracks within the ranks of the exchange traded industry are beginning to show. BlackRock and Vanguard, two of the biggest asset managers and themselves providers of ETFs, have criticised ETNs for creating potential conflicts of interest for the banks which sponsor them. In doing so, the two companies have shone a spotlight on the use of ETNs as a vehicle for "recycling risk." That involves banks using an ETN to offset positions they incur through various businesses. The more a bank can match such risks internally, the more money it saves - and may even make. ETFs cannot do this due to regulatory limitations in the way they are structured. Credit Suisse has declined to talk publicly about its decision last month to close the TVIX note. But the ETN, designed to give a leveraged return on changes in short-term Vix futures levels, is just one of a recent crop of volatility-related exchange traded products that have been developed. Providing such volatility-related products may be particularly attractive for banks, analysts say, because they can be especially useful in helping to offset one of the biggest risks they can incur in recent markets, so-called correlation risk. Correlation, when markets for various securities move in tandem with each other, can be difficult for big banks to hedge. "Correlation, can be "recycled," meaning repackaged and sold as a separate product," JPMorgan analyst Kian Abouhossein wrote in a 2010 note on the future of the global investment banking industry. Still, some product designers for big banks say that the ability to recycle risk is not their main motivation in providing the products. One designer at a large European bank says: "Internal risk recycling can enhance profitability, but it's not central to decisions about whether to launch new funds." Although note products issued by banks are currently attracting most attention, ETFs themselves have also been in an unflattering spotlight in recent months. The Bank of England has criticised "synthetic ETFs," which use derivatives agreed between banks to replicate a certain asset class or securities, in particular. Banks may use such ETFs as a way to fund some of the most expensive, or illiquid, parts of their balance sheets. In the last year, synthetic ETF providers have made significant strides to improve transparency about the collateral pools that ultimately back their funds, while providers of physical ETFs have started to disclose details about how collateral under their care may be deployed for corporate purposes. But little is still known about ETN counterparts. ETN issuers stress the notes are openly marketed as unsecured debt obligations that expose buyers to the credit risk of the issuing bank. "The whole genesis of mutual fund regulation was towards standardisation of the types of investments that can be made," says Deborah Fuhr at ETF Global Insight. But when you move away from the highly-regulated fund structure to other vehicles such as notes, there is less standardisation, and more freedom in terms of what notes can invest in and how they are structured.