Forex Exchange Traded Notes
Forex Exchange Traded Notes or ETNs are a relatively new instrument. Forex ETNs are debt securities that are issued by banks and other investment firms. ETNs are generally registered with the U.S. Securities Exchange Commission and trade on the major U.S. securities exchanges. ETNs can be liquidated either by selling them on the applicable exchange or holding them to maturity.
An example of the operation of a currency ETN can be illustrated as follows. For U.S. persons, they would typically pay U.S. dollars to purchase the ETNs. At maturity, the U.S. person would be repaid in U.S. dollars; however, the amount repayable would take into account changes in currency values between U.S. dollars and the currency referenced in the ETN.
For example, if the ETN were a Euro ETN, the amount repayable would be based on what the result would be if the originally invested amount were converted into Euros on the day of investment and converted back into U.S. dollars on the maturity date. Hence, the holder would bear the changes in currency value during the term of the instrument. The holder would also receive interest for the period the ETN was outstanding.
While this is a very convenient way to gain foreign currency exposure, an investor must take into account several adverse factors. First, if the ETN is issued by a bank or investment bank, the holder is exposed to the credit risk of the bank or investment bank. This is not just a hypothetical risk. Holders of ETNs and other structured instruments issued by Lehman Bros. suffered severe losses when Lehman Bros. holding company filed for bankruptcy. You may want check the size of various large banks that have issued a particular ETN to check on the current backing.
Second, the IRS has issued guidance that all of the income recognized on an ETN is "ordinary income" not more advantageous capital gain income. By contrast, an investment in a foreign currency futures contract traded on a U.S. futures exchange or the purchase of a spot forex contract (with an appropriate and timely election) will result in capital gain income under the favorable 60/40 rules under Section 1256.
Third, ETNs can be very thinly traded making disposition of them difficult and where possible, often at a disadvantageous price.
Fourth, ETNs often have an annual embedded basis point charge. We have noted annual charges of approximately 0.40% in the ones we have reviewed. This is not an inexpensive amount.
If you are interested in reviewing more details on these, here are some links to some of the offering documents on the SEC's Edgar website from November 2008: