When is marginable collateral not marginable collateral? When it is an ETN, or Exchange Trade Note: the cousin of the Exchange Traded Fund (ETF). The very mutated, and unabashedly evil cousin of the ETF that is.

At least such is the view of US brokerage Interactive Brokers (and certainly not of the ECB where as is widely known blocks of feta cheese and olive oil are perfectly acceptable forms of collateral).

First, what exactly is an ETN?

Here is the IB definition:

ETNs are not equity shares but rather a form of unsecured debt whereby the issuing institution promises to pay a return linked to a market index or other benchmark. As ETNs generally do not buy or hold assets like an Exchange Traded Fund (ETF), their returns are realized through holdings of derivative contracts such as options, futures and swaps. While ETNs trade on exchanges in a manner similar to equities, their issuance, redemption, credit, liquidity and performance characteristics are structurally distinct from other Portfolio Margining products.

In other words, something oddly reminiscent of the equity tranche of a synthetic CDO, in which case alarm bells should already be going off at the thought that a CDO squared can be the collateral used to back other margined purchases, which by that definition makes it what, a CDO cubed?

Here is some additional information on ETNs from Bloomberg:

ETNs are exchange-traded notes, cousin of the far better-known exchange-traded fund, or ETF, and they have been at the center of some drama lately. Despite a drop in new launches and critical articles in the financial news media, ETNs are growing at twice the rate of ETFs — and not many things have grown faster than ETFs, except maybe the Internet. Total ETN assets jumped 47 percent, or $8 billion, over the past 12 months, to $25 billion, compared to about 25 percent for ETFs.

What makes all this so curious is that almost everything ETNs track you can get in an ETF, with less risk. So why on earth have these things captured $25 billion in assets, much less $25?

The answer lies largely in their tax treatment, which appeals to income-oriented investors.

What Are They?

Like ETFs, ETNs trade on an exchange, track an index and provide real-time, intra-day updates on the underlying value of the product (think of that as the fair value for the ETN at any given moment in time). Unlike ETFs, they don’t hold an underlying basket of securities or futures contracts. Instead, they’re unsecured debt obligations from a bank or other financial institution and promise to match the performance of a certain index over a specified period. If the issuer defaults, investors could be wiped out. Lehman Brothers had a couple of ETNs. It’s unclear whether investors, which were mercifully few, got their money back.

Custom-Made Products

Custom-tailored ETNs, designed and launched with one investor in mind, account for about $3.4 billion of the total, or 13 percent. These products are the fastest-growing area in the ETN world and got about half of that $8 billion 12-month asset growth. One example is the Barclays ETN+ FI Enhanced Global High Yield ETN (FIGY). It provides leveraged exposure to the MSCI World High Dividend Yield Index. It was created for Fisher Investments, which worked with Barclays to construct it so that it would fill specific investment needs for the firm’s clients. Fisher Investments accounts for 97 percent of the $1.5 billion in this particular ETN.

The High-Octane Stuff

ETNs built around volatility indexes are the most hard-core of the hard-core, and a big reason ETNs get a bad rap. These ETNs account for 10 percent of total ETN assets and asset growth was flat over the past 12 months. However, they account for 75 percent of ETN trading volume. These things mostly lose money over the long term, but traders love them for fast, liquid and convenient exposure to different variations of volatility.

An example of what can go wrong here is the VelocityShares Daily 2x VIX Short-Term ETN (TVIX). The Chicago Board Options Exchange Volatility Index, known as the VIX, is a gauge of U.S. stock volatility. The VelocityShares ETF returns two times the daily return of the VIX futures contracts. TVIX is a combination of three things individual investors should stay away from: VIX, the futures market and leverage. Not only that, but TVIX once stopped issuing new shares for a short period, which caused its price to become wildly unhinged from its underlying net asset value. Some retail investors lost large chunks of money.

After reading the above, one should hardly be surprised at the following announcement from Interactive Brokers:

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Pursuant to a recent decision by FINRA whereby Exchange Traded Notes (ETNs) will no longer be eligible for Portfolio Margining, these securities, including options having an ETN as an underlying, will be phased out of the program by OCC during the week of May 19, 2014.

In fact, a far bigger surprise is that FINRA and other regulators had allowed these synthetic, self-destructing non-assets to be used as margin collateral in the first place. However in a New Normal world, in which everything is rehypothecated countless times, it becomes clear why even these so-called assets had to be recycled into even more purchasing power. And so they were, until next Monday, when first IB and shortly thereafter all other brokers will have no choice but to phase them out as marginal products.

More from IB:

What This Means to You

You are receiving this communication as you maintain a Portfolio Margining account and either currently hold or have recently held positions which are subject to phase out. Once phased out, these securities will be margined in accordance with Reg. T, the effect of which will likely result in an increase to your overall margin requirement. Any increase will result from one or more of the following computational differences:

1. Portfolio Margining offers a risk based computation through which requirements are determined assuming price changes as low as 15%. This compares to Reg. T under which these securities will be subject to initial and maintenance margin requirements of 50% and 25%, respectively.

2. Portfolio Margining recognizes hedges and offers margin relief between qualifying long and short positions that Reg. T does not. As example, securities which are functionally identical but have different leverage objectives such as the PowerShares DB Crude Oil Short ETN (SZO) and the PowerShares DB Crude Oil Double Short ETN (DTO) are afforded full risk offset if one is long and the other short. Similarly, Portfolio Margining offers partial offset between securities which are distinct but have historically exhibited high positive correlation. As example, a position in the PowerShares DB Crude Oil Short ETN (SZO) and the iPath S&P GSCI Crude Oil TR Index ETN (OIL) would be eligible for partial offset if one is long and the other short.

3. The requirement for options under Portfolio Margining is determined through use of a pricing model whereas under Reg. T options are treated in a manner similar to that of the underlying stock. As a result, requirements may be substantially higher under Reg. T., particularly for options which are deep out-of-the-money and with little time remaining until expiration. In addition, unlike Portfolio Margining, Reg. T provides option margin offsets only under a limited set of defined strategies.

When Will This Change Take Place?

OCC will begin removing products from Portfolio Margining starting May 19, 2014 and expected to have all products removed by May 23, 2014. They have not published a schedule detailing which products will be removed on which day.

More importantly, this development means that suddenly market participants will have to come up with $25 billion in new collateral, such as cash, to replace the elimination of ETNs as a margin class. In this hyper levered market, that may be harder than it sounds.

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Finally, does this announcement apply to you? If you hold any of the 187 “securities” listed below the answer is yes, and get ready to either sell the security or add an identical amount of cash to your account.

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