Last October, I posted a Currency of Ideas entry titled, "ETFs In the Spotlight," in which I highlighted a Senate hearing focused on potential risks in the growing $1 trillion trade of Exchange Traded Funds or Notes (ETFs/ETNs), including concerns with a lack of transparency, impact on market volatility, and contribution to systemic market risk. A particular concern at the hearing was that a lack of transparency about underlying positions of some complex ETFs or ETNs may pose significant risk to investors -- especially in leveraged products.

As it turns out, this concern about leveraged ETFs/ETNs was well-founded. Over the past 48 hours, the "VelocityShares Daily 2x VIX Short Term Exchange Traded Note" or "TVIX" has plummeted by more than 50%. Most alarming is that this drop is largely disconnected from movements in the underlying VIX index it is intended to track.

TVIX was created by Credit Suisse to return two-times the movement in the VIX (the Chicago Board Options Exchange Market Volatility Index), which measures the implied volatility of the S&P 500. TVIX is commonly referred to as the "fear index" or "fear gauge." When fear rises and market volatility increases, investors in TVIX expect a positive return.

So what happened to TVIX?
An ETF or ETN is best understood as an entity that derives its value from assets that it holds. In the simplest of examples, an ETF may hold a basket of stocks, which comprise the "asset" of the fund. By dividing the total asset value -- the value of the basket of stocks -- by the number of ETF shares, one can calculate the NAV, or Net Asset Value.

An ETF, however, trades real-time on exchanges, and therefore the share price of the ETF does not always precisely match the NAV per share. This disconnect creates an arbitrage opportunity where large financial institutions can receive newly issued ETF shares or redeem previously held ETF shares until the price of that ETF share eliminates the arbitrage opportunity.

As applied to TVIX, it turns out that because Credit Suisse was struggling to satisfy demand for new share issuances (for reasons not yet clear), it chose to cease all issuances entirely as of February 21st. This meant that there was no longer an arbitrage opportunity that had served as the key mechanism to keep the TVIX share price in-line with its NAV. This untenable situation where the share price was 89% above the NAV lasted for nearly a month, until yesterday when sellers realized the disconnect and began dumping TVIX stock. Having traded earlier in the week, and indeed for the better part of the past month, at or above $15/share, TVIX closed today slightly above $7/share.

What does all of this mean? First, despite language in the TVIX prospectus that cautions those who are not "knowledgeable investors" from investing in TVIX, many if not most investors were caught completely by surprise that ETFs/ETNs are fallible.

Second, the case is undoubtedly stronger now that policymakers should take some action to ensure that investors understand risks involved in certain complex ETF/ETN products.

And finally, the call from some within the industry -- to require product-label differentiation when the assets underlying a traded security are not equities, but rather are a combination of derivatives, swaps, and notes -- now appears sagely prescient.