New proposals from the U.S. securities watchdog aimed at reducing risks in exchange-traded funds (ETFs) may end up being the best thing that ever happened to rival exchange-traded notes (ETNs).

ETFs holding some $225 billion worth of assets are likely to violate the new rules suggested by the Securities and Exchange Commission (SEC), and could ironically spark a mass migration of investors into riskier products.

“The two pieces of rule-making proposed by the SEC–one on liquidity, and one on derivatives–will have one significant unintended consequence: they will drive investors into less well-regulated products like ETNs,” said Dave Nadig, Director of ETFs at FactSet Research Systems.

Both proposals are "tweaks" to the Investment Company Act of 1940 and would apply to open-end investment companies, which includes mutual funds and ETFs, according to Nathan Dean, Government Policy Analyst with Bloomberg Intelligence.

“These rules are likely to be finalized in the third quarter of this year, but not effective for at least 18 months,” said Dean, who expects the rules to be finalized, but most likely in an altered form as the industry has pushed back on a variety of factors. The question is how altered they will be from their initial proposal.

The first rule proposal attempts to address liquidity concerns by requiring that no more than 15 percent of a fund’s holdings take longer than seven days to liquidate without moving the market. This effectively means that “every broad corporate and high-yield bond fund and every broad emerging markets fund would be in trouble," according to Nadig, who ran the numbers using his own trading estimates of how many ETFs would be in violation.

This adds up to a little over $200 billion in assets and would include some hugely-popular ETFs such as the Vanguard FTSE Emerging Markets ETF (VWO), the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), and the iShares iBoxx $ High Yield Corporate Bond ETF (HYG). This is why Blackrock Inc. has met with the SEC at least four times and offered suggestions, such as a tiered approach to the liquidity rules, according to Dean.

The other proposal attempts to address derivatives usage by limiting the leverage in 40 Act funds to 150 percent. That puts a majority of the two-times and three-times levered ETFs in violation. While the issuers may be able to find clever workarounds to get to the two- and three-times exposure while still remaining in compliance, it does put another $25 billion at risk of being in violation, leaving many investors searching to find other ways to get this exposure, such as ETNs.

Unlike ETFs, exchange-traded notes involve investors taking on significant credit risk to the ETN's issuers.

ETNs are unsecured debt obligations regulated under the less-stringent Securities Act of 1933, and are not required to physically hold anything. As such, there is a risk that the issuer could default and investors would lose some or all of their investment. This is very different to the structure of a high-yield bond ETF or even a leveraged ETF, both of which physically hold the securities or derivatives involved. Shareholders have ownership of those assets even if the issuer goes out of business.