The Revolution Begins Part 2

Dusted ourselves down and carrying on, are we? BlondeMoney has taken your temperature and this is why you’re saying that the inverse-Vol product blow-up of Monday night doesn’t really matter:

  • It was an esoteric product with hardly any AUM
  • Caveat emptor, if you buy something and don’t read the prospectus, more fool you
  • We all knew this stuff was dodgy, so it’s no surprise
  • No-one has found any significant bodies
  • Market was too one-sided, this cleared out positioning and gives great levels to get back in
  • VIX at these levels is more normal anyway

First stage of grief, as we know, is Denial. It’s an odd kind of grief though: most discretionary investors were sick of the low vol / higher stocks feedback loop. You’d have thought many people would have embraced this mini earthquake. The reason they haven’t is that there’s no apparent fundamental reason for it to have occurred. Embracing the XIV blow-up would only be possible if it fed into the narrative: which appears to be, yields going up due to a late-cycle tax cut plus several Fed rate hikes, equals another ‘taper tantrum’. But it’s not really a tantrum, is it? Emerging markets, currencies, credit spreads, well they’ve barely budged. Also, as Toby Nangle pointed out, stocks came roaring back on Tuesday, in tandem with higher interest rates:

So discretionary traders must either admit that something else is going on, or consign the entire event to the folder marked “flash crashes” which to be fair had a heck of a lot of entries in 2015-16, but has largely avoided them for almost 18 months.

That would be a mistake.

There is an overarching narrative in play here. It’s just not macroeconomic. Nor can it just be written off as “retail gets involved in stuff they don’t fully understand, Part 724”.

It is in fact systemic.

The issues that took down the XIV are replicated throughout the exchange traded product (ETP) world. These products have to track an underlying. To do so, there are authorised participants who are expected to arbitrage away any difference between the ETF and the intrinsic value of its underlying. If the ETF traded under its intrinsic value, the arbitrage would suggest buying the ETF and then selling the underlying to make a risk-free profit (and vice versa).

There are so many issues with this, BlondeMoney is currently writing a larger report about it. For now, just mull this little list of problems that could affect the arbitrage process:

  • It becomes impossible to buy/sell the underlying
  • Other markets get used as a proxy hedge
  • The intrinsic value falls/rises faster than it can be hedged away
  • Algos drive the hedging and speed up the moves
  • Market makers disappear
  • Issuers are incentivised to move the market against the owners of their product
  • Issuers play pass the parcel with the risk and it ends up with someone who can’t handle it

This final point is now relevant for the XIV. Credit Suisse announced no loss from the entire debacle. Their spokesperson said: ‘We are the issuer of the ETN and, having issued it, we hedge the risk. We hedge XIV by trading VIX futures. … The positions constitute part of a portfolio.

Undoubtedly it was CS covering themselves by trading in VIX Futures right at the close; having bought when the VIX was around $25 it’s no surprise they looked happy when it was up at $50 the following day. ProShares were even smarter with their SVXY: they had to strike a NAV of a theoretical $4.22 on the close, but the next day it opened at $11.42.The NAV would have reflected the actual asset holdings of the fund, which suggests they also made a profit on their VIX futures hedging. VIX futures trade almost 24 hours; the VIX does not (well, it’s not even tradeable but that’s a whole other story).

The XIV has an extra twist. It is an exchange-traded note: as a “note” the credit risk lies with CS and they promise to deliver the return of a specific index via an over-the-counter derivative. They can hedge themselves by getting another counterparty to promise to deliver the same return to them, by writing another OTC derivative back to CS. Thing is, this other institution may not have finished hedging the mess that wound up at their door.

So, we don’t know where the bodies are yet, because the XIV hasn’t actually agreed on a closing price. In the acceleration event press release, Credit Suisse only said:

The date of the delivery of the irrevocable call notice, which is expected to be February 15, 2018, will constitute the accelerated valuation date, subject to postponement due to certain events’.

Note that it’s “expected to be February 15th” – is this so that other participants can get out of their risk? Is it “subject to postponement” if those events drive the price even lower? Is this just CS buying time for the market to digest more XIV hedging?

If so, then trapped counterparties will need to keep on buying VIX futures, and if they can’t do that, they’ll sell S&P 500 instead.

Alongside all of this, the liquidity in all of these markets is much reduced. Yes, the closure of XIV will take out some of the exponential convexity from the market. But there’s still the VXX out there, which is the fourth most traded ETF in the world with $1.5bn in AUM. This is a straightforward play on the VIX: meaning that if the VIX keeps going up, the VXX will need to keep buying VIX futures. And into a market that is now significantly smaller than it was.

Take a look at liquidity in the S&P500 futures market on Tuesday, courtesy of Nanex LLC:

The S&P500 futures market is NOT an esoteric market. It’s large and widely used. But it became so illiquid on Tuesday that one trader (@AMKcm) commented that you could buy an options structure such that you’d receive a premium and only lose money if the market dropped more than 25% in 4 days. In other words, liquid markets became disrupted.

Oh and did we mention about how the VIX itself is used for risk management of entire portfolios? After the financial crisis, long-term money managers felt that an early warning sign would be required so that they could shift their allocations ahead of time. The VIX would be an ideal input to a risk overlay, would it not? No point ramping up the equity exposure if the Fear Gauge is creeping higher, right?

Now, this is long term money. It doesn’t react within 24 hours. It takes smoothed monthly averages of prices before signals shift. And of course it takes readings of other risk sensitive indicators like credit spreads.

But if the price of the VIX remains elevated as the XIV closure takes time to come into effect, this will feed into long term investments. Then they will take risk off the table. In other words, sell everything that has gone up and get some cash back. Stocks and bonds have, until recently, been rallying. Both are now at risk.

And then we get into a feedback loop of our own. Wouldn’t it just be like us to have assets all completely correlated to one another right at the moment this is all happening? So that when one asset falls, all the others do as well? Well let’s have a look at where cross-asset correlation is right now, courtesy of Deutsche Bank:

Yes that’s right folks. Correlation is almost 1. Note that they are correct to point out this correlation is driven by “very strong momentum across asset classes”. Momentum, that’s the key.

There is not some great big macro narrative here. It’s just normal herding behaviour.

There are almost 5,000 exchange traded funds out there, containing ~4.5 trillion USD of assets. That increased by 1 trillion dollars last year; the year before it increased by $500bn. Growth is exponential. It needs a home. It goes to the place that most recently made money. Momentum is everything.

The problem with momentum is that a market becomes completely one-sided. That’s what happened on Monday. We simply ran out of any more equity buyers and the VIX hit a point where the ETPs linked to it had to, quite literally, knock themselves out.

The activity this week is not just about some small esoteric fund. It’s a reminder that the whole world now has the short volatility trade on; and that the products the world is using for this trade are one big negative feedback loop.

Macro will be irrelevant. All you need to know is how a market works. If momentum runs out, the trade is over. Panic sets in. Everyone heads for the exit at once, screaming “Fire”!

It’s Wile E. Coyote running out of road.

This week’s events have set the road runner on his trail. Either momentum will naturally shift, as it did this week, or an external event will make us realise the cliff edge has been whipped out from under us. Oh, now where else have we heard about a cliff edge… Brexit, anyone?

The Revolution Has Begun.

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