The Revolution Begins

As you awaken, strange events have taken place into the dark of the New York Close last night. You may have some questions.

Was it a flash crash? Well, it moved quickly but it wasn’t blink and you missed it. The VIX hit 38.8, more than double where it was trading on Friday, but it was a steady run higher for the last couple of hours of the trading day.

Stock markets followed suit, suffering their worst losses for several years.

So it was just a healthy correction then? That’s fine, we’ve all been waiting for that, the cash on the sidelines will be put to work into the close… Except that it wasn’t. The Dow was down 3% with half an hour left to trade; the mythical plunge protection team were nowhere to be seen with it finally closing down 4.6%.

So has something really bad happened? Well, we certainly got good jobs data out of the US on Friday, with wages growing at their fastest pace in 9 years.  So, the economy is doing well. Sure, that meant that interest rates have been rising, with the market finally, after all these years of those pesky Fed dots, now pricing in the 3 raises that the Fed suggested should take place this year.

This doesn’t sound bad, that sounds good? Yes, it is, and hence explained why stocks were hitting record highs as market interest rates hit multi-year highs.

So what happened?

Don’t look too hard for the narrative. The market just got too one-sided. More specifically, the volatility market had become a one-way bet. The signs were all there: the WSJ article, ‘As Stocks Reach New Highs, Investors Abandon Hedges’; the BAML surveyinvestors long, unprotected & say equity bull runs to ‘19’; and the biggest equity inflows in history:

Yes, this was an accident waiting to happen. But the big thing to focus on here is what happened to the VIX and all products linked to the price of the VIX.

If you, like BlondeMoney, switched on your computer screen last night and heard the VIX was trading at 35, where would you have expected currencies and interest rates to be trading? Well the last time the VIX spiked to those levels was 25th August 2015: the same day that the New Zealand Dollar suffered its biggest drop in 30 years. Not much of that to see (at least not at the time of writing). What’s the difference between now and then? More central bank money sloshing around, and more passive money sloshing around. More belief that because things have been calm and asset prices have been rising for so long, they will continue to do so.

A 100%+ rise in the VIX on nothing should put an end to that.

August 2015 provided us with a warning. This is what happened to the VIX then:

Prices for the CBOE Volatility Index, the market’s favored barometer of volatility, did not update for the first half hour of the trading, a result of market volatility that also led to erratic quotes in S&P 500 options, Suzanne Cosgrove, a spokeswoman for the CBOE said.’

Traders who wanted to buy and sell SPX options were held back because a lack of liquidity caused problems in their pricing. Many were at zero or had bid/ask spreads so wide that they were unusable for trading. As a result, SPX options barely traded.

“Basically, the computer market makers that sit behind it all were flashing ‘I don’t want to trade’ signs,” said Jim Strugger, a derivatives strategist at MKM Partners.

The lack of liquidity was not restricted to SPX options, but was broad based, with even normally very liquid sector Exchange Traded Funds (ETFs) hardly trading in the first hour or so, strategists said.’

Oh and this is where we come to the very big problem that we have now. What have been the biggest beneficiaries of all the passive money of the past few years? ETFs into Short Volatility strategies you say? The two biggest are known as XIV (inverse VIX) and SVXY and good lord yes they did indeed see some lovely big inflows at the start of this year:

Why should I care? These guys knew what they were getting into… you win some, you lose some.

Caveat emptor indeed my friend. But that’s a bit like saying people should have known what a CDO squared was. They should, but the unwind in the price of securitised products was instrumental in causing the financial crisis in 2008.

Here is the SVXY in a chart:

As it trades inversely to the VIX, it’s no surprise to see the price has fallen. But look more closely at the x axis. These products trade outside of the hours that the VIX trades.  The SVXY lost 32% during the usual trading day but then slipped another 81%. It was trading at $114 on Friday. At the time of writing it is trading at $14.

This has sent people scrambling to check out the prospectus of the fund they have invested in. It can’t deviate so far from its intrinsic value, can it?

Here’s the prospectus for the XIV, and it turns out that funnily enough it makes a provision for these deviations. It describes an “acceleration event”. This is legal terminology for “we are redeeming this note now because some serious stuff has gone down”. In other words, your note is worth nothing now, because the following occurred:

Right now, it looks likely that these exchange-traded products based on the VIX have gone through a fall of 80%, hitting the 20% level to trigger this provision.

So you’re saying that a product that was supposed to track an index just went to almost zero?


And these aren’t just some random esoteric products. 6-8million is their average daily volume. As of last night, the volume traded yesterday was over 40 million. The SVXY is the 47th most traded ETF in the world, ranking above the Vanguard FTSE Europe ETF or the SPDR DJIA ETF.

Anyone holding an ETF right now should check what it is they actually own. Volatility ETFs are the canary in the coalmine. The VXX is the fourth most popular ETF, and put simply, it gives exposure to S&P500 volatility. It has been popular as a tail hedge, a way of owning some of the “Fear” that the VIX index is supposed to represent. But a cursory look at the VXX prospectus reveals the following:

‘The VIX index tends to spike when anxiety increases, and as such often moves in the opposite direction of stocks. However, it’s important to note that VXX does not represent a spot investment in the VIX, but rather is linked to an index comprised of VIX futures. As such, the performance of this product will often vary significantly from a hypothetical investment in the VIX (which isn’t possible to establish). ‘

So it tracks something hypothetical, and it may not even track it that well?


Oh and one more thing:

‘One structural note: as an ETN, VXX avoids tracking error but may expose investors to credit risk’

The XIV is an ETN, provided by Credit Suisse. This means it contains credit risk with respect to the bank providing the note. No wonder CS shares are down 5% in after-hours trading. Oh, and the small matter of CS owning 39% of the XIV shares outstanding too.

Blondemoney doesn’t like hyperbole but our opening note for 2018 was entitled “Revolution”. We warned then:

This is the year the Revolution gathers pace. The voters have chosen new leaders, new policies. Financial markets are so far ignoring that, pumped up on cheap money and low vol. But the free money taps are being switched off. The passive trend followers won’t continue once volatility infects the system. So far, it’s holding firm. Political risk can’t be priced, so it’s being ignored. But the foundation of the Buy The Dip machine is being whittled down. First the central banks moved away. Next the passive money will find it’s going into a home that’s unsupported by new governmental policies. And finally it will give way when we shift to a new volatility regime.

What to watch:

  • Any pause or reversal in passive money inflows

  • Any disconnect in pricing in any liquid market, even if it’s only for a few seconds

  • Problems reported in administrating ETFs and other passive vehicles

So what do I do now?

It may take some time for the penny to drop, but the tremor in the VIX-linked products has broken the permanent liquidity illusion. Now, there will be a reassessment, slowly, of ETF/ETN investments. Denial at first, refusal to accept what has been seen. But eventually the realisation: They may not protect against all risks, nor perform as expected in all scenarios. The tinder is gathered; the central bank fire extinguishers are absent and ineffectual. The spark now will be the unexpected. Or rather, the unpriced. Political risk remains the prime suspect. Own something liquid and politically safe, like Japanese Yen. The euphoria will be hard to shift; there will be talk of reduced Fed rate hikes, or delayed ECB taper. But what can they possibly do when it turns out the market owns a bunch of investments that aren’t as liquid as they look?

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