A month ago global markets were thrown into a tailspin, with US equities suffering one of their fastest 10 per cent corrections in history. The mayhem raised questions about a small but complex corner of markets where investors trade volatility itself.
How ‘Vix-mageddon’ unfolded
The turbulence caused and was at least partly exacerbated by the collapse of several exchange traded products linked to Vix, the Cboe’s index that aims to measure the implied volatility of the US stock market.
Their implosion on February 5, called “Vix-mageddon” by traders, was accelerated by their own hedging activity, other traders jostling to take advantage of its predictability and a lack of liquidity in the Vix derivatives market.
“People were buying Vix futures going into the close as the stock market was moving lower and expecting the Vix to head higher,” says Pam Finelli, global head of equity derivatives research at Deutsche Bank.
This could happen because the ETPs’ rule-based hedging needs were well known among other sophisticated traders and because the low-volatility environment throughout 2017 helped them grow quickly, making them huge players in the volatility market.
One reason why traders could anticipate the Vix shooting higher was because the rules governing the performance of the ETPs, which were publicly disclosed in their prospectuses, indicated outsized buying demand near the close of trading that day.
“At 3.45pm it was an absolute no-brainer to buy Vix futures and watch the whole thing explode,” says a banker closely familiar with the products.
In order to manufacture the “inverse” returns of the Vix futures index, they link to the ETPs, sell Vix futures and adjust their short positions in response to market moves and investor inflows.
At the close of Friday before February’s week of turbulence, Credit Suisse’s XIV and ProShares’ SVXY were short about 200,000 futures — three-quarters of the average daily volume across Vix futures expiring by March in the preceding month.
But the volatility futures index they reference had nearly doubled by the close on the fateful Monday, which reduced the funds’ theoretical value to near zero and required almost all of the futures to be bought back.
The rules link the ETPs’ performance to the futures’ closing, or settlement, level at 4.15pm. Generally, certainty of execution increases by trading nearer the close, but crowding trades into a short period of time can ratchet the settlement price higher — hurting ETP investors further. And in early February, the Vix futures volumes surged, especially for the near-term contracts maturing that month and in March.
Pravit Chintawongvanich at Macro Risk Advisors says that “there is definitely a feedback loop near the close that pushed the futures price up”. The banker highlights that as higher futures levels lead to more buying pressure and vice versa, “the only time where you could have known how much to buy was when it was too late”.
The role of the TAS market
In order to minimise execution risk and avoid suspicion that too much trading near the close could elicit, ETP managers distribute some of their hedging to other traders. But this only passes the hot potato.
In aggregate, market participants must still buy most of the futures near the settlement price because there are no significant traders on the other side that have natural offsetting positions.
Mr Chintawongvanich says that “the amount they had to buy this time was much larger than during previous events, when rebalance requirements were much smaller. Ultimately someone had to buy the futures and the liquidity was just not there.”
One tool that ETP managers use to balance the demands is an order type known as “trade at settlement”. It must be entered minutes before the closing time and delivers futures to the buyer at a small premium or discount to the settlement price. On the fateful Monday of February 5, about 167,000 February and March futures traded in the TAS market, twice the volume of any other day in the most recent 10 months. Given the abruptness of the spike in the last few minutes, TAS sellers that bought the futures they were required to deliver with some distance to the close made a lot of money.
Inverse-Vix ETP managers such as Nomura, Credit Suisse and ProShares may not have succeeded in buying all the required futures as their prices rallied higher. That would have left them short at the close, which could have benefited them subsequently, because Vix futures levels traded lower after they reopened.
A New York-based equity derivatives portfolio manager says that “there is an ecosystem of traders that profits from trading in anticipation of ETP flows ahead of the settlement”.
Clients were warned of the possible pitfalls, with XIV’s termsheet stating that “daily rebalancing will impair the performance of the ETNs, if the underlying index experiences volatility”.
Will Vix ETPs cause problems again?
With two of the inverse Vix ETPs now dead, analysts expect this corner of markets to become calmer. Moreover, ProShares last week decided to reduce leverage on its surviving products, which will help shrink their market footprint.
The ETP provider’s inverse Vix vehicle, SVXY, will reduce its exposure to the reverse of the volatility index by half, while the leverage of its UVXY long Vix ETF will be ratcheted back from 200 per cent to 150 per cent.
“Leverage cuts for ProShares vol ETFs further reduce the potential for technically driven Vix spikes on large Vix ETP-driven rebalancing flows,” Deutsche Bank wrote in research after the announcement.
Nonetheless, some analysts and fund managers remain concerned that the volatility derivatives market still has the potential to cause upsets, and argue that the broader ecosystem should be re-evaluated in light of the February turmoil.
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