The 'Doom Loop' Was Realized: A Postmortem

Summary

Ok, here is my postmortem on the VIX ETPs. I've written a ton about this over the past 24 hours, but I wanted to pen something exclusive here.

To be clear, the argument about whether those products posed a risk both to their investors and to the market more generally was settled on Tuesday.

The feedback loop that I've variously discussed over the past year was indeed triggered.

Unfortunately, this is a scenario where I wish I would have been wrong.

So "way" back in September of last year I wrote something for this platform called "When A 'Fire' Becomes A 'Seismic Conflagration.'"

It was a short piece documenting a pretty amusing "oops" moment when, at roughly 5:40 AM New York time on September 6, the British Geological Survey accidentally triggered a fleeting risk-off move in USDJPY and U.S. Treasurys with a tweet that some folks (and by "folks" I mean algos) mistook for "news" about a new earthquake in North Korea.

As I wrote at the time, "human beings would have immediately know the tweet was in reference to the September 3 test, but the robots didn't make the connection."

After noting that, I went on to suggest that because of the precarious setup created by the ubiquitous short volatility trade and the presence of systematic/programmatic strats in markets, an innocuous trigger event such as an errant tweet could accidentally end up tipping the first domino on the way to activating what I've variously described as the "doom loop."

To some readers, that seemed like quite a stretch. That is, I skipped neatly from lampooning a poorly worded tweet from the British Geological Survey to citing a New York Times interview with Artemis Capital's Christopher Cole on the way to talking about how VIX ETP rebalance risk could end up exacerbating a vol. spike and ultimately forcing systematic strats like CTAs and vol. control funds to deleverage into a falling market.

But it wasn't as much of a stretch as it seemed. Let me remind you of what Christopher Cole told the Times (in the interview linked above) about how short vol. vehicles could end up facilitating systematic selling:

At the moment, Mr. Cole calculates that as much as $1.5 trillion in investor money is betting the markets will remain as they more or less have been since 2009: volatility free.

Mr. Cole says this $1.5 trillion in short volatility money can play a similar role today if the fear gauge index spikes sharply.

All of a sudden VIX sellers will become VIX buyers, which will send the index soaring and stocks plummeting.

As he sees it, the formulaic strategies that sold stock market futures into a falling market in 1987 and the short volatility money of today are akin to barrels of petroleum that can turn a mere fire into a seismic conflagration.

Wow, that sure sounds hyperbolic, right? Wrong. In fact, Cole was simply describing the setup for what ended up happening just over five months later.

As Heisenberg regulars are no doubt aware, the September article linked here at the outset was just one of probably a half dozen I've written for this platform about the "doom loop" dynamic. Just a few months before that post, for instance, I wrote a pretty scathing post called "Vicious VIX: Jason Miller Made $53,000, But Larry Tabb Got Bilked" in which I suggested in no uncertain terms that retail investors should not be allowed to trade volatility using ETPs.

That post elicited some jeers from readers, jeers which can be summarized as follows: "Who am I to say what retail investors should and shouldn't be able to trade?"

Well, as it turns out, I was (and am) the guy who was trying to exercise a little benign paternalism by suggesting that the average investor is imperiling not only their own financial well-being, but the entire financial system by perpetuating a dynamic that was steadily pushing up "rebalance risk." What is "rebalance risk?" Rebalance risk is the vega-to-buy on an N-vol. spike in the VIX futs curve and it effectively represents the panic bid that would occur in the event inverse and levered VIX ETPs became forced buyers.

As it happens, I have an entire section of my site dedicated to updating readers on what that number is, and as of the last post I did on it before Monday, it was sitting at $110mm on just a 3-point spike (at the time, that would have been from a weighted average of 11.5 to 14.5). As Goldman's (NYSE:GS) Rocky Fishman wrote in the note the following chart is from (dated January 11), that was “double the highest ever seen before 2017 and represents ~60% of daily 1st/2nd VIX futures volume, and around 30% of open interest."

Hmmm. As I've said previously, you do not have to be a derivatives strategist to posit that in a pinch, that kind of flow might be difficult for the market to absorb, even taking into consideration increases in futures volume/liquidity provision.

Ok, so my argument has always been that what would end up happening is something would trigger a vol. spike and because of the low starting point, even a nominally small move to the upside would look huge in percentage terms. If the initial move higher became acute enough, it could start tipping dominos. On Monday, the VIX spiked more than 100%.

As I detailed quickly in my Black Monday postmortem, something snapped just after 3:00 PM in New York. There was a panic bid for Treasurys (as Bloomberg documented virtually in real-time, between 3 PM and 3:10 PM ET, 266k TYH8 contracts traded in screens as 10Y yields reached 2.705%) and the Dow suddenly plunged further, declining as much as 6% at the lows.

Things were chaotic into the close, but after the bell, VelocityShares Daily Inverse VIX Short-Term ETN (XIV) dove 80%, sending retail investors on social media into a veritable frenzy.

(Bloomberg, Kevin Muir's annotations)

It was immediately clear what was going on and I said as much:

Hey guys?

XIV looks like it might be done.

Sure enough, just hours later, Nomura announced that the Next Notes S&P 500 VIX Short-Term Futures Inverse Daily Excess Return Index ETN would be redeemed after one of the conditions was triggered due to movements in the underlying index. That amounted to confirmation that XIV was effectively finished.

Fast forward to Tuesday morning and sure enough, Credit Suisse pulled the plug:

  • CREDIT SUISSE SEES IRREVOCABLE CALL NOTICE ON VELOCITY SHARES
  • CREDIT SUISSE REPORTS EVENT ACCELERATION OF XIV ETNS

It would reopen later in the session, but the bottom line for XIV holders and also for investors in ProShares Short VIX Short-Term Futures ETF (SVXY) is this:

(Heisenberg)

Now, if you go back and you read the September article mentioned here at the outset, you'll find this passage:

[The dynamics] discussed above have the potential to accelerate the initial move lower in a big way, effectively making it impossible to get out unscathed.

That's what you saw on Monday. Investors were blindsided. And this underscores not only why I spent so much time last year warning about the potential damage for XIV and SVXY investors, but also about the implications for the larger investing community of what those investors were participating in. Here is the play-by-play on what happened as recounted and explained by Goldman:

Technical buying likely furthered dramatic end-of-day movements in VIX futures. VIX futures, which had been barely up on the day as late as 2 PM NY time, rose quickly to the 4:00 PM cash equity market close, and then jumped significantly further between 4:00 PM and 4:15 PM NY time. We see VIX ETP rebalancing as a key component of these flows, as levered and inverse ETP issuers were economically driven to buy more VIX futures prior to the close to avoid unhedged overnight risk (ETN issuers) or excessive tracking error (ETF issuers). This buying of VIX futures, whether to reduce a now-oversized short futures position on a shrinking short VIX product or to grow the too-small long position of a much-larger levered product, could have pushed VIX futures prices up more, driving up their demand to buy more – a market feedback loop. By the end of the day, VIX ETP issuers had to buy $230mm vega (230k VIX futures) – 50% of the open interest of front-two futures – which was on top of around $80mm of vega VIX futures issuers likely would have bought on Friday. In a fast-moving, late-afternoon market, this supply was hard to find. By the time the 4:15 NY time futures close had arrived, the February VIX future was up over 100% on the day, and the March VIX future was up 87%. VIX futures fell quickly in overnight trading even though SPX futures were also down.

And this is from RBC's Charlie McElligott:

The ‘grey swan’ we all have spoken about for years—that being the absurd ‘tail wagging the dog’ potential of VIX ETN market structure (inverse and leveraged products) AND the massive growth in ‘negative convexity’ / ‘vol target’ / ‘vol rebalancing’ strategies to either generate extra income or ‘systematically allocate risk’ (looks good in the prospectus, right?!) –finally ‘broke’ the volatility market, and has now bled-through to the ‘underlying’ spot equities market…as the short vol trade went ‘lights out'.

There's the "doom loop," folks - right there. And it helped cost us 1,200 Dow points. The VIX move on Monday was a 13-standard deviation event.

(Goldman)

Let that sink in. That should be impossible. And hilariously, it got worse. On Tuesday morning, the VIX spiked to 50 which, had it stayed there, would have been the highest close since 2009:

(Heisenberg)

It would of course fall during the U.S. session, but something wasn't right. Look at the choppy (and at one point flatline-ish) action right around the open:

(Heisenberg)

To be clear, the sellside desks were all over this, all day long. Barclays (NYSE:BCS) had their explainer, Morgan (NYSE:MS) had one, Goldman had two, SocGen (OTCPK:SCGLY) had one, Deutsche (NYSE:DB) weighed in, and on and on. There is no question about whether what happened late Monday afternoon was exacerbated by the VIX ETPs.

Additionally, shares of CBOE (CBOE) were crushed on Tuesday and according to Wells Fargo (NYSE:WFC), that's attributable to fresh questions about what all of this means for volumes. Here's an excerpt from a short note out midday:

We unfortunately don’t know how much of CBOE’s volumes are tied to short volatility strategies. However, VIX related volumes at CBOE have accelerated in recent years (VIX related volumes were up 20%+ in 2017) at the same time the “short volatility” trade was growing in popularity. It is therefore probably not unreasonable to conclude that much of the growth in recent years was being driven by “short volatility.” We suspect the retail investors that have been wiped out by this trade may not be too keen to trade volatility going forward.

Note that last bolded bit (that's why I bolded it). Retail investors were run over here. Plain and simple. And in the process, the entire market suffered. As one popular Bloomberg columnist put it, "VIX ETP blow-up has to be the most telegraphed blow-up in market history."

Indeed. And see that's the thing - this was destined to go wrong and once the sellside desks started quantifying the rebalance risk, someone (maybe regulators) should have stepped in. Here's what I wrote in a piece for Dealbreaker Tuesday afternoon:

I’m not exactly sure what could have been done, because the horse left the proverbial barn on this years ago, but if anyone outside of sellside derivatives desks had taken the time to actually do the math and connect the dots on the type of systemic risk these vehicles were embedding in markets, it would have been immediately clear that this was bound to go horribly awry one day with God only knew what consequences.

The "bright" side is this (from Macro Risk Advisors’ Pravit Chintawongvanich):

Importantly, from a market risk standpoint, XIV and SVXY have already covered 96% of their risk and essentially no longer have any market impact on VIX futures.

That was echoed by multiple desks on Tuesday.

Of course it doesn't say anything about whether and to what extent CTAs, vol. control funds and the rest of the systematic crowd will be forced to unwind if things get worse or really, if volatility simply remains some semblance of elevated. I would point out that as usual, the folks on the buyside of this equation think those fears are overblown. Predictably, Cliff Asness was out suggesting that quants will not be the cause of any meltdown that transpires. Here's what he told Bloomberg's Dani Burger on Tuesday:

Trend-following has been around forever, and it’s smaller than it was a decade ago. People aren’t wrong in direction here, but they’re way off on magnitude.

The risk parity crowd will make similar arguments in terms of claiming that they won't have an outsized impact let alone be the proximate cause if things get worse.

In any event, we can have a discussion about where things go from here in terms of whether the evolution of market structure may or may not cause further problems, but with regard to the VIX ETP risk, that debate is settled. They collapsed and in the process they spilled over into the underlying, proving that the "tail" was indeed "wagging the dog."

I certainly hope that the rest of the risks I've flagged in terms of market structure (and yes, that includes the rampant proliferation of ETFs including and especially high yield vehicles) do not end up causing the kinds of problems that I've suggested they might cause, because if being "right" means investors having to go through what's illustrated in those XIV and SVXY charts, well, then I'm perfectly happy being wrong.

Nothing further. For now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.