Each morning, at the market’s open, Seth M. Golden, a former logistics manager at a Target store, fires up the computer in his home office in northern Florida and does what he has done for years: Put on bets that Wall Street’s index of volatility, the VIX, will keep falling.
To be sure, it spawned its fair share of derisive memes that spread like wild fire among market participants who understood how patently absurd the idea of former Target managers shorting vol. for a living really was, but it should have set off louder alarm bells. That is, this should have been flagged by regulators as something that was inherently dangerous.
Now 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 the doomsday vehicles used by Seth and his ilk 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.
I’m not going to regale you with the tedious details (there’s more than you would ever want to know in my “doom loop” archive), but generally speaking, there are two critical issues, one of which has implications for the broader market.
The first problem with inverse VIX ETPs is that because of the low starting point for vol., even a nominally small spike looks fucking huge in percentage terms. Well, some of those vehicles have what amount to knock-out clauses in the prospectus which effectively means that in a particularly acute scenario, the products are liquidated/redeemed. On that score, February 5, 2018 is “a date which will live in infamy” for Target managers-turned vol. sellers. The VIX spiked 100%+ at one point on Monday and headed into the close, there was a palpable sense of concern about what that might mean for the Seth Goldens of the world. Sure enough, after the bell, XIV collapsed 80%:
All you had to do to confirm your suspicions that retail investors never read the prospectus on XIV was tune into Twitter and StockTwits where thousands of Target managers were losing their minds in real-time trying to figure out what had happened. As I put it while this was going down: “Hey guys? XIV looks like it might be done.”
While Credit Suisse was mum on Monday evening, we got what amounted to confirmation that the worst case scenario was indeed playing out when Nomura announced that the Next Notes S&P500 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.
Fast forward 12 hours (give or take) and the black swan landed. Credit Suisse pulled the plug on XIV.
To be clear, not every one of these vehicles suffered the same fate and the conditions for “acceleration events” vary, but the overarching point is that retail investors clearly did not understand that this was even possible. And because they couldn’t even be bothered to read the prospectus which spells out how and why a given fund can effectively terminate at the drop of a hat depending on market conditions, you can be damn sure those investors had no idea why the trade was working in first place.
But hey, “there’s always Target”, right? I mean, assuming you didn’t tell your superior to go fuck himself before triumphantly throwing your name tag on the floor and walking out during the middle of a shift after you made your first couple of hundred thousand shorting vol. via products you didn’t understand.
On a more serious note (and this is the second of the two problems mentioned above), levered and inverse VIX ETPs present (or actually “presented” because it’s to a certain extent past tense now) a sizable rebalance risk. And see this is where someone (regulators, anyone) should have said something. Those things are effectively forced to panic buy VIX futs into a vol. spike if said spike is large enough. That rebalance has the potential to exacerbate an already bad situation depending on what the vega-to-buy looks like. Depending on liquidity, that could be difficult for the market to absorb. It certainly seems as though that risk was realized on Monday and it likely contributed to the chaos that unfolded over the last hour of trading on Wall Street, chaos which continued after the close.
As ridiculous as it seemed at the time the NYT article was published, anyone who knew anything about this realized that the evolution in market structure that was behind the Seth Golden story had the potential to crash the market one day. The proliferation of short vol. strategies embedded a material amount of systemic risk into markets and just to be clear, it is not 100% clear that this is over. While the deck has been cleared in terms of the VIX ETP rebalance risk, a sustained spike in vol. has the potential to cause an unwind in systematic strategies.
Whatever the case, now everyone suddenly understands that there’s a limit when it comes to how much market democratization is desirable. As pretentious as it might sound, retail investors have no business whatsoever explicitly shorting volatility. That was (always) absurd on its face.
The bottom line is that the proliferation of short vol. products was an example of financial market democratization gone too far. There are certain things you do not want the guy in charge of stocking the shelves at your local big box retailer doing, and it turns out that shorting volatility is one of those things.
Who knew trading VIX futures wasn’t as simple as making the cigarette break schedule at Walmart? Apparently not regulators.