History often rhymes – TVIX, VVX doesnt really rhyme but its close. Below is a very good review of what happened when TVIX broker and almost caused major problems for Credit Suisse.
For many investors, all was well the week of Feb. 13 but anyone who peeked behind the scenes caught a glimpse of an episode worthy of its own award show in the financial world.
For many investors, all was well the week of Feb. 13 as the S&P 500 finally reached highs not seen since June 2008. The VIX dropped over the week by nearly 7 percent to finish at 17.78 that Friday as short-term volatility also receded. Yet anyone who peeked behind the scenes caught a firsthand look at an episode worthy of its own award show in the financial world.
Out of nowhere, the following week, on Feb. 22, Credit Suisse, the sponsor behind VelocityShares’ line of VIX exchange-traded products, temporarily suspended creation of shares in TVIX, a two-times levered short-term VIX ETP. According to a terse news release, the product’s assets had gone beyond the firm’s own internal trading limits. That was it. Except that the suspension electrified attention from market commentators.
So what happened? Well, the first forebodings occurred on Feb. 10 when notional vega volumes for TVIX over the day reached 52 million, an astounding increase of 128 percent from the previous day’s TVIX notional vega volume. Vega traded is the dollar exposure to the change in volatility. It disregards the notional price of the derivative contract. While somewhat odd, the VIX did spike 12 percent that day, which would indicate more the extreme skittishness on part of SPX option traders as the S&P 500 declined by 0.9 percent. High volumes in TVIX would be expected given the majority of its users are short-term speculators playing the index.
The following week – the week of Feb. 13 – another round of huge notional vega volumes in TVIX traded. Daily volume averaged 52 million each day, with a one-day peak of 72 million on Feb. 15. That compared with a five-day average daily 23 million in the prior week.
Authorized participants, who include market makers and HFT firms, have the ability to create new shares of TVIX to meet demand and ensure liquidity in the product. In the week of Feb. 13, total notional vega outstanding for TVIX notes jumped by 40 percent, or 17 million, to reach 60 million in just five days. As exchange-traded notes are unsecured debt securities, this number also indicates exposure from the point of view of the note issuer and the associated broker-dealer.
Keep in mind that under the ETN model, dealers are not limited to the VIX futures market and can hedge exposure via a variety of products. This feature is a plus given that liquidity flows across various products within the ecosystem of the S&P 500 volatility market. The caveat is end-user counter-party exposure.
Perfectly hedging that change in TVIX exposure over the week would require an equivalent 17 million in additional notional vega exposure, for the issuer, to rebalance the notes’ underlying holdings. That’s 3.4 million each day. The front-month VIX future traded a five-day average of 82 million per day in notional vega volume that week. Using these back-of-the-envelope calculations, a rebalancing of TVIX hedges would account for an estimated 4 percent of the front-month futures volume. This does not include the additional volume that would account for the daily rolling of the note.
While these numbers don’t seem like much, remember this is per point change in volatility – and in this case the corresponding VIX futures. This also does not take into account the market impact of this trading – an influence on the VIX futures price – that would make it tougher to cost effectively hedge.
During that Feb. 13 week, the front-month VIX future’s price rose, particularly on Feb. 15 when it jumped to 24.25, a 15 percent spike from the previous day. At the end of the week there was a 3.58 premium over the spot VIX, or 19 percent, and that premium remained elevated over the following week.
I’m not necessarily arguing a connection between the huge increase in TVIX vega volumes, the rebalancing to hedge the change in vega outstanding, or the spike in the underlying front-month VIX future. Rather, the confluence of the events all contributed to a perfect storm that made it difficult to manage exposure, which undoubtedly played a hand in Credit Suisse’s decision to suspend creation of TVIX notes.
In other words, I imagine a prudent trading manager took a look at TVIX liquidity, compared it with liquidity in the VIX futures market, assessed the desk’s position, and decided, ‘Whoah. Let’s back away from this. Better safe than sorry.” Further issuance of TVIX notes was then suspended.
One consequence was TVIX then effectively became a closed-end fund. With a cap on supply, TVIX began trading at a premium to its net asset value, the level of which has fluctuated since and remains in place today. The price of this premium is an additional market-determined element for TVIX that should be interesting to observe as it changes with differing levels of volatility.
While this episode has been great fodder for market commentators all around, there is a broader implication for industry participants. It demonstrates the limited direct arbitrage of VIX futures to the underlying spot VIX – and thus movements in the VIX futures market can be subject entirely to forces of supply and demand. While front-month VIX futures tend to trade at a slight premium to spot, the movements of the past few weeks highlights the potential for the contract to occasionally and temporarily move in a different direction than the underlying spot VIX. As more participants trade volatility directly, thereby broadening the variety of views on the direction of the VIX, it is likely this kind of action will happen again.
Surging liquidity in the VIX ETPs – which in turn has broadened access to volatility – is a key driver behind trading volumes in the VIX futures. Welcome to the new world of volatility as an asset class.