12 February 2018

ViX has made the stock market less stable

By Patrick L Young

It’s fashionable, if ill-considered, to dismiss financial innovation. Yet financial innovation has, over time, benefited mankind. On a very simple level, credit cards are a nifty product that preclude the need to carry large amounts of cash or worry too much about crossing between currency zones. At the same time, of course, simply to wave through all financial innovation as progress would, even to those of us who advocate financial innovation, appear foolhardy.

In recent days financial markets have been buffeted by a spot of volatility which has had the interesting side impact of leading to a particular focus on financial innovation. At first glance, the idea that products based on volatility might themselves be prone to volatility when markets become excitable, is a truism. A product called the ViX (short for “Volatility Index”) has long captured the imagination of a cluster of investors. The ViX itself is a second-generation derivatives product measuring volatility (the first – the Volax – was, alas, discontinued by the Deutsche Börse during one of their periodic absences of forethought).

Essentially the ViX measures the likelihood of volatility in the S&P5000 stock index. In recent times, the US share market has been going upwards in a fairly relaxed fashion, which has caused ViX to trend down. ViX is agnostic about the actual direction of the market; rather, it is interested in how much the market oscillates – in other words, markets that are metaphorically on herbal infusions have a low ViX, while those that are agitated by extreme caffeination to the point of ADHD will exhibit a high ViX rating.

For some time the ViX has been almost soporific – leading various people to believe that easy money involved merely selling volatility and sleeping soundly. That volatility down trend changed in early February, when the US stock market declined fairly brusquely and the ViX rocketed upwards.

So at its base the ViX is akin to a handy gauge of the stock market’s stress levels. However, like all tools in the financial armoury, it has its limits. Bankers in particular have a remarkably stubborn streak, which tends to make them milk any good idea with such vigour that it ends up looking foolish. Step forward, in this case, the highly-paid wizards of Credit Suisse who took the ViX contract and turned it inside out. They even inverted the name, calling it the XIV. In practical terms, the XIV essentially did what it was supposed to – garnering fees for the bank and helping clients transfer risk (since all markets can be seen as differing perspectives between counterparties) and generally looking like a wonderful tool – until volatility spiked.

With the XIV being a market which would go down as volatility went up, the recent market shenanigans meant the XIV collapsed. In fact, it imploded to the point where Credit Suisse promptly closed the product down and undertook a carpet sweep repo. Folk who had made easy money on low volatility were left with some serious wound-licking.

Which gives us a point to ponder about the structure of volatility markets. While a rev counter is a great tool for assessing the health of engines and speedometers enable us to stay on the right side of speed cameras, the ViX isn’t like that, because it isn’t per se unrelated to the markets it is trading. Market folk might refer to this as the “egg chicken repo origin agreement” (since they think that everything can be indexed, and that it’s always better to discuss finance in jargon, in case ordinary people should find out what a nebulous influence many financiers are on their fiscal well-being).

The Chicago Board Options Exchange (CBOE) saw its own share drop by double digits in a day and press conferences were hastily called. To be fair, the CBOE itself did no wrong all week and operated impeccably. That said, many wondered just why it had been so eager to licence such a multiplicitous series of variations on a theme of ViX. Indeed the Financial Times talked with one of the original ViX futures designers, and quoted his breathtaking remark: “I don’t think all the people buying these products understand the complex mechanics of it. I think they are terrible products that serve no real purpose.”

A lot of leveraged products have slipped into the market via the nifty mechanism of Exchange Traded Funds. ETFs are wonderful things, delivering a unit-trust style investment for a fraction of the cost of that antiquated product. However, a trend has arisen for leveraged products such as ETNs (Exchange Traded Notes – of which the XIV is an example). Some of these products can resemble a powder keg of leverage that is primed to explode when the market has a sustained shakeout. Regulators, particularly the US stock-centric SEC, look as if they have been negligent in clearing such products without sufficient health warnings – while the long gradual upswing of stocks in the demented QE era of funny money has lulled investors into a false sense of security.

The February correction may have delivered a sufficiently short sharp shock to jolt the complacency of regulators.

In essence, having a ViX gauge measuring volatility is one thing. Having a ViX which can be traded alongside the prevailing markets is another. But having a vast array of differentiated products trading volatility may, it could fairly be argued, be influencing volatility itself. The worry is that the more highly leveraged products could be causing that volatility to be exacerbated. (For example, why, given that we can already buy and sell volatility in ViX futures, do we need a separate ETN providing a turbocharged inverse volatility index?)

Before Credit Suisse pulled the plug on XIV many traders felt the product had become so inherently unstable as to exacerbate volatility. It is not the first time that such an innovation has turned out to be a problem.

The canny stock investor and derivatives dervish Thomas Peterffy (founder & CEO of the multi-billion-dollar Interactive Brokers) has likened the volatility markets craze to portfolio insurance. Portfolio insurance was developed back in the dark ages of analogue trading as a quasi-insurance hedging vogue. Many later thought it had been instrumental in the great crash of 1987 rather than helping alleviate market losses.

Peterffy has certainly identified one key point: for all the brouhaha of the last decade painting the ViX as some remarkable piece of financial alchemy, the simple truth is that many financial products are not that highly evolved. But then again, financial products are often developed by economists. And the one thing traders know is that when an overwhelming majority of economists agree on anything, the only thing you can do is trade the other way.

Patrick L Young is a former stock exchange CEO and publisher of Exchange Invest.