24/3/18: A Traders’ Nightmare: When all Risks Coincide

Really great analysis of recent volatility spike (early February correction) from the BIS Quarterly:

“The VIX is an index of one-month implied volatility constructed from S&P 500 option prices across a range of strike prices. …Because it is derived from option prices, theoretically the VIX is the sum of expected future volatility and the volatility risk premium. Model estimates indicate that the rise in the VIX on 5 February far exceeded the change in expectations about future volatility (Graph A1, centre panel). The magnitude of the risk premium (ie the model residual) suggests that the VIX spike was largely due to internal dynamics in equity options or VIX futures markets.”

“Indeed, the considerable expansion in the VIX futures market – market size (ie total open interest) rose from a daily average of about 180,000 contracts in 2011 to 590,000 in 2017 – means such dynamics are likely to have had a growing impact on the level of the VIX.”

And the dynamics were spectacular. Per BIS:

“Among the growing users of VIX futures are issuers of volatility exchange-traded products (ETPs). These products allow investors to trade volatility for hedging or speculative purposes. Issuers of leveraged volatility ETPs take long positions in VIX futures to magnify returns relative to the VIX – for example, a 2X VIX ETP with $200 million in assets would double the daily gains or losses for its investors by using leverage to build a $400 million notional position in VIX futures. Inverse volatility ETPs take short positions in VIX futures so as to allow investors to bet on lower volatility.” One that comes to mind immediately is XIV. 

And things went spectacularly South for these, once VIX started heading North.

“The assets of select leveraged and inverse volatility ETPs have expanded sharply over recent years, reaching about $15 billion at end-2017 (Graph A1, right-hand panel). …many market participants use these products to make long-term bets on volatility remaining low or becoming lower. Given the historical tendency of volatility increases to be rather sharp, such strategies can amount to “collecting pennies in front of a steamroller”.

“Even though the aggregate positions in these instruments are relatively small, systematic trading strategies of the issuers of leveraged and inverse volatility ETPs appear to have been a key factor behind the volatility spike that occurred on the afternoon of 5 February. Given the rise in the VIX earlier in the day, market participants could expect leveraged long volatility ETPs to rebalance their holdings by buying more VIX futures at the end of the day to maintain their target daily exposure (eg twice or three times their assets). They also knew that inverse volatility ETPs would have to buy VIX futures to cover the losses on their short position in VIX futures. So, both long and short volatility ETPs had to buy VIX futures. The rebalancing by both types of funds takes place right before 16:15, when they publish their daily net asset value. Hence, because the VIX had already been rising since the previous trading day, market participants knew that both types of ETP would be positioned on the same side of the VIX futures market right after New York equity market close.”

“The scene was set.” Or put differently, once information about leveraged funds having to go long at the end of the day became market information, arbitrage went to work like a sledgehammer over trading books. The impact risk, compounded by adverse price movements, went through the roof. The two key changes in trading environment were made even more egregious by the fact that intraday spreads are usually higher toward the day close, and risk of non-execution had become completely intolerable for the leveraged funds. Which means spreads ballooned. This was a classic trading nightmare:

“There were signs that other market participants began bidding up VIX futures prices at around 15:30 in anticipation of the end-of-day rebalancing by volatility ETPs (Graph A2, left-hand panel). Due to the mechanical nature of the rebalancing, a higher VIX futures price necessitated even greater VIX futures purchases by the ETPs, creating a feedback loop. Transaction data show a spike in trading volume to 115,862 VIX futures contracts, or roughly one quarter of the entire market, and at highly inflated prices, within one minute at 16:08. The value of one of the inverse volatility ETPs, XIV, fell 84% and the product was subsequently terminated.”

26/10/15: About that Repaired Liquidity

Over recent months, I warned about the weakening liquidity in the global markets in my column for the Village Magazine, for the Manning Financial newsletter. And I covered the topic in my analysis of both the IMF WEO/FSR updates for October.

The problem continues to persist despite monetary policy remaining accommodative.

Per Credit Suisse report (emphasis is mine): “While bid-ask spreads for sovereign and corporate bonds in the U.S. and Europe have narrowed significantly from the wide gulfs of 2008, they are still well above their pre-crisis lows. Sovereign bond markets have also become shallower since the U.S. Federal Reserve began tapering its asset purchases in 2014 – and even markets that look deep based on trading volume can bottom out fast during bouts of volatility."

Credit Suisse points to October 15, 2014, when "U.S. 10-year Treasury bond yields fell 16 basis points and then recovered within 12 minutes, fluctuating 37 basis points over the course of a single trading day" - a rare event that happened only three times since 1998.  "Even for U.S. large-cap stocks, where bid-ask spreads are at their lowest levels since 2007, trades are increasingly clustered in the most liquid hours of the day. One in six S&P 500 stock transactions occurred in the last hour of trading in 2014, compared to one in 10 in 2007." In other words, world's most liquid market is now experiencing trades clustering seemingly linked to liquidity timing. "It also seems to be getting more difficult – and costly – to execute large equity orders. Block trades of more than 1,000 shares comprise just 10 percent of all transactions compared to one-third a decade ago. Bid-ask spreads for U.S. small-cap stocks have also widened relative to large caps.”

In simple terms, all of this indicates that the old regime of ever-expanding liquidity conditions in the markets that prevailed over two decades preceding the Global Financial Crisis are no longer with us.

Credit Suisse attributes pre-crisis markets deepening to three factors:

1. financial sector deregulation;
2. technological advances in trading; and
3. highly expansionary monetary policies

Per Credit Suisse: “…all three trends are reversing course. Dealer inventories fell dramatically after regulators raised banks’ capital reserve requirements and banned proprietary trading in the wake of the crisis. Total trading assets at the top 10 U.S. and European banks have fallen 17 percent since their 2010 peak. On the technology front, Credit Suisse says that “the marginal benefits of innovation in trading are receding” as high-frequency trading speeds push the boundaries of physics. And while zero interest rate policies in the developed world have supported risky assets since 2008, Credit Suisse believes rate hikes from the Federal Reserve and Bank of England could cause liquidity to evaporate from bond markets.”

Which is the same as saying that one a drug addiction kicks in, the highs of each subsequent hit tend to become replaced by the lows of each crash.

And which brings us to the point of concern forward:

• emerging regulatory environments (separation of banking activities across trading vs retail lines - covered by the EBU reforms and discussed in depth here, introduction of financial transactions taxes - covered here, increased costs of capital buffers - covered in the EBU reforms link above), as well as 
• changing market structures (rates 'normalisation' and dissipating power of global SWFs - written about here and briefly discussed in the context of early warnings here) 

all signal more instability linked to liquidity pressures in the markets in the future. Not less. Which is all fine and dandy, except the entire promise of the global financial reforms post Global Financial Crisis has been to lower that said structural instability.

Which is to remind us all that the road to hell is so often paved with good intentions.