Time for position limits on Vix futures?

Holy cow! Index Universe – self-described defenders of the ETF industry — have admitted there may be an issue with these products affecting the underlying assets, after all.

The case in point is the TVIX ETN, which started behaving oddly (ballooning in size) at the beginning of February. Note our stories about the matter here and here.

Here, meanwhile, is the sudden dose of reality that’s finally hit Index Universe (H/T Kid Dynamite):

A quick back-of-the-envelope calculation yields a pretty interesting set of numbers. As an industry, ETF issuers are net long over $1.5 billion of front-month exposure, and over $600 million of second-month exposure. Since we’re constantly defending the ETF industry as being “too small to be a systemic threat,” we initially assumed this was no big deal. But then we ran the numbers on the actual open interest in VIX futures:

To be honest, our initial reaction here was “holy cow!” For all intents and purposes, this small handful of ETFs effectively is the market for short-term VIX futures. And that’s actually more of a problem than you might even think.

Because most of the products need to rebalance daily—pro-cyclically—this means there’ll always be buyers on the days when the VIX is up, and sellers when the VIX is down. This has the effect of making VIX futures more volatile.

But none of that really gets to the point. There are actually two major issues here.

The first one relates to position limits. As we’ve pointed out before, given the regulatory hysteria applied to the influence of passive funds (such as ETFs) on underlying commodity markets, why on earth would regulators not have assumed that the Vix Index might be affected in exactly the same way?

The second point, which is still being overlooked, is the role of risk recycling via these products. We simply do not know how much Vix ETN exposure is or is not hedged via the Vix futures market, and how much of it is hedged internally via the issuer banks, or via other securities. Vix futures in many cases are the last resort hedge.

Thus, to make the assumption that ‘x’ ETN-size translates to ‘y’ Vix future exposure, is simply naive.

Tabb’s Henry Chien made the point well last week:

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.

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.

That’s to say, it’s all about the issuer desk’s overall position, which may or may not be completely positioned in Vix futures.

As for the tail wagging the dog effect, should regulators not show some consistency and at least have a formal look into the possible effects? We think that unhinged volatility levels are, after all, just as much of a concern for investors as pumped up commodity prices.

Related links:
As Volatility Turns: Understanding the TVIX Saga
- Tabb Forum
Volatility ETFs Often Own All VIX Futures
– Index Universe
Double trouble in TVIX -
FT Alphaville
Vix wagging
– FT Alphaville

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