So earlier this week we brought you Goldman’s breakdown of the nearly $4 billion VIX ETP industry.
We also noted that chances are, a whole lot of people using those vehicles have no idea what they’re doing. Because if Goldman’s clients are generally clueless (which, judging by the language in the actual note, they are), then that doesn’t bode well for the retail crowd.
Well, in a testament to the potential impact these products could have in an “adverse” scenario, Deutsche Bank is out explaining that it would only take a spike in the weighted average VIX future to ~23 (so, just the 66th percentile over the past 10 years) to trigger a massive short squeeze. Here’s more…
Via Deutsche Bank
Feedback Loops: Short VIX ETPs growing – their issuers’ short covering could exacerbate a severe selloff scenario
Inflows and performance to short VIX ETPs raise their importance as a feedback loop. There is now over $100mm vega in short VIX ETPs – the most since the immediate aftermath of the Brexit vote. There are two ways in which short VIX ETPs can be a feedback loop, exacerbating vol-of-vol: daily rebalancing of the note and the potential for the products to be redeemed in a very severe scenario. The combination of large short VIX ETPs and also below-peak but still substantial double-levered VIX ETPs leaves their issuers with around $70mm vega to buy on a sudden 5-vol spike. This number is not outsized given very strong VIX futures activity, but should a moment of illiquidity impair VIX futures liquidity it could become significant.
XIV would be redeemed on a sudden spike to a 66th %ile vol level. Although a sudden, dramatic, vol spike is far from our core view, investors need to consider what can happen in severe scenarios. To protect issuers from losses should an ETP’s NAV head below zero, issuers have the right to redeem the shares (which would put them in a position of covering all of the short futures) on a sudden spike in vol. The XIV’s threshold is an 80% selloff (VIX futures jumping 80%) in a single day. The unusually low level of vol has brought that threshold to a level that is not unthinkable: a weighted average VIX future around 23, which is the 95th %ile of the past three years, and the 66th %ile over the past 10 years.