A Nightmare On Wall Street – Updating The Feedback Doom Loop

Remember “Investigating The Market’s ‘Nightmare Scenario'”?

Of course you don’t. That post is from May and you’ve been drunk slept since then.

But it was an important piece. Essentially, it outlined the potential consequences of the feedback loop that’s embedded in markets thanks to the proliferation of VIX ETPs and systematic strats that lever up in a low vol. regime.

Here, in a nutshell, is the potential problem:

One wonders, for instance, what would happen if rebalancing by VIX ETPs after a sudden vol spike exacerbated said vol spike which in turn forced vol control funds and CTAs to deleverage all at once. And then there’s the risk parity component.

More than a few strategists have explored this recently, with JPMorgan’s own Marko Kolanovic (that would be “Gandalf”) being the latest prominent figure to note that given the low starting point for vol., a nominally/optically small VIX spike would look rather large in percentage terms and that could lead to “catastrophic” losses for some strats. For those who missed it, here’s the actual quote:

Given the low starting point of the VIX, these strategies are at risk of catastrophic losses. For some strategies, this would happen if the VIX increases from ~10 to only ~20 (not far from the historical average level for VIX). While historically such an increase never happened, we think that this time may be different and sudden increases of that magnitude are possible. One scenario would be of e.g. VIX increasing from ~10 to ~15, followed by a collapse in liquidity given the market’s knowledge that certain structures need to cover short positions.

That echoes something Deutsche Bank’s Rocky Fishman has been warning about (or maybe “pontificating on” is less hyperbolic) for months. Here’s what Fishman said earlier this year:

VIX ETPs are a larger-than-usual feedback loop in markets. Inverse and levered VIX ETPs’ need to buy VIX futures when vol is rising and sell it when vol is falling creates a feedback loop in vol that can lead to high vol-of-vol. Currently, the combination of low VIX futures levels (making an N-point vol spike look like a huge percentage), large short ETPs, and large levered ETPs leaves over $70mm vega to buy on a hypothetical 5-vol spike in the VIX futures curve

However, it is uncertain how liquid the VIX futures market would be after that kind of vol spike. The large amount of vega to buy may be hard for the market to absorb in some stress events, which may cause further exacerbation of a vol spike.

Well speaking of vega to buy on a vol. spike and liquidity in VIX futs, Rocky is back with his latest take on this and as you may or may not know, he tracks everything outlined above with a handy “dashboard.” Here’s the updated version:

Two things stick out there: 1) vega to buy on a 5-vol move is now up to $100 million; that’s in the 98th percentile versus the last five years; 2) CTA equity exposure is now in the 91st percentile.

Here’s a full update on the nightmare scenario…

Via Deutsche Bank

Large inverse, levered VIX ETPs are likely to cause volatility to outperform on an SPX selloff

VIX ETP rebalancing impact remains large. VIX ETP providers would need to buy around $100mm vega on a hypothetical 5-vol spike in the VIX futures curve, which is over 40% of the 2-month average daily 1st/2nd/3rd VIX futures volume.

An N-vol move would be a large percentage move from low vol levels. VIX futures are several points below their historical average and markets would not require a tail event to experience a moderate 2 vol move in VIX futures. A large percentage move means ETP providers would have to buy more VIX futures on a rebalance, pushing vol levels higher.

Short ETPs have had large outflows this month. The SVXY and XIV has drawn significant cash outflows this month following strong performance. This is the first month since February to see net outflows.

Expect implied vol to outperform on a large SPX selloff. ETP issuers would have to buy VIX futures as vol is rising, which can push vol higher and is be a substantial risk with the products still large and vol levels low.

CTAs exposure to equities and US Treasuries are near highs

CTAs continue to increase exposure to equities and US Treasuries. Our estimated CTA betas to SPX and EFA have increased further over the last month, while EEM exposure is flat. SPX and EFA exposure is in the 90th%-ile over the last 3 years. While being long equities indicates a “risk on” sentiment, CTAs have continued to have limited exposure to commodities ex-oil and gold. In fact CTA exposure to gold is near highs, while their beta to Treasuries are similarly stretched.

Vol remains low among asset classes. Global equities and Treasuries have continued their rallies, with implied vol levels near floors. Low vol and recent performance have caused to CTAs to increase exposure to these asset classes.

With CTA betas to SPX and EFA growing, a sharp equity selloff could be exacerbated by CTA selling. CTAs would have to sell futures into a declining market on a selloff, the higher the beta to an asset class the more CTAs would likely have to sell.