The potential for VIX ETPs to tip the first domino on the way to triggering the dreaded feedback doom loop that starts with a panicked rebalance into a VIX spike and progresses to force vol. control funds and CTAs to deleverage into a falling market has never been higher.
We’ve discussed this ad nauseam in these pages and you can review the entire series here (from most recent to oldest in descending order):
- The ‘Doom Loop’: How VIX ETPs Exacerbated Last Week’s Vol. Spike
- A Nightmare On Wall Street – Updating The Feedback Doom Loop (Again)
- A Nightmare On Wall Street – Updating The Feedback Doom Loop
- Investigating The Market’s “Nightmare Scenario”
Quickly recapping, because of the low starting point, a nominally small VIX spike would look huge in percentage terms. Here’s why that’s a problem courtesy of “Gandalf” (Marko Kolanovic):
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.
Needless to say, panic short covering into collapsing liquidity would be a disaster – if the market can’t absorb it, the VIX spike would likely be supercharged.
Well, that raises questions about how programmatic strats would react if the vol. spike suddenly threw equities for a “loop” (pun intended).
It’s possible to get a sense of the impact VIX ETPs would have by monitoring vega-to-buy (what providers would need to buy on a hypothetical N-vol spike in the VIX futures curve). Thanks to inflows to short VIX ETPs (which totaled ~$1.5 billion in August increasing the AUM to ~$2.8 billion), that figure is at an all-time high. Here’s Deutsche Bank:
Potential impact of VIX ETPs reaches new highs. VIX ETP providers would need to buy around $150mm vega on a hypothetical 5-vol spike in the VIX futures curve, which is ~50% of the average daily 1st/2nd/3rd VIX futures volume over the last 2 months.
This vega-to-buy is at a record highs, almost doubling since mid-July on inflows to short VIX ETPs.
Mercifully, futures volume has grown with ETP interest, which means the impact of that rebalance is just now getting back to its previous highs. “Even as the vega rebalance on a vol spike has doubled in size over the last year, the impact on the market as measured by VIX futures has not eclipsed the early 2016 levels,” Deutsche Bank continues. So that’s good in the sense that the market is keeping up, but bad in the sense that “back near the highs” in terms of impact still means… well… it means “back near the highs.”
Here are the visuals:
Is there a bright side to this nightmare?
Yes, actually. According to Deutsche’s feedback loop dashboard, vol. control funds and CTAs wouldn’t likely exacerbate a selloff if things turn ugly (note that every category in the “risk impact” column was shaded red this time last month).