‘The Risk Remains Large’: Updating The VIX ETP ‘Doom Loop’

Ok, I think this is as good a time as any to update you on where this market stands in terms of what we’ve variously dubbed the “nightmare loop” or, if you like, the “doom loop.”

Generally speaking, what we’re talking about when we talk about “feedback loops” in this context is the potential for a VIX spike to trigger a panicked rebalance by inverse and levered VIX ETPs that would in turn exacerbate said spike and eventually force vol. control funds and CTAs to deleverage into a falling market. The following quote from JPMorgan’s own “Gandalf” (Marko Kolanovic) is obligatory for posts on this topic:

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.

If you need a refresher on this, you’re encouraged to see the following posts (in descending order, most recent at the top):

The last time we checked in on this was on September 17 (first post in the list above), when we noted that according to Deutsche Bank, the potential impact of VIX ETPs had hit a new high as VIX ETP providers would need to buy around $150mm vega on a hypothetical 5-vol spike in the VIX futures curve. That figure represented a near doubling since mid-July on inflows to short VIX ETPs. Ultimately, the rebalance reached $180 million last month.

Ok, so that would eventually moderate – bit. As Deutsche notes in their latest update, there were large outflows from short vol ETPs in September:

This follows the record-low VIX settlement in September below 10. Roughly 2/3rds of August’s inflows into the short volatility ETPs have come off in September. This movement is similar to past periods following vol spikes, which see an increase in short vol exposure followed by an unwind as vol declines.

That said, levered long funds saw renewed inflows. Here’s the chart:

The end result: still precarious…

VIX ETP rebalancing impact near 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.

As you can see, it wouldn’t take much to push the rebalance back to a record and indeed if vol. remains suppressed it seems entirely likely that’s what we’ll see. Reiterating Kolanovic’s point, Deutsche concludes as follows:

The risk from VIX ETPs remains large because it doesn’t take a large vol move to cause a large rebalance. With VIX future levels this low, a given N-vol move is a large percentage of the weighted VIX future – increasing the sensitivity of these percentage-based products. With VIX futures several points below their historical average, a several point move would not be a tail scenario.

Note that last bolded bit: it doesn’t take a tail scenario to trigger this.