Heisenberg Report

‘The Biggest Risk Is A Quick SPX Selloff At The End Of The Day’: It’s Time For A ‘Doom Loop’ Update

Ok, so it’s time to talk about VIX ETPs and the “doom loop” again.

Hopefully you don’t need a refresher on this, because if you do it likely means you haven’t been paying much attention to how shifts in market structure are creating systemic risks that no one understands, but just in case, the idea is that thanks to the low starting point on the VIX, a nominally small spike could force inverse and levered VIX ETPs to panic buy VIX futs into said spike, thus exacerbating the situation and ultimately forcing CTAs, vol. control funds, and risk parity to deleverage into a falling market.

This is either very scary or not a big deal depending on the predisposition of the person you’re asking. One person who has been tracking this for quite sometime is Goldman’s Rocky Fishman. Rocky was at Deutsche until mid-2017 and upon jumping ship to the Squid, he picked up right where he left off. On Thursday, he’s out with a new piece on VIX ETP rebalance risk, but before he gets to that, he notes something anomalous.


“The net position of VIX ETPs has become short over the past few weeks, for only the second time in their eight year history,” Fishman begins, before explaining that “the shift toward negative net vega has happened for passive reasons: the shares’ strong performance (XIV up 185% in 2017) has left each share of the XIV and SVXY with 50% more VIX futures exposure than it had three months ago, offsetting net outflows from the products.”

While that, in and of itself, isn’t necessarily something to be overly concerned about, Fishman notes that “the size of inverse and levered ETPs in the aggregate is important and the growth of inverse VIX ETP products is worrisome [because] although small in the context of the broader US equity market (VIX ETPs have around $5bln total AUM), ETPs are large in the context of the VIX derivatives market.”

There’s a very interesting discussion in the note that finds Fishman breaking down CFTC positioning, but in the interest of brevity, we’ll cut to the above-mentioned “doom loop” dynamic. The bottom line is this:

The most important takeaway of the net short VIX ETP position is that short VIX ETPs now have more vega to buy on a given vol spike than ever before – leaving the potential for an outsized increase in volatility should the SPX sell off sharply.

Just a 3-point spike in VIX futures (so, from the current weighted average of 11.5 to 14.5) would force VIX ETP issuers to buy $110mm vega. That, Fishman says with some alarm, is “double the highest ever seen before 2017” and represents “~60% of daily 1st/2nd VIX futures volume, and around 30% of open interest.”

If that were to materialize and the rebalance were to exacerbate the vol. spike, well then Marko Kolanovic’s “quantitative exuberance” comes into play. Recall this from Marko’s year-ahead outlook:

We think that for the next market crisis, irrational exuberance in the ‘tech bubble’ sense is not needed. The reason is the prevalence of quantitative and passive strategies that don’t decide based on emotions, but rather based on measures such as the level of interest rates, volatility, price momentum, or bond-equity correlation. Examples of these strategies include Volatility Targeting, Low Volatility strategies, Trend Following strategies, Risk Parity strategies, Dynamical hedging strategies, Volatility selling strategies, and others. In addition, there are relative value strategies that transmit risk premia compression across asset classes and strategies. With volatility at record lows and central bank balance sheet inflows peaking this year, these strategies currently experience ‘quantitative exuberance’ that poses risk when monetary policies start normalizing in a meaningful way next year.

Right. Bloomberg’s Tommi Utoslahti was out underscoring this overnight. “Sustained lower volatility enables traders and hedge funds to take more leverage for the same value-at-risk (VAR) score,” Utoslahti wrote, adding that “the longer markets stay calm, the more vulnerable they become to a sudden shock causing an outsized deleveraging event.”

Fishman reminds you that the biggest risk is an “a quick SPX selloff near the end of a trading day, pushing issuers to rebalance positions quickly to avoid unhedged overnight risk (ETN issuers) or excessive tracking error (ETF issuers).”

What could cause this, you ask?

Well, as far as the quick selloff at the end of the day goes, think: Mueller, North Korea and/or Trump with Trump being the common denominator.

But more generally, an uptick in inflation that catches central banks behind the curve and brings out the hawks could be what tips the first domino on a bond tantrum.

Or, something out of left field – like say the “fake news” that China is halting purchases of U.S. Treasurys.

Unlikely? Of course. Possible? Also of course. And once the ball gets rolling, it will be hard to stop the self-feeding nightmare.

“Come play with us Danny…”