Insights

Can you answer this question?

Posted by Michael Mescher on 07 Aug, 2017

With volatility on historic lows, many investors incorrectly assume a low VIX is indicative of a stable market. In spite of this perception, volatility professionals are becoming increasingly vocal about a new type of hidden systemic risk buried in the structured product space. This poorly understood risk has the potential to create a cascading effect across markets resulting in significant deleveraging and rapid wealth destruction. To make matters worse, this leads to a rise in correlation which further compounds exposure and losses.

Here’s one example of this hidden risk:

Since 2009, the volatility ETP space has exploded in popularity and reflects billions in notional exposure. One such product, XIV (AUM = $830M), sells VIX futures and collects the risk premium for selling volatility. If the underlying portfolio of short VIX futures appreciates more than 80% in one day, the fund winds down, resulting in a market order to liquidate the short futures position.

With VIX futures at all time historical lows, 80% becomes an increasingly attainable move in a period of market stress. As a reference, the deleveraging of August 2015 recorded the corresponding VIX futures at a level 133% higher than current market prices.

In the event of a liquidation, this product (which is one of many) would by itself be required to buy approximately 70,000 VIX futures. In addition to XIV, other volatility products would have a similar mandate to buy VIX futures at market prices. Morgan Stanley recently highlighted this dynamic with the below chart:

vix futures

VIX futures trade about 100,000 contracts a day on average. An order to buy 200,000 would represent risk of $200M per handle when futures can move a handle over the course of a few seconds. Given the risk restrictions on banks in a post 2008 world, who steps in to sell that risk?

[EDIT]: here you can find a follow up on this piece.


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