LONDON, Feb 9 — The global market turmoil of the past week has shone a light on complex trading instruments listed in the United States and Europe — a number of which have been taken off the market — which some investors blame for the scale of the disruption.
Monday's stock sell-off triggered the biggest rise ever in S&P 500 volatility futures, forcing Credit Suisse and Nomura to close down products that enable investors to short the VIX after they posted massive losses.
The VIX itself measures market expectations of how choppy the S&P 500 might be over the coming month. With the US index becoming the most widely-traded in the world, the VIX is seen by many as a key barometer of investment sentiment.
Investors trade volatility through VIX futures contracts, reflecting bets on future stock swings.
Inverse exchange-traded products (ETPs) based on the VIX add another element of complexity, allowing investors to take short positions on volatility futures, hence betting on fading volatility.
Add in leveraged products, which enable the buyer to multiply the scale of their bet many times over, and the possibility for market havoc becomes clear.
The popularity of these products has grown in the past two years as strong global growth and low interest rates cemented expectations volatility would stay muted.
One of the main concerns with the products now available is that regular retail investors with no specialised knowledge have been trading them in growing numbers, greatly exacerbating the market swings they can produce.
Inverse volatility ETPs in Europe, for example, sank this week after a key gauge of European stock volatility surged. Providers of these products said, however, they were not at risk of a major blow-up as they have different structures and precautions to ensure only professional investors can use them.
But there are signs regulators are beginning to take note of the growing cottage industry for products such as inverse VIX trackers and other leveraged bets on market volatility.
Credit Suisse said its inverse VIX exchange-traded note (ETN), the second-most widely used product tracking the VIX, would stop trading by Feb 20, and the Swiss market watchdog on Wednesday said it was in touch with the bank about the product.
Sharp swings in European VIX ETFs
Most leveraged and inverse tracker products are US-listed, and have proliferated as the ETF industry itself expanded. Europe's ETF market is comparatively less developed.
But European products which do offer inverse or leveraged exposure to volatility have also been on a rollercoaster ride as volatility markets convulsed.
The London-listed Boost VIX short-term futures 2.25x leveraged daily ETP, issued by WisdomTree, soared 44 per cent on Tuesday and sank back 42 per cent on Wednesday as the VIX returned to more normal levels.
These were easily its biggest swings since its inception in March 2016. Some 23 million shares were traded in the instrument on Tuesday, more than six times the daily average, a WisdomTree spokesperson said.
UBS bank's VelocityShares inverse VSTOXX futures ETN, which allows investors to short the European volatility gauge, halted trading on Tuesday after a sharp fall.
Still, the ETN had assets under management of around US$30 million (RM118 million) on Tuesday, tiny compared with the XIV, which had a net asset value of US$1.9 billion prior to its collapse according to Lipper.
A source close to the matter said UBS was not affected by moves in its ETN as it was not a note-holder itself and did not need to hedge its position, contrary to Credit Suisse.
Formal regulation required?
ETF issuers said they had screening processes in place to ensure investors were sufficiently experienced to trade the products responsibly.
All the biggest European ETF providers said their products were mainly used by professional, not retail, investors.
But the fact ETFs are listed on exchanges means any investor can technically gain access to them. And it's easier than ever for inexperienced investors to buy these products, as retail investment platforms and apps have proliferated.
The Boost ETP tracking the VIX is available on Hargreaves Lansdown's investment platform, which has more than 1 million private investor clients.
A spokesman for Hargreaves Lansdown said the product is flagged on their platform as “sophisticated,” meaning investors must complete a questionnaire before buying it.
“If... we deem they do not have sufficient knowledge and/or experience, they are not able to trade that security,” he said.
Credit Suisse's XIV ETF was offered on eToro, a self-styled 'social media investment platform' allowing retail investors to follow each other, share portfolios and chat about trades. The platform has nine million users.
A day after Credit Suisse said it was closing the fund, a Romania-based eToro user commented “$XIV — time to buy the dip? Any chance for a rebound?”
European fund structure differs from US
Lyxor Asset Management, a subsidiary of France's Societe Generale, offers only ETFs rather than ETNs.
Its leveraged products, which include an ETF tracking the VIX and others providing double short exposure to major European indexes, are mainly used by professional investors for hedging purposes, and do not feature on the firm's retail website, Laird said.
British bank Barclays, which offers ETNs tracking the VSTOXX and VIX short- and medium-term futures through its iPath ETF arm, declined to comment on its products.
Britain's Financial Conduct Authority, which warned in April 2016 that exchange-traded products carried risks and were not suitable for all investors, had no comment on events this week.
Spread-betting offers leverage trades
Leveraged volatility trades are not limited to ETFs. Spreadbetting firms also offer "mom and pop" investors the opportunity to bet on the VIX.
CMC Markets allows investors to take a position in VIX of up to 10 times their upfront investment.
The margin rate increases from 10 per cent for a small position size to a maximum of 75 per cent for bigger bets.
“There are no plans to restrict leverage,” a CMC Markets spokesperson said on Wednesday.
Rival firm IG imposes a leverage limit of 8:1 on VIX futures, one of the tightest limits on their platform, and requires anyone wanting to trade VIX products to be classified as a professional investor.
“The few people that are speculating on it really know their stuff,” said IG dealer Ludwik Chodzko-Zajko.
A spokesperson for Plus500, which offers leverage of up to 50:1, declined to comment, citing a close period before the company reports results.
Echoes of past excess
For some investors, the implosion of these widely available leveraged products evokes past crises triggered by excessive financial engineering.
“It reminds me of the portfolio insurance in the 1987 meltdown,” said Marc Chandler, global head of currency strategy at Brown Brothers Harriman, referring to the Black Monday crash.
“Another example of financial innovation that the planet doesn't really need,” said Eric Moore, fund manager at Miton Group in London.
Blackrock, the biggest provider of ETFs in Europe through its iShares platform, criticised the inverse and leveraged products it said had magnified the sell-off.
“Inverse and leveraged Exchange-Traded Products are not ETFs, and they don't perform like ETFs under stress,” the world's biggest asset manager said in a statement. It said it supported a regulatory classification system that would clearly demarcate these products. — Reuters