NEW YORK (AFP) – Wall Street’s plunge this week has brought scrutiny to complex niche products to trade on volatility that market experts believe were poorly structured and exacerbated swings in stocks.
Only days before markets began to go haywire, Barclays chief executive Jes Staley warned about the risky investments at the World Economic Forum in Davos.
Many investors were using the exchange-traded products to place bets that volatility would stay low or go down, a “very smart” wager during a period of persistently low volatility, Staley said.
“But if this thing turns, hold on to your hat,” he added.
That change took place on Monday as the Dow Jones Industrial Average was in the midst of a more than 1,000 point drop that included a violent 800-point dive in the blue-chip index over 10 minutes.
During that period, the CBOE Volatility Index, known as the “VIX” index, also shot higher.
That shift spelled instant losses for “short-vol” trading vehicles, including exchange traded products by Japanese bank Nomura and Credit Suisse that had predicted volatility would go down, known as a “short” investment.
Because the VIX is known unofficially as Wall Street’s “fear” index over possible bad future outcomes, a sudden surge likely contributed to the brutal losses in the equity markets.
Short bets on volatility had become a popular stance, outnumbering trades that anticipated a rise in volatility and in one case earning a return of almost 200 per cent in 2017, according to a note from Goldman Sachs.
“Hedge funds, prop traders, retail investors… everybody was on the same exposure,” said Brett Manning, senior market analyst at Briefing.com. “It worked really well for a long time.”
But the investment suddenly went south when markets turned sharply on February 2, when a surprisingly strong US jobs report sparked worries about inflation.
“Everybody was on the same side of the trade,” said Manning. “Hedge funds started to move out and people started to panic to cover these investments.”
Conditions worsened this week, leading both Credit Suisse and Nomura to liquidate their funds amid heavy losses.
In the aftermath of the turbulence, Fidelity Investments halted trading on exchange traded funds that bet on low volatility.
While it’s impossible to know the exact losses, the market was estimated at between $3 billion and $4 billion, a small part of the overall market for exchange traded products, a growing type of investment that is traded on exchanges and based on assets, such as stocks, commodities or indices.
The investments were widely known in the financial world as failure-prone because of the tendency of markets to eventually become volatile.
Credit Suisse even warned in its prospectus that the “long-term expected value” of the investment is “zero”.
Regulators are now looking more closely at the vehicles. Swiss regulators are following up with Credit Suisse, and New York Federal Reserve President William Dudley pledged more scrutiny of the products.
Asset manager BlackRock called for a “regulatory classification system that would label levered and inverse exchange traded products differently than plain-vanilla (ones) in order to clarify for both regulators and investors the risks associated with those products.”
One consequence of this week’s shakeout is that the products in question have been “significantly defanged,” making a repeat peformance of the February 5 chaos unlikely anytime soon, said a note from Bank of America Merrill Lynch.