Vapor Risk

One definition of “volatile” is “passing off readily in the form of vapor.”

Through yesterday, XIV, the exchange-traded security representing a one-day swap from Credit Suisse and offered by VelocityShares, had seen 94% of its value vaporized. It triggered a technical provision in the fund’s prospectus that says Credit Suisse may redeem the backing notes if the fund loses more than 80% of its value. It’s shutting down.

By mixing exposure to futures and other derivatives of varying lengths tied to the S&P 500, XIV aims to let investors capture not the appreciation of stocks or their decline if one shorted them, but instead the difference between current and future prices. Volatility.

The fund says in sternly worded and repeating fashion things like: The ETNs are riskier than securities that have intermediate or long-term investment objectives, and may not be suitable for investors who plan to hold them for longer than one day.

The idea for investors is hitting the trifecta – long rising stocks, short falling stocks, and with things like XIV, capturing the difference between prices to boot.

The problem for “synthetic” exchange-traded notes (ETNs) like XIV backed by a Credit Suisse promissory note is they hold no assets save commitment to replicate an outcome. They are for all intents and purposes vapor.

They have proved wildly popular, with several volatility ETNs routinely in the top 25 most actively traded stocks. In a low-volatility environment, differences in prices between short-term and long-term options and futures can mean returns of 5-10% on a given day, without particular risk to either party.

But if volatility renders futures and options worthless because prices have changed too much, all the investor’s capital vanishes.

Is this what rocked stocks globally? No. There is, however, a lesson about how global financial markets work that can be drawn from the demise of XIV.  Everyone transfers risk. Investing in volatility is in a sense a hedge against being wrong in long and short positions. If you are, you still make money on the spread.

The biggest risk-transfer effort relates to currencies and interest rates. As with stocks, the transference of unexpected fluctuations through swaps – which the Bank for International Settlements says have $540 trillion of notional value (but precious little actual value, rather like XIV) – only works if the disturbances are small.

In the past month, the US Treasury was laying in dry powder before the debt ceiling. The size of auctions exploded by about 50%. Getting people to buy 50% more of the same thing caused interest rates to shoot up. The rise in debt devalued the dollar, a double whammy. Hedges fell apart.

Counterparties for these hedging swaps also transfer the risk, often with short-term Exchange-Traded-Fund (ETF) or ETN hedges that lapse on Fridays. They are the same banks like Credit Suisse making markets in stocks. This is what caused stocks to swoon, not a strong jobs number or higher wages. On Friday, Feb 2, stocks imploded. I suspect counterparties were selling assets to cover losses.

Now we come to a warning about ETFs. Their original creators, who were in the derivatives business, likened ETF shares to commodity warehouse receipts, a representation of something physically residing elsewhere.

In this long bull market, money has poured into ETFs. The supply of things in the warehouse has not kept pace with the exposure to it via ETFs.  We have written over and over about this problem. The way ETFs trade and the way underlying assets increase or decrease are two different processes.  Investors buy and sell the warehouse receipts. The fund and its Authorized Participants in large block transactions occasionally adjust underlying warehouse assets.

We can see by tracking the amount of money flowing to big ETFs from Blackrock, Vanguard and State Street and counter-checking those flows against reported fund turnover that insufficient warehouse commodities (stocks) back ETF shares.

Why? Because buying and selling things incurs transaction costs and tax consequences, which diminishes fund performance. Shaving those is a gutsy strategy – sort of like dumping fuel in a car race to give yourself an advantage in the last flaps by running light and on fumes.

But you can run out of fuel. If the value of the stuff in the warehouse plunges as everybody tries to sell, we’ll find out what part of those warehouse receipts are backed by vapor.

So far that has not happened. But we don’t know what damage has been done to market makers short ETF shares and long stocks or vice versa. The next week will be telling. If a major counterparty was irreparably harmed, we could be in a world of vapor.

If not, the hurt will fade and we’ll revert to normal. Right now, forecasts for stocks in our models say vapor risk is small. But let’s see what happens come Friday, another short-term expiration for derivatives.