Tagged: ETNs



No other word for it.

Yesterday as VIX volatility futures settled on an odd Tuesday, Barclays suspended two of the market’s biggest Exchange Traded Notes (ETNs), VXX and OIL.

Let me explain what it means and why it’s a colossal market-structure deal.

VXX is the iPath Series B S&P 500 VIX Short-Term Futures ETN. OIL is the iPath Pure Beta Crude Oil ETN (OIL). iPath is a prominent Barclays brand. Barclays created the iShares line that Blackrock bought.  It’s an industry pioneer.

Illustration 76839447 © Ekaterina Muzyka | Dreamstime.com

These are marketplace standards, like LIBOR used to be.  This isn’t some back-alley structured product pitched from a boiler room in Bulgaria (no offense to the Bulgarians).

Let’s understand how they work. ETNs are similar to Exchange Traded Funds (ETFs) in that both trade like stocks.  But ETNs are unsecured, structured debt.

The aim of these particular notes is to pay the return via trading reflected in crude oil, and volatility in the S&P 500 stock index. 

OIL uses quantitative data to select baskets of West Texas Intermediate oil futures that the model projects will best reflect the “spot” market for oil – its immediate price.  But nobody owning OIL owns anything. The ETN is just a proxy, a derivative.

VXX is the standard-bearer for trading short-term stock-volatility. It’s not an investment vehicle per se but a way to profit from or guard against the instability of stock-prices.  It’s recalibrated daily to reflect the CBOE Volatility Index, the VIX.

In a nutshell, a security intended to give exposure to volatility was undone by volatility.

I loved this phrase about it from ETF.com: “Volatility ETPs have a history of erasing vast sums of investor capital over holdings periods as short as a few days.”

ETP is an acronym encompassing both ETFs and ETNs as Exchange Traded Products.

It’s not that Barclays shut them down. They continue trading for now. The bank said in a statement that it “does not currently have sufficient issuance capacity to support further sales from inventory and any further issuances of the ETNs.”

ETF industry icon Dave Nadig said, “The ‘Issuance Capacity’ thing is a bit of a get out of jail free card, so we can interpret that as ‘we no longer feel comfortable managing the implied risk of this product.’”

Barclays said it intends to resume supporting the funds at some future point. But we’ll see.  Credit Suisse ETNs that failed in Mar 2020 amid Pandemic volatility were stopped temporarily too but suspensions became permanent.

The lesson is clear. The market is too unpredictable to support single-day bets, which these instruments are principally designed for. 

I’ve long written about the risks in ETPs. They’re all derivatives and all subject to suddenly becoming worthless, though the risk is relatively small.

And it’s incorrect to suppose it can happen only to ETNs. All tracking instruments are at risk of failure if the underlying measure, whatever it is, moves too unpredictably.

You might say, “This is why we focus on the long-term.  You can’t predict the short-term.”

Bosh. Any market incapable of delivering reliable prices is a dysfunctional one.  It’s like saying, “I don’t know what to bid on that Childe Hassam painting but I’m sure over the long-term it’ll become clear.”

Bluntly, that’s asinine. Price is determined by buyers and sellers meeting at the nexus of supply and demand.  If you can’t sort out what any of that is, your market is a mess.

It remains bewildering to me why this is acceptable to investors and public companies. 

It’s how I feel about empty store shelves in the USA. No excuses. It reflects disastrous decisions by leaders owing a civic duty to make ones that are in our best interests.

Same principle applies. We have a market that’s supposed to be overseen in a way that best serves investors and public companies. Instead it’s cacophony, confusion, bellicosity, mayhem.

At least we at ModernIR can see it, measure it, explain it, know it.  We’ve been telling clients that it’s bizarre beyond the pale for S&P 500 stocks to have more than 3% intraday volatility for 50 straight days. Never happened before.

Well, now we know the cost.

Oh, and the clincher? VIX options expired yesterday. Save for four times since 2008, they always expire on WEDNESDAY. Did one day undo Barclays?  Yes.

That’s why market structure matters. Your board and c-suite better know something about it.

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.

Mean Reversion

If our stock reverts to the mean, I don’t see that high-frequency trading matters.

I’m paraphrasing what many CEOs and CFOs believe. The market is complicated. There’s volatility. Trading is global. ETFs and derivatives probably affect volume. But I’m trading at a reasonable multiple of forward earnings, so who cares?

I hear that question sometimes. More often, reporters tell me they hear it from CEOs and CFOs. What difference does it make that 60% of my volume is the same shares trading over and over? So we had 7,800 public companies in the Wilshire 5000 in 1997 and now there are 3,600 in it. My stock trades at 16 times earnings. That’s about right.

So long as my house goes up in value, what do I care that people are getting these really ridiculous variable-rate, no-money-down mortgages for 125% of the home’s value, which means they’re financing the furniture over 30 years? What difference does it make to me? My house is still up 15% in value.

According to the ETF Industry Association, at July 2012 there were 1,486 exchange-traded products (ETPs), up from zero about 15 years ago, give or take, and fast approaching one ETP for every two stocks. The industry had net July inflows of $17.1 billion, mostly to equity ETFs. (more…)

Facing the Book Facts

My flight today to Cincinnati through Atlanta froze in the blizzard of lost travel dreams. Which proved fortuitous, as I was able to skip Atlanta and flight straight to Cincinnati, saving me five hours. I love blizzards.

Speaking of sharing personal details, Facebook is the biggest entrepreneurial deal of the current day. It’s also a focal point for the widening divide between public markets and growth enterprises. Facebook may or may not go public. If it does, much of its prodigious progress will already have been funded, and the public markets will serve more as a wealth-transfer device than a capital-raising tool.

It’s a microcosm for investor relations. Speaking of speaking, I’m at the NIRI Tri-State Chapter tomorrow for what I have assured my hosts will be a riveting exploration of how to be cool in an IR seat heated to silliness by transient trading. Hope to see you locals there, by sled, snowmobile or telemark!

Anyway, according to the stock-market newsletter Crosscurrents, the average holding time for institutional positions is now 2.8 months. “The theory that buy-and-hold was the superior way to ensure gains over the long term, has been ditched completely in favor of technology,” writes Alan Newman, its author. (more…)