By betting on calm, did investors worsen the stock market fall? | Nils Pratley

Back in 2008, the non-financial world had to digest a lot of jargon in a hurry – collateralised debt obligations (CDOs), asset-backed securities (ABSs) and the rest of the alphabet soup of derivative products that contributed to the great banking crash.

This week’s diet has felt similar. As the Dow Jones industrial average twice fell 1,000 points in a day, we have had to swallow tales about the VIX, the inverse VIX, the XIV, and ETPs. Did this overdose of three-letter acronyms really cause the stock markets to swoon? Have those geniuses in the back offices of investment banks really baffled themselves – and a lot of investors – with complexity again?

The short answer to the second question is: yes. The chart shows one of the most spectacular blow-ups you could hope to see. This is the XIV – it is actually the snappier name for the Credit Suisse VelocityShares Daily Inverse VIX Short Term exchange traded note – since the start of 2016. It was a beautiful investment until, suddenly, it was a disaster.

What is the XIV? It was a way to bet that the S&P 500, the main US stock index, would be tranquil – in other words suffer few outbreaks of volatility. The measure of volatility is called the VIX and it is compiled and published by the Chicago Board Options Exchange by noting the prices of various option contracts in the market and then applying a mathematical formula. The VIX is more famously known as the “fear index”.

In itself, the VIX is just a number – its long-term average is about 20, more than 30 is a worry, and more than 40 could herald a crisis. For much of last year it was between 10 and 12 but on Tuesday it hit 50, before recoiling back to around 30 currently.

The fun starts when products are invented to trade and speculate on how the VIX will perform. Conventional futures contracts came first. Then ETFs, or exchange-traded funds, a low-cost product that has taken the financial world by storm in the last couple of decades, followed.

The XIV is slightly different (it’s a note, rather than a fund) but it comes from the same school. By trading S&P 500 options, or contracts to buy and sell the S&P at points in the future, it was structured to do the exact opposite of the VIX. If volatility in the stock market was low – as it was throughout 2016 and 2017 – owners of the XIV would do well. In the jargon, they were “short vol”.

But, if volatility exploded, then the XIV would fall.

The best that can be said about the product is that it did exactly what it said on the tin: XIV was virtually wiped out with Monday’s 4% market fall in the US.

But here’s the intriguing question. Did the sheer weight of “short vol” bets in the market, via XIV and its imitators, cause the volatility? And, once the selling started, were the pressures intensified because all those “short vol” positions had to be reversed in a hurry? Was the market feeding on itself?

Sandy Rattray, who jointly devised the formula to trade futures contracts tied to the VIX back in 2003, thinks so. He told the FT this week that this wasn’t merely a case of the tail wagging the dog. “What happened on Monday was the tail grabbed the dog and gave it a swing around the room,” he said.

Rattray is not alone in thinking inverse VIX products, and those that spice up profits and losses by using leverage, are ridiculous. “They are not liquid and, under stress, do not perform like plain-vanilla ETFs tied to physical securities,” said BlackRock, the world’s biggest fund manager, which refuses to sell them. It agrees that leveraged “short vol” investment products “magnified a downdraft” in stock markets.

So is this just a story of dumb investors, who should have heeded the many warnings that the stock market wouldn’t stay quiet for ever, getting their comeupance? One worry is that the problems go deeper. A big concern is that the two years of calm in the VIX encouraged investors to believe it was safe to make risky bets in their never-ending search for income.

Alex Brazier, the Bank of England’s executive director for financial stability, gave a well-timed speech at the start of this month in which he likened “short vol” to selling insurance. “If markets stay stable, as the insurer is betting they will, no payout is made and the insurance collects a premium. If markets stay stable, it’s a nice little earner for the insurer.”

But there could be two knock-on effects. First, betting on low volatility could become self-fulfilling as buyers of the insurance contracts hedge their positions in market; that encourages more people to sell insurance. Then, because the world seems less risky, investors take on more risk – which is the dangerous part.

“Taking on more risk because implied volatility is low is the equivalent of ignoring the road conditions and driving faster because your insurance got cheaper as a herd of new entrants flooded the car insurance market,” said Brazier. “When accidents start to increase, the whole thing can go into reverse.”

Is that what happened this week? It certainly looks to be part of the explanation. A relatively small move in the US bond market, triggered by worries over inflation, created a huge reaction in the stock market.

The good news (sort of) is that the drama has been confined so far to share prices. The CDO and ABS blow-ups a decade ago were a similar debacle in mispricing risk but they were so damaging because they caused banking collapses, which inflicted pain on the real economy.

With the VIX-related silliness, it could just be a matter of removing the dead speculators from the pitch and getting back to proper work. If those “short vol” bets only amount to $5bn or so – as some analysts estimate – the numbers aren’t big enough to have serious consequences.

Are they that small, though? The parallel worry is that the popular, and briefly lucrative, “short vol” trade has been mirrored in ways yet to be revealed. Has a decade of cheap money provoked other dangerous forms of risk-taking? If central bankers, fretting about inflation again, are raising interest rates, are investors dressed for a change in the financial weather? That debate will rage and may not be settled quickly – in which case volatility is back.