Credit Suisse Tames Rogue VIX Note Premium With Share Issuance
Credit Suisse Group AG (CSGN)’s attempt to restore order to its exchange-traded U.S. equity volatility note cut the price of the security in half this week, reining in the premium to the index it tracks after it almost doubled.
The VelocityShares Daily 2x VIX Short-Term ETN, or TVIX, has whipsawed investors since Credit Suisse suspended creation of new shares last month. The security climbed 89 percent above the value of the futures it tracks before the bank reversed its decision and said it would add stock. The TVIX, designed to double the return of Chicago Board Options Exchange Volatility Index futures, plunged 50 percent over the past two days to $7.16. The note’s premium to its so-called indicative value shrank to 6.9 percent.
The divergence between the price of the TVIX (TVIX) and the value of the futures it tracks may draw regulatory scrutiny to the way financial firms manage the supply of leveraged exchange-traded notes, according to Colby Wright of Central Michigan University. Individual investors may not have been aware of the premium and could have gotten trapped before Credit Suisse responded to pent-up demand for the TVIX by saying it would issue new shares, thereby reducing the cost to borrow the note and sell it short, he said.
“Retail investors have no business investing any significant chunks of money in a security like this,” Wright, an assistant professor of finance at Central Michigan who has written academic papers on the securities, said in a phone interview, referring to leveraged notes. “The real error here is that, and maybe regulators need to look at this, is that any time you see the price that is 30, 40, 50, 60 percent above its indicative value, investors need to be warned about that.”
Trading in the ETN highlights the hazards of exchange- traded securities when disruptions occur in systems designed to balance supply and demand. Because the notes are normally pegged to underlying assets such as stocks, bonds and indexes, sponsors regularly create and redeem shares to offset price distortions caused when investors buy and sell them.
Credit Suisse announced after the close of trading on March 22 that share issuance would resume, confirming trader speculation that helped drag the TVIX down 29 percent that day. The Zurich-based bank halted share creation on Feb. 21 after surging demand for securities tracking volatility swelled the note’s market value to almost $700 million from $162.8 million at the end of 2011.
“People should have made a bigger deal on Feb. 21 when they were suspending it because it’s directly tied to how the product became overvalued,” said Peter Tchir, founder of TF Market Advisors in New York. “The product got too big and then this turning on and turning off of the creation rights doesn’t seem to go through a very formal process and yet it’s clearly critical to the value and how these things trade.”
Jack Grone, a spokesman for Credit Suisse in New York, declined to comment beyond the statement announcing new creations would resume.
The Securities and Exchange Commission examined whether exchange-traded funds contributed to equity-market volatility two years ago after the intraday plunge on May 6, 2010. The International Monetary Fund said last year that European ETFs that generate returns through derivatives add a layer of complexity and risk to financial markets.
BlackRock Inc. (BLK), the world’s largest provider, called on regulators in November to create stricter rules to enable investors to differentiate between low-risk, traditional ETFs and more complex products like ETNs and Europe’s so-called “synthetic” ETFs.
“These volatility ETFs will be closely monitored by the equity derivatives industry, especially when volatility is once again on the rise,” Stuart Rosenthal, chief executive officer of Factor Advisors LLC in New York, said in a March 22 phone interview. “I don’t think we have heard the last word about TVIX creations and for that matter volatility ETFs.”
The drop in TVIX shares on March 22 reflected short selling amid speculation new shares would come into the market after the ETN climbed to record premiums, said Chris Hempstead, director of exchange-traded-fund execution service at WallachBeth Capital LLC in New York.
“It’s not overly surprising given what happened to TVIX during the trading day,” said Dominic Salvino, a specialist on the CBOE floor for Group One Trading, the primary market maker for VIX (VIX) options. “They weren’t forced to do this in a legal sense, but there were some reputational questions for them given the fact that product was performing so poorly and was no longer doing what it was meant to do.”
Volume reached 30.2 million shares on March 22, almost 8 times the daily mean since it was created in 2010, and was 29.3 million the following day. The note closed at $14.43 on March 21, or a record 89 percent above its so-called indicative value. The gap narrowed to 30 percent on March 22 and 6.9 percent the following day as the security extended its decline since Oct. 3 to 93 percent. The S&P 500 has rallied 27 percent since that day, which marked the benchmark U.S. equity gauge’s 2011 low.
In the March 22 announcement three hours after the close of trading in New York, Credit Suisse said the first round of issuance is aimed at lowering the cost of borrowing shares to the level seen before the Feb. 21 suspension. In a short sale, a trader borrows stock and sells it, hoping to profit from a decline by replacing it at lower prices later.
“Credit Suisse may from time to time issue the ETNs into inventory of its affiliates to make the ETNs available for lending at or about rates that prevailed prior to the temporary suspension of issuances of the ETNs,” the company said.
The number of shares sold short in the Credit Suisse note was 4 million at the end of February, up from less than 1.5 million at the end of 2011, according to data compiled by Bloomberg. The ETN fell 83 percent from Oct. 3 to Feb. 29.
Starting March 28, shares will be issued to authorized market makers. Normally, banks create and redeem ETNs based on the level of demand for the securities. That demand usually doesn’t affect the price since the ETNs track an index.
“Credit Suisse may issue additional ETNs from time to time to be sold solely to authorized market makers,” according to a statement. “Credit Suisse may condition its acceptance of a market maker’s offer to purchase the ETNs on its agreeing to sell to Credit Suisse specified hedging instruments consistent with Credit Suisse’s hedging strategy, including but not limited to swaps.”
The VelocityShares ETN aims to produce twice the daily return of the S&P 500 VIX Short-Term Futures Index, which tracks a trading strategy involving futures on the CBOE Volatility Index. The VIX, as the CBOE gauge is known, is used as a benchmark measure of U.S. equities derivatives and measures the cost of protection from losses in U.S. stocks. It fell 4.8 percent on March 23 and is poised for a record two-quarter drop of almost 66 percent.
Credit Suisse’s decision to halt new issuance of TVIX shares preceded a period in which the ETN began moving independently of its underlying assets. The S&P 500 VIX Short- Term Futures Index lost 32 percent between Feb. 21, the day of the suspension, and March 21. That was more than twice the decline in the ETN.
The faster decrease in the underlying index contributed to a widening in the premium of the TVIX to the underlying asset. The gap reached 36 percent on March 16 and then swelled to 62 percent, 78 percent and 89 percent in the next three days before falling, according to data compiled by Bloomberg.
“Investors should probably remain sidelined until TVIX has returned to its NAV and stabilized there,” Jim Strugger, a derivatives strategist for MKM Partners LLC in Stamford, Connecticut, said in a March 22 e-mail.
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