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Volatility Jump Has Traders Asking About VIX Note Poison Pill

Updated on
  • Futures indicate 80% drop that could trigger liquidation
  • VIX front-month future surged more than 100% on Monday
Bloomberg’s Cameron Crise discusses the VIX and the Dow’s biggest two-day decline since May.

The Cboe Volatility Index’s biggest rally ever is raising thorny questions about the future of exchange-traded products tied to the gauge.

An ETP meant to mirror moves in the front of the VIX’s futures curve plunged more than 75 percent in after-hours trading following an 80 percent spike in contracts that comprise its underlying index during the trading day, potentially putting in play triggers that would enable the fund’s owners to liquidate it to avoid losses.

Nicole Sharp, a spokeswoman for the note’s sponsor, Credit Suisse AG’s VelocityShares, said in an emailed statement that “The XIV ETN activity is reflective of today’s market volatility. There is no material impact to Credit Suisse.” She didn’t elaborate on the fate of the product.

But professional traders said a logical interpretation of language in their prospectuses suggests the notes could be liquidated under circumstances that resemble today’s.

The surge in volatility has already claimed one victim: Nomura Europe Finance announced the early redemption of its Next Notes S&P 500 VIX Short-Term Futures Inverse Daily Excess Return Index ETN, which had 32.4 billion yen (approximately $300 million) in assets.

Trading was halted in VelocityShares Daily Inverse VIX Short-Term ETN, which trades under XIV, according to a market statement Tuesday.

“If they lose more than 80 percent of their value, the sponsor has the right to liquidate and they should, or they take on the risk. Thus if Bloomberg’s indicative value is correct, they are due to be liquidated,” Michael O’Rourke, chief market strategist at JonesTrading, said.The fund, the VelocityShares Daily Inverse VIX Short-Term ETN, has been wildly popular in the past year as volatility on American equity markets sank to historic lows, delivering an eye-popping return of more than 187 percent last year. It pulled in nearly $1 billion in just the first five weeks of this year, while the VelocityShares Daily Inverse VIX Short-Term ETN (ticker XIV) has added almost $750 million over the same time frame.

Meanwhile, investors have been reluctant to bet on volatility amid the market’s extended period of calm. The ProShares Ultra VIX Short-Term Futures ETF (ticker UVXY) has experienced $83 million in outflows this year, while the iPath S&P 500 VIX Short-Term Futures ETN (VXX) has seen $52 million leave.

That all changed in a hurry Monday when the Dow Jones Industrial Average sank as much as 1,597 points on its way to the worst day since August 2011. The VIX jumped 115 percent, sending the XIV and SVXY funds down at least 15 percent.

Those moves picked up steam in afterhours, as the spike in the VIX spread to its futures contracts -- the assets used to determine the price of the funds, in this case, the inverse of the S&P 500 VIX Short-Term Futures Index. To prevent massive selling from pushing the value of the fund into negative territory, the issuers outline so-called acceleration events would give them the power to liquidate the fund. From the prospectus:

“An Acceleration Event includes any event that adversely affects our ability to hedge or our rights in connection with the ETNs, including, but not limited to, if the Intraday Indicative Value is equal to or less than 20% of the prior day’s Closing Indicative Value,” the VelocityShares Daily Inverse VIX Short-Term ETN’s prospectus states.

Betting Against Volatility

Short VIX funds, XIV and SVXY, have taken in over $1 billion this year combined

Source: Bloomberg

— With assistance by Todd White

(Updates with trading halt in XIV note in sixth paragraph.)
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