Market participants around the world are still reeling from this week’s wild ride that saw major U.S. indexes drop more than 5% and the Dow Jones Industrial Average swing by at least 1,000 points in all but one day. Early causal assessments pointed to the threat of rising interest rates and inflation, political uncertainty in Washington, and overpriced equity valuations. Other commentators attributed the sell-off to an overdue market correction driven by fear and the proverbial “animal spirits.” And yet others, such as Treasury Secretary Steve Mnuchin, blamed that amorphous bugaboo – algorithmic trading.
An abundance of theories explaining market movements is common in the immediate aftermath of large price swings and underscores the financial press’ need to attach a narrative to events whose root causes are far too complex to be wholly understood in the short-term, or perhaps ever. Needless to say, these theories are often wrong.
What is certain about this past week is that volatility spiked, as measured by the CBOE Volatility Index (VIX) (commonly referred to as the “fear index” or the “temperature” of the market) which jumped 116 percent during Monday’s trading and closed out at a level only matched by the Russian Ruble crisis of 1998, the credit crisis of 2009, and in 2011 when S&P downgraded US credit from AAA to AA+.
The increase in volatility gave rise to another theory as to why markets were so turbulent this past week, which involved traders who had previously bet on markets remaining calm by shorting VIX futures (“shorting volatility” in trader speak) getting crushed when the VIX shot up. The theory posited that VIX futures were trading in a “contango” position (the VIX reference was lower than the VIX futures price), and in a calm market (which was the norm in the 12 months preceding the crash) this was essentially a license to print money as traders could short the VIX futures and then, as VIX futures prices dropped to near spot levels around contract expiration, the traders would profit by covering their positions – and all of this worked rather seamlessly until the volatility spiked and they had to quickly cover at a loss.
Enter The Exchange Traded, Volatility Linked, Products
The losses on shorting VIX futures weren’t the end of the story. Over the last several years, a number of innovative exchange traded products (ETPs) have been engineered that are linked, not to a basket of securities or other assets, but to volatility on its own accord. So not only can traders short fear through VIX futures, but market participants, including institutional and retail investors, can buy ETPs (which are often structured in the form of an unsecured debt instrument or “exchange traded note”(ETN)) that make money if fear goes up, like the Barclay’s iPath VIX Short Term Futures Note (VXX), or make money if fear goes down, like the Proshares Short VIX ETF (SVXY))– independent of the performance of the actual stock market. When volatility spiked on Monday, funds that were bearish on fear (SVXY) took a pounding while the fear bulls (VXX) surged in price. One particular note, Credit Suisse’s VelocityShares Daily Inverse VIX Short-Term ETN (XIV), an ETN which pays off the “inverse” of the VIX – effectively a bet that markets will be calm – was hit particularly hard, ending the day on Tuesday “at a more than 92 percent discount to [its] closing value the prior day” and leading Credit Suisse to terminate the note.
Why Do These Products Exist At All? And What About Bitcoin ETFs!
The media reaction to VIX linked notes has been swift – with many questioning why the products exist in the first place. Jim Cramer called them “reckless”, a “toxic cigarette” and “practically designed to fail” – suggesting that they put pressure on the actual S&P 500 and wondering why they were allowed in the first place. Carl Icahn said that these “wacky” funds were making the market like a “casino on steroids.” Blackrock, the world’s largest asset manager, called for more regulation and disclosure on ETN’s risks. Even Devesh Shah, the actual inventor of the VIX volatility index publically stated, “in my wildest imagination I don’t know why these products exist.”
So why do these products exist? Does a viable futures market necessarily imply that creating an ETF for the market is a good idea? If that’s the case, should Bitcoin (BTC) enthusiasts cry foul that a BTC ETF can’t get off the ground, despite a regulated BTC futures market? Amazingly, the VIX actually surpassed BTC in volatility this past week. Perhaps a suitable line between BTC and VIX can be drawn by the distinction of opacity (VIX funds) versus the potential for manipulation (the underlying fear in allowing a BTC ETF).
VIX linked funds, it could be argued, aren’t unfair or subject to manipulation, but are just risky (and the risks aren’t well understood). As trader Tom Hearden describes, “[t]he products in question are a derivative of a derivative of a derivative…There was a prospectus, but I am sure it has risk and product details that were not understood.”
Both Credit Suisse and CBOE were quick to defend VIX products, stating that they weren’t to blame for the crash and that they have a legitimate purpose –hedging risk. CBOE said that while ETPs played a role, the larger culprit was “volatility control funds” (portfolios with a defined volatility profile or “risk-parity” strategy). Credit Suisse maintained that the XIV was never meant to be a long-term investment, the fund was marketed exclusively to professional investors, and (citing page 197 of their prospectus) the “long term expected value” of the note was zero.
If Fear Is A Viable Benchmark What Else Can We Link To?
Just because something “can” be created doesn’t necessarily mean that it “should”. There are a large number of exotic exchange traded products in the market, including exchange-traded funds that fight obesity, promote organic food, and combat global warming. However, you can make the argument that there is a legitimate economic purpose behind these exotic funds (providing a diversified investment opportunity for exposure to companies within the fund’s respective mandate). What is the true economic purpose of a volatility-linked ETN? Is it really a hedge? Also, if we can link fear to a financial product why not link other “things” that don’t have a clear economic purpose but can be continuously monitored – like sea temperature, annual deaths by flu or (gasp) cryptocurrency prices?
Volatility Linked Notes May Have Introduced A New Layer of Systemic Risk
One might argue that the economic function of VIX-linked products is hedging. As such, they’ve been described as “a small slug of insurance against any sudden market crashes.” A rebut however is that these products don’t really perform (at least that well) the economic function that they are purportedly designed for. Also, given the events of the recent crash, they are being used more for short-term speculation than hedging. More importantly, they are now being talked about in association with the concept of “systemic risk”. Market analyst John Waggoner believes that VIX-linked ETNs (like XIV) are “particularly dangerous” because they are redeemed in large blocks; therefore, when purchasing an ETN the buyer takes on an element of counterparty risk (the creditworthiness of the issuer). If the sole purpose in owning a VIX-linked ETN were to hedge, why then would you add an additional risk layer? Why not just use the VIX futures? Also, by having a volatility linked ETN or ETP in the market, you increase the risk of retail investors being impacted.
Money Manager Doug Kass calls VIX-linked ETPs “a function of the distorted, dangerous world of new investment products and strategies” and they “have no business existing except to please gamblers.” Kass also adds that these products have a domino and ripple effect in light of mechanical and automated trading. Even if you don’t accept the premise that VIX futures or linked products caused the recent crash, it’s hard to deny the fact that they likely made the crash worse. This is somewhat ironic since, as Stephen Gandel describes, the VIX itself was designed to “make the market less volatile by giving investors a better picture of the possibility of a stock drop and the ability to hedge against it.”
What’s Next: Better Disclosure Or Addressing Financial Complexity?
Calls for regulatory reform often accompany a crash – and it is likely that several agencies will be addressing VIX funds over the next few months (as well as financial products that have a tenuous economic purpose beyond speculation). Is more, or better disclosure, the answer? Both the SEC and FINRA have outstanding investor alerts on ETNs but their boilerplate warnings offer little assistance for something as complex as a VIX inverse note like the XIV. Also, the risks are set out in densely worded prospectus (that are mostly read by lawyers), and it’s hard to believe that more risk disclosure is the answer to this problem.
Bloomberg’s Stephen Gandel believes that the Consumer Financial Protection Bureau (CFPB) was created specifically for this purpose – to “shield investors from inappropriate products and shoddy practices and police markets that could give risk to financial instability.” Gandel also lists the Financial Stability Oversight Counsel (FSOC) as a potential aid – but in our current deregulatory environment the CFPB and the FSOC are unlikely to take up the charge.
On a positive note, the Financial Industry Regulatory Authority (FINRA) has shown a willingness to take measures against the reckless sale of volatility-linked products to retail customers. On October 16, 2017, it ordered Wells Fargo to pay over $3.4 million in restitution to customers who were given “unsuitable recommendations” to invest in various volatility linked ETFs between July 1, 2010 and May 1, 2012. To better regulate this dangerous sector, FINRA has also issued Regulatory Notice 17-32, which sets out “sales practice obligations” for firms marketing volatility linked ETPs and Regulatory Notice 12-03, which provides for “heighted supervision” of complex products like volatility linked notes
Instead of better policing sales tactics, perhaps it is time to address a different, but much more difficult question: do we benefit from continually increasing financial market complexity? Is perpetual product innovation worthwhile when the resulting system is one of astounding complexity, opacity, interconnection and contagion? Would a more simple financial market produce a better balance of risk to return, facilitate transparency and efficiency, and mitigate systemic risk?
Many academic studies have shown that there is a relationship between financial system complexity and increased systemic risk. A group of researchers, including Nobel laureate Joseph Stigliz, recently identified that, because of the “multilayer networks” that are created by financial institutions contracting with each other and holding common asset exposures, “small errors on the knowledge of the network” can create “large errors in the probability of systemic defaults.” In other words, because the system is so complex, it is harder to protect against systemic risk, and the “social costs of financial crises” may now be much higher.
Professor Kathryn Judge, using the securitization of home loans into mortgage-backed securities (MBS) and collateralized debt obligations (CDO) as a case study (transactions she calls “Fragmentation Nodes”), has argued that, in this case, more complex financial innovations increased systemic risk by limiting transparency and flexibility. She further reveals that added disclosure wouldn’t have solved the MBS/CDO problem (a point not lost on the VIX-linked products debate) and that regulators should have targeted the systemic risk by reducing the complexity of the transaction itself. She concludes that continuing financial innovations outside of MBS and CDOs (like in the proliferation by banks of new financial products to combat decreasing profit margins) will also increase systemic risk through information loss, fragmentation, lengthening the “chain” between investor and investment, and (directly applicable to VIX linked products) creating “contingent and dynamic economic interests.”
The complexity and opacity of both the over-the-counter derivatives market, and the day-to-day operations of large financial institutions, and how they interacted with each other in wholesale and repo markets, undoubtedly influenced the 2008 global financial crisis. Complexity has also been cited as a contributing factor to the Enron scandal and the Long-Term Capital Management failure. Even our regulatory system (in dealing with financial market complexity) has evolved to become so incredibly complex that, when viewed through the lens of software design (which detects for inter-dependencies), MIT Professor Andrew Lo and his research team revealed that regulatory complexity creates the potential for unintended consequences.
I believe that more studies of this nature are warranted, and where the system can be simplified it should. Just because we “can” create something doesn’t always mean that it is a good idea to do so. In some cases, simpler is better, and financial products that don’t serve their purported function, are overly complex and opaque, and have potential interconnection and systemic risks, should be questioned.
 See Jeff Cox, Why The Market Is So Volatile Right Now, CNBC (February 6, 2018), https://www.cnbc.com/2018/02/06/why-the-market-sell-off-just-keeps-going.html.
 See Max Abelson & Joe Weisenthal, An Investor of the VIX: ‘I Don’t Know Why These Products Exist’, Bloomberg Markets (February 6, 2018), https://www.bloomberg.com/news/articles/2018-02-06/an-inventor-of-the-vix-i-don-t-know-why-these-products-exist.
 See Nathan Bomey, Fears of Market Volatility Swell as Stocks Plunge, USA Today (February 6, 2018), https://www.usatoday.com/story/money/2018/02/06/fears-market-volatility-swell-stocks-plunge/310264002/.
 See Jim Edwards, VIX: The ‘fear index’ has only been this high on 3 prior occasions, Business Insider (February 6, 2018), http://www.businessinsider.com/vix-fear-index-volatility-2018-2.
 See id.
 See Joanna Ossinger, VIX-Related ETPs Go Wild In After-Hours Trading Route, Bloomberg Markets (February 5, 2018), https://www.bloomberg.com/news/articles/2018-02-05/vix-related-etps-go-wild-in-after-hours-trading-in-wake-of-rout.
 See Thomas Franck, Credit Suisse says it will end trading in the volatility security that’s become the focus of this sell off, CNBC (February 6, 2018), https://www.cnbc.com/2018/02/06/the-obscure-volatility-security-thats-become-the-focus-of-this-sell-off-is-halted-after-an-80-percent-plunge.html.
 Michael Shields & Trevor Hunnicutt, Credit Suisse ‘volatility’ fund liquidated after market selloff, Reuters (February 6, 2017), https://www.reuters.com/article/us-credit-suisse-gp-notes/credit-suisse-volatility-fund-liquidated-after-market-selloff-idUSKBN1FQ256.
 Berkeley Lovelace Jr., Cramer: A little-known security tied to a calm market became a ‘toxic cigarette’ for this sell off, CNBC (February 6, 2018), https://www.cnbc.com/2018/02/06/cramer-xiv-note-proved-to-be-a-toxic-cigarette-for-the-market.html.
 See Elizabeth Gurdus, Cramer rails against VIX trading products: They are ‘practically designed to fail’, CNBC (February 7, 2018), https://www.cnbc.com/2018/02/06/cramer-vix-trading-products-are-practically-designed-to-fail.html.
 Matthew J. Belvedere, Icahn: The Market Will One Day ‘Implode” Because Of These Wacky Funds Using So Much Leverage, CNBC (February 6, 2018), https://www.cnbc.com/2018/02/06/billionaire-investor-carl-icahn-there-are-too-many-derivatives-and-the-current-market-is-a-rumbling-warning.html.
 Bloomberg, BlackRock Urges More Regulation After Inverse Notes Collapse (February 6, 2018), https://www.bloomberg.com/news/articles/2018-02-06/blackrock-urges-regulators-to-act-after-inverse-notes-collapse
 Max Abelson & Joe Weisenthal, An Inventor of the VIX: ‘I Don’t Know Why These Products Exist’, Bloomberg (February 6, 2018), https://www.bloomberg.com/news/articles/2018-02-06/an-inventor-of-the-vix-i-don-t-know-why-these-products-exist
 See Jen Wieczner, Bitcoin Is Less Volatile Than Stock Market Volatility Index, SEC Chair Says, Fortune (February 7, 2018), http://fortune.com/2018/02/06/bitcoin-stock-volatility-vix-sec/.
 Natasha Turak, Credit Suisse Defends Controversial Financial Product At The Center Of The Market Turmoil, CNBC (February 7, 2018), https://www.cnbc.com/2018/02/07/credit-suisse-defends-controversial-xiv-etn-amid-market-turmoil.html.
 Joe Rennison, Gregory Meyer & Nicole Bullock, CBEO Says Vix Products Not To Blame For Market Rout, Financial Times (February 7, 2018), https://www.ft.com/content/4eeac462-0bb9-11e8-8eb7-42f857ea9f09.
 See Turak, supra note 22.
 Yuval Rosenberg, Volatility Indexes Offer Hedge For Investors, Fortune (March 2, 2009), http://archive.fortune.com/2009/02/27/magazines/fortune/volatility_index_notes.fortune/index.htm?postversion=2009030213.
 See John Waggoner, Exchange-traded notes add another lawyer of risk, Investment News (February 7, 2018), http://www.investmentnews.com/article/20180207/FREE/180209934/exchange-traded-notes-add-another-layer-of-risk.
 Doug Kass, Kill The Quants (and Levered ETFs and ETNs) Before They Kill Our Market, Real Money (February 6, 2018), https://realmoney.thestreet.com/articles/02/06/2018/kill-quants-and-levered-etfs-and-etns-they-kill-our-market.
 See generally, Steven Pearlstein, The robots vs. robots trading that has hijacked the stock market, The Washington Post (February 7, 2018), https://www.washingtonpost.com/news/wonk/wp/2018/02/07/the-robots-v-robots-trading-that-has-hijacked-the-stock-market/?utm_term=.9a0b677ad4ee.
 Stephen Gandel, Regulators Let Wall Street Turn VIX Index on Its Head, Bloomberg (February 6, 2018), https://www.bloomberg.com/gadfly/articles/2018-02-06/regulators-let-wall-street-turn-vix-index-on-its-head.
 See Financial Industry Regulatory Authority, News Release, FINRA Orders Wells Fargo Broker-Dealers to Pay $3.4 Million in Restitution and Reminds Firms of Sales Practice Obligations for Volatility-Linked Products (October 16, 2017), http://www.finra.org/newsroom/2017/finra-orders-wells-fargo-broker-dealers-pay-34-million-restitution-and-reminds-firms.
 See generally Steven L. Schwarcz, Regulating Complexity in Financial Markets, 87 Wash. Univ. L. Rev. 211 (2009); Alex J. Pollock, Financial Markets and “System Effects”: Complexity, Recursiveness, Uncertainty and Mistakes in Finance, American Enterprise Institute Working Paper (July 24, 2012), http://www.aei.org/publication/financial-markets-and-system-effects-complexity-recursiveness-uncertainty-and-mistakes-in-finance/; Koehler, Christian, The Relationship between the Complexity of Financial Derivatives and Systemic Risk (May 31, 2011). Available at SSRN: https://ssrn.com/abstract=2511541
 Stefano Battiston, Guido Caldarelli, Robert M. May, Tarik Roukny & Joseph E. Stiglitz, Proceedings of the National Academy of Sciences of the United States of America, PNAS September 2016, 113 (36) 10031-10036, https://doi.org/10.1073/pnas.1521573113
 See Id.
 See Kathryn Judge, Fragmentation Nodes: A Study In Financial Innovation, Complexity, and Systemic Risk, 64 Stan. L. Rev. 657 (2012).
 Id. at 722.
 See Lynn A. Stout, Derivatives and the Legal Origin of the 2008 Credit Crisis, 1 Harvard. L. Rev 2 (2011).
 See Manuel A. Utset, Complex Financial Institutions and Systemic Risk, 45 Ga. L. Rev. 779 (2011).
 See Daniel Altman, Contracts So Complex They Imperil The System, The New York Times (February 24, 2002), http://www.nytimes.com/2002/02/24/business/contracts-so-complex-they-imperil-the-system.html.
 William Li, Pablo Azar, David Larochelle, Phil Hill, & Andrew W. Lo, Law Is Code: A Software Engineering Approach to Analyzing the United States Code, 10 J. Bus. & Tech. L. 297 (2015).