On December 14, 2006, Lehman Brothers and Bear Stearns reported huge earnings, helping push major US indexes toward record numbers. Fewer than two years later, both investment banks collapsed and their stocks became virtually worthless. JPMorgan bought Bear Stearns for $2 a share in March 2008 and that September, Lehman made the largest bankruptcy filing in history. The meltdowns precipitated the Great Recession.
Wall Street promised to do better. Regulators implemented a broad range of guardrails, such as the Dodd-Frank Act, to ensure something similar wouldn’t happen again. But ultra-risky behaviors and products are still on the market — and being advertised to everyday investors who might not understand them.
In the midst of early February’s market turmoil that saw the Dow Jones Industrial Average decline by 1,175 points — its largest point drop in one day ever — and the S&P 500 enter correction territory (a decline of 10 percent or more from its previous high), a handful of investment products fell, essentially, to zero.
Financial vehicles sanctioned by the Securities and Exchange Commission with billions of dollars in them lost their entire value in a matter of hours. The companies behind them say they did what they were supposed to, but it’s clear that hyper-risky products — including those that can be wiped out fast — have survived and even thrived well past 2008.
The story of how and why it happened is, at the very least, a teachable moment for everyday investors; the fear, though, is that a crash like this signals that there might be a broader underlying risk to global markets.
The matter in question is the products that trade at the inverse of the market’s “fear gauge,” the Cboe Volatility Index, which trades as VIX. Developed in 1986, the VIX is a marker of the expectation of stock market volatility in the near future. It goes up when investors are nervous and remains low when they are not — in 2017, it was historically low, which might have lulled some investors into complacency.
There are a variety of investment products based on it, including the iPath S&P 500 VIX Short Term Futures exchange-traded note (VXX) and the ProShares VIX Short-Term Futures exchange-traded fund (VIXY) and, crucially, inverse products that move in the opposite direction of what the VIX does.
On Monday, February 5, the value of the VIX more than doubled in a single day — for the first time ever. Because it measures volatility, the VIX was essentially signaling a haywire day in the markets. While the VIX’s sudden spike was out of the ordinary, it wasn’t catastrophic for the markets at large. Those investors betting against it, however, were blindsided. A few billion dollars vanished as products that trade at the inverse of the VIX, which essentially wagered on the market’s stability, cratered.
The VelocityShares Daily Inverse VIX Short-Term exchange-traded note (XIV), a product issued by Credit Suisse, and the ProShares Short VIX Short-Term Futures exchange-traded fund (SVXY), both plunged by 80 percent in the hours after the VIX’s spike. As of the morning of Friday, February 2, the funds had a combined $3.2 billion in assets. On Monday, February 5, they were among the most heavily-traded symbols at Fidelity’s website, according to market insight and research firm DataTrek Research.
XIV opened the day on Monday at $99. At market open on Tuesday, it had plummeted to $7.35. Trading on the XIV, SVXY, and the VelocityShares Daily Inverse VIX Medium-Term exchange-traded note (ZIV) was halted temporarily on Tuesday morning. By Friday, retail brokerage Fidelity had temporarily blocked customers from buying all three products “to prevent customers from outsized risk during the current market environment.” (It will lift the block on Monday, February 26.)
Credit Suisse pulled its XIV product off the market entirely. Japanese bank Nomura said it would shutter a similar product as well. ProShares said it’s still keeping its ETF out there — saying, essentially that the product it did what it’s supposed to do, and too bad for investors who lost their money.
“There’s a lot of ways to bet against volatility, which was a winning trade for a long time,” Eric Balchunas, a senior ETF analyst at Bloomberg Intelligence, told me. “It got crowded, it went in the other direction, and it hurt people who were holding at the very end.”
The investments in question did what they were supposed to — it’s just pretty crazy that they can do that in the first place
The Credit Suisse and ProShares inverse investments had been on a stellar run until very recently. Volatility on Wall Street has been historically low for months, and for investors, the products became a decent way to make money in such a setting: Each gained about 180 percent in 2017. The S&P 500, by comparison, climbed by about 20 percent. (And even with early February’s losses, it’s worth noting that they’ve generated more money than they’ve lost over their lifetimes.)
But when they crashed, a major defect surfaced. “It’s kind of a design flaw to issue a product that can mathematically go to zero in a day,” said Nick Colas, co-founder of DataTrek. “People criticize Bitcoin, but Bitcoin doesn’t go to zero in a day.”
Nomura issued an apology for its note’s crash. “We sincerely apologize for causing significant difficulties to investors,” its Nomura Europe Finance unit told Bloomberg. The Japanese bank itself did not lose any money in its note crash. Neither did Credit Suisse. And while it is pulling its note, the Swiss bank is not apologizing. CEO Tidjane Thiam told CNBC that investors who held shares of XIV had bet against at volatility at their own risk. “It worked well for a long time until it didn’t, which is generally what happens in markets,” he said.
ProShares, on the other hand, is barreling ahead. It said in a statement that its ETF’s performance “was consistent with its objective” and will keep trading as usual.
“I think Credit Suisse looked at it as a PR problem,” Balchunas, from Bloomberg, told me. As for ProShares, “you could argue from a business point of view that was a good decision because they’re now going to get a lot of the [Credit Suisse] XIV refugees.”
Retail investors putting money in the inverse VIX products didn’t entirely understand what they were getting into
Outright, there isn’t anything particularly nefarious about what happened. For institutional investors — banks, hedge funds, etc. — this kind of risk is largely the name of the game. But in the case of everyday retail investors, many might not have understood the full magnitude of gamble they made, or how the product they were investing in worked.
Bloomberg’s Matt Levine pointed out that retail investors appeared not to fully grasp the product they were buying. XIV was trading with a bit of a lag compared to the VIX’s spike, so they were piling in when the VIX was at its peak — but before XIV had reacted:
“There tends to be these teachable moments every four to five years,” Balchunas, the Bloomberg ETF analyst, told me. “I would think that after this case, a lot of retail investors, even if they didn’t use it, may have now made a mental note of, ‘Okay, I’m not going near those.’”
And a lot of investors appear to have learned the hard way. About 5 million XIV shares worth $500 million traded between 3 and 4 pm on Monday, February 5, when the VIX was near its peak but the XIV hadn’t yet reacted, per Levine.
A Reddit forum titled “tradeXIV” for XIV traders turned into a litany of horror stories. “When I bought XIV at $95 today, I received a warning from my broker along the lines of, ‘Either you are really stupid, or you are too smart to be using Vanguard,’” one user wrote. (The price soon after dropped to about $5.) Another user claimed to have lost $3 to $4 million and posted a screenshot. “XIV was basically a legal ponzi scheme,” one thread read on a forum dedicated to volatility trading. Another, “CREDIT SUISSE DID NOTHING WRONG.” One user wrote, “Feel so depressed..keep replaying over and over,” of the experience.
The XIV prospectus says that the notes are “intended to be trading tools for sophisticated investors” and “may not be suitable for investors who plan to hold them for longer than one day.” It also says that if the price goes down by more than 80 percent, they can close the product — which they did. The document is 179 pages long. A Credit Suisse spokeswoman said in an email that the bank did not market XIV but that it was sold through a broker, and the bank cannot control who the broker markets to.
Even before early February’s market turmoil, Fidelity, which temporarily blocked the inverse volatility products after their freefall, required customers to sign an agreement that calls out the risks of volatility and leveraged products, a spokeswoman said. They must have registered a “most aggressive” risk tolerance in setting up their accounts, meaning they theoretically can tolerate wild fluctuations.
A spokeswoman for TD Ameritrade, another popular brokerage firm, said the company still offers SVXY to its customers but has been clear about the risks involved. “These are not products for every investor, and we provide a clear notification and information to ensure they are aware of the risks,” she said. She added that the company also alerts clients when there are “unusual market conditions” and emphasized that “interest is usually very limited to our more sophisticated clients.”
Since the early-February market volatility, TD Ameritrade has increased the margin requirement on SVXY to 100 percent — meaning investors can’t leverage their investments and have to pay for it all in cash. “It protects us both,” the spokeswoman said. “It limits the amount they can leverage.”
Inverse volatility products aside, early February’s market meltdown raises some bigger questions
Early February’s market meltdown and the VIX’s giant spike have sparked some broader debates and concerns about market stability in general and volatility specifically.
The inverse VIX notes and funds that crashed have some eerie similarities to some of the investment products that have sparked broader meltdowns in the past — say, the portfolio insurance that exacerbated the 1987 stock market crash, or the credit default swaps and subprime mortgages that precipitated the Great Recession. “You get these products that seem innocuous at the time and generally work pretty well for a long period of time, and then something comes along, and their inherent flaw is revealed,” said Colas, the DataTrek founder.
Portfolio insurance products were algorithm-based products created to protect investors from falling markets by selling “ever-increasing numbers of futures contracts,” the New York Times explained in 2012, because “the short position in futures contracts would then offset the losses caused by falls in the stocks they owned.” The only problem was that all of these algorithms were programmed to sell if the market fell — which they did, all at the same time on one day in 1987, Wall Street’s “Black Monday” meltdown. The 2008 financial crisis, on the other hand, was triggered in part by subprime mortgages — essentially, loans given to homeowners unlikely to be able to pay them back — and investment vehicles based on them in which these toxic assets were bundled and often hidden. (It is worth noting that both the Credit Suisse ETN and the ProShares ETF began trading after the 2008 financial crisis. A Securities and Exchange Commission spokeswoman declined to comment.)
There has been speculation in some corners that the inverse products helped fuel this month’s sudden stock slump, which saw the Dow Jones Industrial Average have its largest one-day point loss ever and put the S&P 500 in correction territory (a decline of more than 10 percent from its peak) for the first time since 2015.
In recent days, there has been even more consternation among people who trade in volatility after a whistleblower wrote a letter to US regulators alleging that there’s a scheme to manipulate the VIX. Washington-based lawyer Jason Zuckerman of Zuckerman Law told the SEC and Commodity Futures Trading Commission that his client, who is anonymous, found a flaw that allows traders to manipulate the VIX. (Cboe, the Chicago-based exchange that operates the VIX, to Bloomberg denied the allegations in a statement.)
What’s more: An academic study last year asserted the VIX might be subject to manipulation. And Bart Chilton, former commissioner of the CFTC, told CNBC recently that the VIX has been “suspect” for several years. “People have been concerned about prices being pushed around. Although, there’s never been any hard evidence,” he said.
The Financial Industry Regulatory Authority, the US finance industry’s self-regulating authority, is reportedly looking into VIX manipulation.
“It’s a bigger risk than we’re giving it credit for, and the manipulation can cause it to compound issues,” Matthew Stock, an attorney at the law firm that sent the letter, told me.“Market volatility selling has grown so big that there’s a distinct systemic risk involved when there are fluctuations in the market.”
He also said there’s a broader point about how retail investors understand volatility and the products surrounding that trade on it. “Why is there such a huge demand on these products that are levered tremendously? Do people actually understand the risk? In times of volatility, do they know these levered products can cause as much loss as they did on February 5?”