In advance of a potentially market-moving public announcement, a popular volatility-focused exchange-traded note collapsed in trading last Thursday, raising a host of questions about who was selling and why. The Securities and Exchange Commission is investigating the situation, according to Bloomberg.
Relentless selling pressure drove shares of VelocityShares Daily 2x VIX Short-Term ETN (TVIX) from an open of $14.78 to a close of $10.20 — an 8.5 standard deviation swing — with three-times daily average volume. The sell-off occurred just hours before Credit Suisse, the ETN’s issuer, announced that new share creation would resume “on a limited basis” after weeks of suspension. The timing of the trades and announcement brings into question whether the bank had acted in response to the market action or if sellers had anticipated the announcement.
TVIX is a complex product by ETP standards, and the story of how the sell-off came to be shines a light on both the limitations that issuers of structured products face as well as the murky world of ETP stock loans.
As an exchanged-traded note, TVIX is a debt instrument issued by Credit Suisse that provides a leveraged short exposure to VIX futures. The leverage feature is reset on a daily basis, making it closely track the performance of the underlying VIX futures over short periods of time but creating potentially significant divergence over longer periods. In this case, that divergence occurred within a much shorter window.
On February 21 Credit Suisse, issuer of the ETN, suspended creation of new shares. It is believed that the bank did so due to difficulty in executing offsetting positions in the underlying VIX futures as the popularity of the product took off and the pace of share creation increased. At the time TVIX was not the largest leveraged exchange-traded product tracking the VIX.
With no new shares entering the market, TVIX began to trade in a manner akin to a closed-end fund, with share prices ultimately building up to a massive premium to its underlying valuation — at one point approaching 100 percent. This buying pressure was exacerbated by a lack of borrowable shares, produced by the issuer’s own decision not to create new ones. As the share price rose well beyond theoretical value, arbitrageurs began buying offset hedges in other VIX-linked instruments to capture the spread, a process complicated by the daily reset on leverage embedded in TVIX.
During the heavy selling it was unclear which traders were long investors and which were arbitrageurs, but the tone of the session suggested to many observers that one or more large players may have entered the market once selling began. “It was obvious someone was applying pressure because the orders coming through [were] best offer, best offer, best offer,” according to an institutional salesman who executed TVIX orders on behalf of clients during the day and asked not be named.
The open-ended share creation process for ETPs allow institutional sales desks to purchase new shares and offset that purchase with a hedge in the underlying market to create borrowable shares to deliver in short sales. With no new share creation, it would have been difficult for non-market-makers to access borrowable shares of TVIX to short. Additionally, tracking the origin of borrowed ETP shares has become more difficult. In recent years, the stock loan business at large banks has fragmented, with ETF market-making groups participating in the market alongside traditional stock loan groups.
In an unilluminating press release on Thursday, Credit Suisse noted that, “Beginning March 23, 2012, 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.”
Both Credit Suisse and VelocityShares declined to comment for this story.
Andrew Barber is the CEO of Waverly Advisors, a research and asset management firm. Neither Andrew nor Waverly hold or have held any positions in the securities discussed in this article.