64 Finance and economics The EconomistFebruary 10th 2018
12Betting on volatilityVexed about Vix
T
HE Cboe Volatility Index, or Vix,
known as the “fear gauge”, spikes
when markets are most jittery. When
Sandy Rattray, now at Man Group, an
asset manager, worked on the Vix in the
early 2000s, he and his team considered
launching an exchange-traded product
(ETP) linked to it, but concluded that it
would be a “horror show” because of
poor returns. Now, however, Vix-linked
ETPs are a big industry, with around $8bn
in assets. Formerly niche investments,
they served vastly to exacerbate this
week’s market turmoil, which saw the
Vix’s largest ever one-day move, when it
more than doubled on February 5th.
The Vix was always intended as a
basis for financial products as well as a
gauge. Vix futures were launched in 2004
and options in 2006. “Long” Vix pro-
ducts, which Mr Rattray looked into, seek
to mirror the index. The problem is that
this means buying futures contracts, with
buyers having to pay a constant premium
over spot prices. So these ETPs tend to
lose money over time, punctuated (but
not fully made up for) by gains when the
Vix spikes. The largest “long” fund, VXX,
issued by Barclays, has lost over 99.9%
since its launch in 2009.
So otherETPs were developed to
“short”—ie, bet against—the Vix index.
Until this week, they were doing hand-
somely. Amid a long spell of subdued
volatility, investors piled in. In January,
assets in short-Vix funds hit a record of
$3.7bn. Credit Suisse issued the largest,
cutely known asXIV (reverse-Vix), which
alone held over $1.9bn. Banks and hedgefunds were the largest holders, but retail
investors may have bought some, too.
As February 5th showed, however,
short-VixETPs can collapse spectacularly
when things go wrong (see chart). A
bearish twinge sent the index up; as
short-Vix funds lost money, they had
frantically to hedge their exposure in the
futures markets. This led to a feedback
loop that drove up the Vix itself and
affected broader markets. Credit Suisse’s
XIVlost over 92% of its value on February
6th. The bank promptly said it would
redeem the product and close the fund.
That is unlikely to be the end of the
saga. Mis-selling claims by private in-
vestors in short-Vix products are in pros-
pect. Yet if such products fall out of fash-
ion, new ones are sure to take their place.
Investors are, it seems, ever happy to pick
up pennies in the road, unaware of the
approaching steamroller.The niche financial products that became central to the market turmoilVix vapoursSource: BloombergExchange-traded products, price, $2015 16 17 180200400600100300500Largest “long”
fund (VXX)Largest “short”
fund (XIV)T
HE “biggest bubble in human history
comes down crashing,” tweeted Nou-
riel Roubini, an economist, gleefully. After
an exhilarating ride skywards in 2017, in-
vestors in crypto-currencies have been
rudely reminded that prices can plunge
earthwards, too. In mid-December the
price ofbitcoin wasjust shy of$20,000; by
February 6th, it had fallen to $6,000, before
recovering a little (see chart).
And bitcoin isnot the only digital cur-
rency to have fallen. Figures from Coin-
MarketCap, a website, show that the total
market capitalisation of crypto-currencies
has fallen by more than half this year, to
under $400bn. This slide has taken place
amid a flurry of hacks, fraud allegations
and a growing regulatory backlash.
Perhaps the most damaging allegations
surround Tether, a company that issues a
virtual currency of the same name. Tether
allows users to move money across ex-
changes and crypto-currencies without
converting it back into “fiat” (central-bank-
backed) money first. In theory, each Tether
is worth one dollar, and the company has
enough greenbacks to redeem them all.
But critics allege that the currency may
simply have been used to prop up bitcoin.
They say that suspiciously large quantities
of Tether were issued wheneverthe bit-
coin price was low, and were allegedly
traded forbitcoin on Bitfinex, a large cur-
rency exchange. It is not known if Tether
has the $2.2bn needed to back its outstand-
ing tokens. Its relationship with its auditor
appears to have ended in recent months.
The company itself has been silent (in-
cluding in responding to The Economist).
Both Tether and Bitfinex—which are report-
ed to have the same boss—are under inves-
tigation by regulators in America. ShouldDigital currenciesCrypto-correction
Bitcoin and co turn out to offer anything
but a shelterfrom the stormDown a bitSource: Bloomberg$ per bitcoin2017 201805,00010,00015,00020,000Most analystsseem to think that the lat-
est equity decline is a temporary setback.
BlackRock, the world’s largest asset-man-
agement group, has called it “an opportu-
nity to add risk to portfolios”. Economic-
growth forecasts are still strong. Fourth-
quarter results for companies in the S&P
500 index have so far shown profits up by
13% and sales 8% higher than the previous
year. Tax cutswill give profits a further lift
and companies may return cash to share-
holders via share buy-backs. All this will
provide support for share prices.
Meanwhile inflation worries seem pre-
mature. Core inflation in America (exclud-
ing food and energy) is just 1.5%. Despite a
higher oil price, Bloomberg’s commodity
index is nearly where it was a year ago. The
same goes for American inflation expecta-
tions, as measured in the bond market.
Two issues will determine whether an-alysts are right to be sanguine. The first is
whether the recent gyrations in the stock-
market were reactive, responding to the re-
cent rise in bond yields, orpredictive, in
the sense of spotting future trouble.
The second relates to the theories of Hy-
man Minsky, an economist who argued
that when growth has been strong for a
while, investors tend to take more risk. This
risk eventually rebounds on them, just as
in 2007, when subprime mortgage loans
proved worthless. Perhaps the slump in
volatility-based funds or even crypto-cur-
rencies could cause a crisis atsome finan-
cial institution, inflicting a dent in confi-
dence more generally.
For the moment such dangers seem
possibilities rather than probabilities. But
like a horror-movie audience, once inves-
tors have been scared once, they may
prove twitchy for a while. 7