Market Turmoil Turns Nightmare for Volatility's Biggest Backer

(Bloomberg) -- Cboe Global Markets Inc. helped make the business of volatility famous, but investors have given the Chicago-based exchange about $4 billion of punishment because of it.

That’s how much value has been wiped off its market capitalization during one of the wildest weeks for markets in recent memory -- precisely the time you’d think the company would be thriving. But several funds tied to Cboe’s VIX index -- the core of its volatility franchise -- lost billions of dollars, prompting criticism of the risks they created and heightening speculation that traders will back off VIX products.

The exchange has defended its VIX products, saying they’ve worked as designed, even as the company’s shares have plunged 27 percent this week and Wall Street analysts have downgraded its stock. It’s an abrupt shift for Cboe, which rallied 69 percent last year, more than any other financial stock in the S&P 500 Index. Executives called this week’s events good marketing for its products.

“We know that there’s a lot of pain in the Street” when the market seesaws, Chief Executive Officer Ed Tilly said on a conference call Wednesday after the close of trading. “This is not meant to be good for Cboe, this has been great. Our volumes are great. We know this has been a very, very tough time.”

Prospects Dimmed

Deutsche Bank AG analyst Brian Bedell later said investors weren’t buying Cboe’s VIX defense and that prospects for trading VIX futures -- contracts Cboe offers exclusively and which served as the basis for the funds that plunged earlier this week -- have dimmed.

The VIX was introduced in the 1990s and turned into a leading market barometer of investor fear. When it spiked, the thinking goes, it meant traders were worried. The index simply tracked option prices of S&P 500 companies, but wasn’t something people could directly invest in. That changed in 2004 when Cboe introduced futures contracts tied to the VIX. Other companies later created exchange-traded notes that gave investors even easier ways to wager on the index.

In recent years, the VIX languished at low levels, persuading traders to buy funds that profit when the index declined. But that strategy blew up Monday with the VIX’s record surge.

Proprietary Products

Cboe’s VIX and SPX products -- proprietary offerings that no other exchange can trade -- have grown over the years to be a huge part of the firm’s revenue. In the fourth quarter, 68 percent of the company’s net transaction revenue came from proprietary products.

Cboe pushed back again Friday after releasing its quarterly earnings. 

“We enjoy as you know incredible growth and profit tremendously when the world markets go sideways,” Tilly said on a call with analysts.

The market swoon -- which took the S&P 500 down more than 10 percent since its January record-- is a great opportunity to tout the portfolio-hedging strategies Cboe’s products offer investors, according to President Chris Concannon. “This event is one of the most successful selling items for us,” he said on the Friday call. “That’s the story that I think is missed in this.”

That didn’t stop the pain. Cboe shares dropped 7.8 percent to $102.54 at 11:22 a.m. in New York, extending this year’s decline to 17 percent.

Blown Up

Two publicly traded volatility funds in particular blew up this week. The VelocityShares Daily Inverse VIX Short-Term ETN plunged 96 percent through Thursday and is being liquidated by Credit Suisse Group AG. The ProShares Short VIX Short-Term Futures is being kept in business even after plummeting 91 percent through Thursday. Both were designed to rise in value when the VIX fell, and vice versa. They were battered when the VIX posted an unprecedented 116 percent surge on Monday.

Individual investors weren’t the ones mostly hurt by that rout, Concannon said. “These are professionals that know what they’re doing,” he said.

The pounding some short volatility funds took hasn’t deterred investors from putting money into the products. Traders are flocking to SVXY, an exchange-traded product that gains when equity-volatility futures fall, similar to the one that imploded this week. It received a record $300 million in inflows even as its value sank to an almost six-year low on Thursday. 

Investors also have been diving into long volatility ETPs, with assets hitting a record this week, said John Deters, Cboe’s chief strategy officer and head of multiasset solutions. The last time those products reached a record was the beginning of 2016, when short-volatility strategy was hit hard, he said.

To contact the reporters on this story: Brian Louis in Chicago at blouis1@bloomberg.net, Nick Baker in Chicago at nbaker7@bloomberg.net.

To contact the editors responsible for this story: Nick Baker at nbaker7@bloomberg.net, Steven Crabill, Alan Mirabella

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