So say equity-derivatives analysts at Deutsche Bank AG, who argue that part of the reason the Chicago Board Options Exchange’s Volatility Index is hovering at multi-decade lows has to do with hedging by large banks, along with rebalancing activity tied to exchange-traded products.
There are plenty of fundamental reasons behind diminished volatility in the S&P 500 index that the VIX is tied to -- including still-ultra-low interest rates at a time of solid economic growth. But the technical factors flagged by Deutsche Bank have the potential to maintain or upset a delicate balancing act at the back-end of markets.
Large dealer banks that buy or sell the S&P 500 to hedge exposure to U.S. equities are helping to suppress realized volatility and keep the VIX low, the Deutsche Bank analysts say. By their estimates, dealers would have to buy $14 billion if the S&P 500 fell by 1 percent. It’s all about "gamma" -- the third Greek letter.
“When dealers are long gamma they sell equities when equities are rising, but buy them when they’re falling,” write Deutsche Bank analysts led by Rocky Fishman. “The primary reason" for the VIX index being so low is the multi-decade low in fluctuations in the market itself, according to the team. And the long gamma positions of dealers "is a contributing factor to the ongoing low-realized vol,” they wrote.
While the hedging needs of big banks have helped keep a lid on volatility by providing a backstop to moves in U.S. equities, the analysts note, the rebalancing requirements of the plethora of exchange-traded products now tied to the VIX could pose a risk to that stability. Such ETPs typically buy VIX futures as the underlying index rises, and sell futures as it declines, creating a so-called ‘short gamma’ position."
If the VIX were to spike, then Deutsche Bank calculates those ETPs would have to buy a record amount of "vega" -- meaning they’d have to put on trades to bet that volatility will increase. “Vega to hedge on a spike has continued its steady rise since the vol increase around U.S. elections, and sits close to $90 million,” a record, they said.
The VIX index closed at 9.77 on May 8, the lowest since 1993. It headed for a third day of gains Wednesday, and was at 11.73 as of 6:51 a.m. New York time.
While the market for VIX futures might be able to absorb some of that buying need in the event that the VIX did make a sudden jump, there’s a risk that the proliferation of ETPs, which have yet to experience a significant increase in volatility, could roil the market. It’s not unlike concerns about credit default swaps in the early days, when analysts were unsure what would happen in case of actual defaults -- given the volume of CDS outstanding compared with the bonds they were based on.
“In terms of overall impact in the market, the vega to sell" is about "40 percent of the overall VIX futures market, making it less of a risk than it was at times last year,” Deutsche Bank concludes. “However, it is uncertain how liquid the VIX futures market would be after that kind of vol spike. The large amount of vega to buy may be hard for the market to absorb in some stress events, which may cause further exacerbation of a vol spike.”