Is VIX Manipulated or Hedged?

(Bloomberg View) -- Vol and VIX.

Credit Suisse AG issued an exchange-traded note called XIV, the VelocityShares Daily Inverse VIX Short-Term ETN, which we have talked about a bunch recently. XIV is a debt of Credit Suisse in an amount that is inversely related to the prices of some futures on the CBOE Volatility Index, the VIX: Each day if the VIX futures go down, Credit Suisse owes XIV holders more money; if the VIX futures go up then it owes them less. In the prospectus for XIV, Credit Suisse tells investors that it plans to hedge XIV. The way the XIV hedging theoretically works is that when the VIX futures go up, Credit Suisse goes into the market and buys futures; when the futures go down, Credit Suisse goes into the market and sells futures. 

Last Monday VIX futures went up during the day, and then at the close they went up a whole lot: People were piling into the market to buy VIX futures right at the last minute. This caused the price of VIX futures to spike, and they closed at a price well above where they had traded during the day (or during the previous year for that matter). That price was also higher than where they opened the next day, or where they have traded since. The single worst time to buy VIX futures in the last five years was at the close last Monday. That is also when the value of the XIV -- Credit Suisse's debt to investors -- was set. Because the VIX futures jumped so much, the XIV was effectively wiped out; it lost about 96 percent of its value, and Credit Suisse later announced that it would be redeemed. Credit Suisse had about a $1.6 billion debt instrument outstanding on Monday morning; by Monday evening it had all but disappeared. We discussed all of this at great length last week. 

Here I want to focus on this aspect of the trade:

  1. Credit Suisse had a liability whose value decreased as the price of VIX futures went up.
  2. Credit Suisse -- or whoever was hedging XIV, or other instruments like it -- may have bought a lot of VIX futures all at once.
  3. VIX futures went up.
  4. Credit Suisse's liability more or less went away.

If you just read that list, and nothing else, one thing that might occur to you is: Hey, wait a minute, Credit Suisse controlled the size of its liability. If it bought VIX futures, the price of VIX futures would go up, and the amount it owed on the XIV note would go down. And in fact someone was buying a lot of VIX futures last Monday, and so the amount Credit Suisse owed on the XIV note went down almost to zero. That's a nice day for Credit Suisse!

One word that might sneak into your vocabulary at this point is "manipulation": If Credit Suisse's own trading of VIX futures can affect the value of its liability, then might it be trading in a way designed to minimize that liability, at the expense of its investors?

I want to urge you not to think that! Everything I wrote above about Credit Suisse's trading behavior is invented, in the sense that I don't know what Credit Suisse was doing last Monday and they won't tell me. But I didn't invent it out of nowhere -- and other people assume much the same behavior -- because it is the theoretical hedge for Credit Suisse's liability. Credit Suisse issued an exchange-traded note based on the inverse of a futures index, and the way to hedge that is well understood by the market, and it is widely assumed (and perhaps legally required!) that a bank that issues an exchange-traded note will hedge it, so that it is not at risk of enormous losses if the underlying index moves.

And that hedging is good. It is good in part because we'd prefer big banks not to have huge unhedged positions, but that's not really why it's good. It's really good because the existence of these theoretical hedges is what allows banks like Credit Suisse to manufacture these derivatives: If you want to bet that the VIX will go down, Credit Suisse will let you make that bet, but it won't take the other side. It won't even have to find someone to take the other side. Instead it will manufacture the other side out of raw materials (VIX futures), and sell you the finished product. And there is an accepted mathematical approach to turning those raw materials into that product. The bank's business is to do that, to turn financial materials into financial products through financial engineering; that's what investment bank trading floors are for. (I mean, the product turned out to be terrible and its investors lost almost all of their money, so perhaps this whole thing isn't great, but to be fair it mostly gave the investors the exposure they signed up for.)

The problem is that the mathematical formula tells Credit Suisse to buy futures when the futures are going up. To a person losing money on his XIV position, this can look like "manipulation." To a person familiar with the mathematical models underpinning XIV hedging, this will look like "hedging." There are real substantive objective differences between those things -- differences of intent and amount and timing -- but in very broad strokes, from the outside, they are often hard to distinguish. If Credit Suisse was buying VIX futures on Monday, that was both reducing its XIV liability and implementing its model for how to hedge XIV. Which part you emphasize will tend to depend on your prior assumptions.

Anyway there are a bunch of stories out today about potential manipulation of the VIX. Not VIX futures, mind you -- which are exchange-traded contracts that settle based on the future level of the VIX -- but the VIX itself, which is an index calculated based on the prices of some options on the S&P 500 Index. The idea is that people who have an economic interest in the VIX -- because they own VIX futures, for instance -- are going out and Doing Bad Things to the prices of those underlying options in order to push the level of the VIX towards where they want it. "The Financial Industry Regulatory Authority is scrutinizing whether traders placed bets on S&P 500 options to influence prices for VIX futures," an anonymous whistleblower has alleged that the VIX is being manipulated, and a paper last year by John Griffin and Amin Shams of the University of Texas argued that there was empirical evidence of that manipulation.

The counterargument is: No, the people with an economic interest in the VIX (the futures owners, etc.) are doing economically rational derivatives trades. Perhaps they are hedging their VIX futures exposure using the underlying options, or they are trying to roll it over by replacing expiring futures with equivalent underlying options. When we talked about the Griffin and Shams paper last year, we discussed an explanation like that. "Some of our most VIX-savvy clients argue that this is not 'manipulation' at all, but simply the means which liquidity providers replace their risk," wrote Pravit Chintawongvanich of Macro Risk Advisors. The VIX-savvy clients emphasize the hedging and rolling, because they are familiar with the models and the market practice. The less VIX-savvy clients see the trading that moves markets, and they assume manipulation. 

I don't know which is right. Usually the answer is "a bit of both": Even executing a theoretical hedge can sometimes involve a bit of sloppy trading or subterfuge intended to move prices in your preferred direction, and plenty of traders deviate from their perfect theoretical hedge. But the hedging explanation tends to be both complicated and boring, while the manipulation explanation is simple and psychologically satisfying, so you would expect it to have more appeal.

What are the Uber drivers up to?

Paul Britton, founder of the $5.9 billion Capstone Investment Advisors, was on his way to his Manhattan office one day last fall when he received unexpected investment advice from his Uber driver.

It went like this: “‘There’s this unbelievable company, these guys just crushed it -- not sure whether it’s in biotech or a technology business, but they’re up 80 percent this year. It’s this company called XIV,’” Britton, 44, remembered the driver saying. Britton said he responded, “I’m like, ‘I’m sorry to have to tell you this, mate. That’s not a company.’”

One vague dream of mine is that I would like to design and teach a course in "financial literacy." I feel like "financial literacy" as it is usually conceived is terrible, just a lot of "if your bank pays 10 percent compound interest and you start with $100 then in three years will you have more or less than $130?" and other arithmetic trivia that is of limited interest in our world of low interest rates and flourishing Ponzi schemes. "Financial literacy" will tell you that the answer is "more than $130," because compound interest Einstein blah blah blah, but the correct answer is "less than $130," and likely zero, because if your bank pays you 10 percent interest in the United States in 2018 it is a Ponzi and will steal your money. There is room for improvement is my point here. 

I have not yet fully planned out my financial-literacy core curriculum, but I would probably offer an elective called "Are These Companies?" Like here is a financial-literacy quiz: Are these companies?

  1. Uber
  2. Tinder
  3. Snapchat
  4. Bitcoin
  5. Blockchain
  6. Long Blockchain
  7. VIX
  8. XIV

If you get at least five of those right then I will allow you to drive for Uber.

Banks as tech companies.

You know, someone invented the XIV ETN. And someone invented the VIX, and VIX futures. And when you read the technical specifications for all of those things, it is clear that they are not trivial feats of engineering. Teams of marketers and traders and quants and technologists and lawyers put many hours into getting them just right, so that they would work as intended. They are technologies, highly engineered tools designed to help customers do things that they couldn't have done before. They are financial technologies, built not out of screens and circuit boards but out of formulas and hedging strategies and legal documents, but that is what you'd expect: Financial firms ought to innovate in financial technology.

Yesterday Goldman Sachs Group Inc. Chief Executive Officer Lloyd Blankfein presented at the Credit Suisse Financial Services Conference, and his presentation is kind of a weird read. The running theme is that Goldman is doing technology stuff to win business. "Engineering underpins our growth initiatives," says a summary page, and it doesn't mean financial engineering. In fixed income, currencies and commodities, engineers are 25 percent of headcount, and the presentation touts growth in Marquee (its client-facing software platform) and "systematic market making." In equities, Goldman touts its quant relationships. In consumer banking (now a thing!), the centerpiece is Marcus, Goldman's online savings and lending platform. And in investment banking, "Engineering enhances client engagement through apps, machine learning and big data analytics." Apps! I hope there is an Uber-for-mergers app: You put in your location and the enterprise value of your deal, and it tells you that a Goldman Sachs banker will be at your office within 7 minutes. Of course the dream is that one day she won't even need to show up, and the app will do the whole merger for you.

This is obviously good and sensible. Making finance more efficient is good, reaching out to customers with technology is good, a big investment bank is probably as well positioned to build banking and trading apps as anyone else. It is just different, though. Instead of developing new financial technologies, Goldman is developing new computer technologies for its financial clients. Financial technology itself, the business of engineering new tools of finance, is perhaps stagnating a bit. "People are -- not unreasonably -- skeptical of financial innovation that is actually financial innovation, that finds new ways to slice cash flows and allocate risks," I wrote a little while ago. Now the innovation is in apps.

(Disclosure: I used to work at Goldman designing derivatives, not apps. Also I have a Marcus savings account.)

Fannie and Freddie.

Wikipedia tells me that Fannie Mae became a public company in 1968; Freddie Mac was formed in 1970. In 2008, in the depths of the financial crisis, they both became wards of the U.S. government, funded and guaranteed by Treasury and -- since 2012 anyway -- paying all of their profits back to the government. Every so often you hear some bleating from politicians or lobbyists or aggrieved owners of Fannie and Freddie stock that this temporary conservatorship is unsustainable, that we need to get private capital back into the mortgage market, that freeing Fannie and Freddie from government control is an urgent matter.

And then nothing at all happens. Bills are introduced every now and then and go nowhere, but realistically there is no evidence that Fannie and Freddie are closer to getting out from government supervision than they were 10 years ago. Everyone is required to talk about this decade-long status quo as though it were abnormal and temporary and about to collapse, but ... why? Fannie and Freddie have now been in conservatorship for one-fifth as long as they were public companies. If this goes for another 10 years, I suspect people will still go around saying that it is unsustainable and needs to be fixed as soon as possible, and I suspect they still won't do it.

Also it is ... fine? I don't know, there are some real objections to the endless conservatorship. Fannie and Freddie shareholders have some legitimate grievances about the 2012 amendments that cut them off from all future profits of the businesses, and writing first-loss mortgage guarantees is an odd business for the Treasury to be in (though Fannie and Freddie sell risk-transfer securities to reduce that oddity and put more of the first-loss risk in private hands), and there are accounting worries about consolidating all of their mortgage guarantees onto the federal government's balance sheet, and presumably recruiting is difficult and morale is low when you are in limbo. But in many ways, having Fannie and Freddie be essentially government agencies seems like a convenient way for the government to implement housing policy and also make some nice profits.

Anyway here's a recent note from Pimco about how the status quo is fine:

Although conservatorship may be unpopular, policymakers must stop treating it as a four-letter word if they truly want to protect and promote a consistent national mortgage rate, broad access to mortgage credit and a deep, liquid secondary mortgage market. Instead, we believe GSE “reform” should simply formalize the current state of affairs – namely, by making the government guarantee explicit and otherwise keeping Fannie and Freddie functioning as they largely are today. In other words, Congress should be honest about conservatorship: It has been and continues to be immensely successful, not to mention wildly profitable, and the current system works. 

On the other hand: "Fannie Needs First Bailout Funds Since 2012 After Tax-Cut Loss." When we last discussed the effect of the new tax law on Fannie Mae's deferred tax assets, I said "this is really going to be the stupidest possible development for the saga of Fannie Mae and Freddie Mac," and here we are.

Blockchain blockchain blockchain.

"Here's how blockchain could solve the post-Brexit Irish border question," it says here, and really it is 2018, why aren't we answering all of our geopolitical questions with blockchain? "Here's how blockchain could solve the Israeli-Palestinian conflict," is a good headline for an article I expect to read within a week, get to work on that.

Meanwhile, we occasionally discuss finance teens in this newsletter, but I regret to inform you that here is a crypto tween:

At 11 years old, he might look a bit out of place at the upscale New York City restaurant Bagatelle, which hosts Crypto Mondays, a meet-up group where crypto and blockchain enthusiasts meet, glad-hand and share ideas about the world of digital currencies.

George is, in reality, far from out of place.

He is the CEO of Pocketful Of Quarters, which, according to its website, is the “universal cryptocurrency for games.”

Yeah look I bet he doesn't look all that out of place at the crypto meetup. I don't know about his cryptocurrency but I will say it's a pretty good name! If you got a 26-year-old to name it he'd probably have come up with, like, "GameCoin." "Pocketful Of Quarters" is unexpected but right, evocative and memorable. More cryptocurrencies should be named by 11-year-olds is I guess the lesson here.

Me elsewhere.

Here is my conversation with Tyler Cowen for Conversations With Tyler.

Things happen.

New Hedge-Fund Tax Dodge Triggers Wild Rush Back Into Delaware. Uber Sales Rose 61% to $2 Billion Last Quarter Under New CEO. Investing: activism enters the mainstream. AT&T Targets Head of DOJ in Defending Time Warner Deal. Inside the Bribery Scandal Sweeping Through the Oil Industry. "Eric Posner and Glen Weyl — the same duo that has called for banning index funds and replacing private property with 'shared ownership' — are now arguing for a scheme to bring a new underclass of indentured servants to the United States." Russia May Invest in Saudi Aramco IPO Via Fund With China. Blackstone, Other Private-Equity Firms May Sit Out Trump Infrastructure Push. Blackstone’s James Hands No. 2 Job at Private-Equity Giant to Jonathan Gray. Broadcom Now Seeking Fewer of Qualcomm’s Board Seats. Manhattan U.S. Attorney Announces Bank Fraud Charges Against NYPD Detective. Louise Linton Is Super-Duper Sorry. Photo of a single atom wins science photo contest. Mattel doubles down on Uno with a new card game called Dos. Dog Barred From Race For Kansas Governor.

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.

To contact the author of this story: Matt Levine at mlevine51@bloomberg.net.

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