Credit Suisse 'volatility' fund liquidated

ETrade Bans Margin Trading on Volatility ETF as Swings Increase

World stock markets nose-dived again on Tuesday amid concerns about a bond market sell-off and rising inflation. In after-hours trading Monday, XIV suffered catastrophic losses.

Stocks slid in highly volatile trading on Monday, with the benchmark S&P 500 index and the Dow Jones Industrials suffering their biggest respective percentage drops since August 2011 as a long-awaited pullback from record highs deepened.

As European markets sank on Tuesday, the region's equivalent to the VIX - the VSTOXX - followed suit with its biggest one-day surge since the September 11 attacks in 2001.

The S&P 500 Index .SPX slumped more than 4 percent on Monday while the VIX index - Wall Street's so-called fear gauge - registered its largest-ever single-day jump. This is because the ETNs do not actually hold any securities, instead they are simply debt issued by banks that promise to pay to investors the amount reflected by the index's performance (minus fees).

Both the VIX and the VSTOXX have drifted lower since early 2016, staying at depressed levels below their 20-year average for almost two years - until Monday's slide in USA stocks.

At this point, only one thing is really clear: the market's low-volatility doldrums are over at long last, and it's only going to get more interesting from here.

The long-awaited market decline from record highs sent people to options for protection, raising prices for those derivatives, and eroding the value of XIV and other investments that effectively bet on tranquil conditions.

The VIX instruments derive their returns based on futures contracts, which also explains why their meltdown occurred at the end of futures trading. "Nevertheless, the Swiss lender this morning set a redemption date of February 20, for the volatility note, well ahead of the December 4, 2030, maturity date", according to Schaeffer's Investment Research. After the dust settled, the combined assets in the two exchange-traded products shrank to $135 million.

I've spent the last day talking to traders trying to reconstruct what might have happened. USA stocks ended Tuesday with gains after another wild trading session.

Davide Silvestrini, EMEA Head of global quantitative and derivatives strategy at JP Morgan, said the sharp losses experienced by short vol strategies will likely lead to reduced volatility selling flows from institutional investors.

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For a long time, shorting the VIX was a profitable trade.

The repercussions have been severe for some funds.

Products such as XIV and its close relation, the ProShares Short VIX Short-Term Futures ETF (SVXY), aim to offer investors exposure to the inverse of the daily moves at the front portion of the VIX futures curve, and typically benefit from market tranquility. That, in turn, prompted Credit Suisse, which had the biggest holding in the ETN, to pull the plug on it.

A similar fund run by Nomura Securities is being liquidated after it crashed. Leverage among the funds may be smaller than before the financial crisis, but they've been able to accrue more assets as momentum across markets marched forward to boost returns.

Did volatility funds hurt the market?

The spike in volatility does open up some attractive options market opportunities.

XIV wasn't the only exchange-traded product hammered by Monday's VIX spike.

During its rapid surge higher, the VIX outpaced the VSTOXX, an event analysts flagged as an extreme move, also suggesting there would be a rapid normalization.

Roll-over rebalancing is related to the fact that the short-term volatility futures contracts expire on a daily basis.

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