Additional risks arise as ‘liquidity gates’ may be imposed, even in the absence of a spike in volatility. In 2012, for example, the price of TVIX ETN fell 60% in two days, despite relatively benign trading conditions elsewhere in the market. The reason was that the promoter of the volatility-linked note announced that it temporarily suspended further issuances of the ETN due to “internal limits” reached on the size of the ETNs. Furthermore, for some of the volatility-linked notes, the prospectus foresee the possibility of ‘termination events’: for example, for XIV ETF a termination event is triggered if the daily percentage drop exceeds 80%. Then a full wipe-out is avoided insofar as it is preceded by a game-over event.
The reaction of the investor base at play – often retail – holds the potential to create cascading effects and to send shockwaves to the market at large. This likely is a blind spot for markets.
Others expect the same:
Data is chaotic now but key numbers show $VXX IV value at +96.10 % for the day and $SVXY IV down -96.67%. It’s likely $XIV & $SVXY terminated. If so their final values will be set by what value the futures were when they closed out their position. Likely at least down 80%.
Also, recall that last Thursday saw investors pour a record $520 million into an exchange-traded note that gains when VIX drops…
They chose… poorly.
As one veteran trader (who has seen numerous volatility cycles), “I’ve never seen anything like this… this is it” referring to the start of the unwind of the biggest aggregate short volatility position the market have ever known.