Wednesday night, March 21, 2012, I was wondering if there was a graceful way for Credit Suisse to restore TVIX to working order and get its share creation process working again. The Wednesday close was $14.43, roughly 2X the $7.62 indicative value (IV) giving a market capitalization of $587 Million. The correct market cap, based on the indicative value was $310 Million. Somehow $277 million needed to go away.
Thursday that problem departed—in a very ungraceful fashion. Apparently, the word got out early, because by Thursday evening when Credit Suisse announced the reopening of share creation on a limited basis, TVIX had plunged 29% to $10.2
It’s tough to keep a quarter billion dollar secret.
TVIX was trading at $9.00 in the Thursday after-market—still 15% away from its closing indicative value of $7.83. Most if not all of that difference will go away Friday.
There was a lot of finger-pointing going on Thursday, but what surprised me the most was the level of ignorance displayed by some of the general media (e.g., CNBC, Forbes). I don’t expect them to be experts on this corner of esoterica, but I do expect them to know that they didn’t understand this field and take the time to consult an expert. It’s not like Bill Luby is an unknown person in the volatility arena.
Regarding Credit Suisse’s reopening, the first step, starting as soon as Friday, March 23rd will be to make TVIX shares available for lending—this will enable short sellers to drive down any remaining premium of TVIX over its IV.
As early as the 28th, share creation may resume, but Credit Suisse can require market makers to sell them specified hedging instruments as part of the transaction. This takes them close to the Exchange Traded Fund (ETF) model, where this is the standard process (e.g., UVXY). TVIX is an Exchange Traded Note (ETN), which normally does share creations on a cash basis, but adding this requirement allows Credit Suisse to at least partially protect themselves if the underlying hedges (e.g.. VIX futures, variance swaps) get pricey.
To exactly hedge these VIX future-based volatility funds all ETN and ETF providers (complete list) would need to roll their mix of futures on a daily basis. Leveraged and inverse funds, need to rebalance their hedges daily to set up for their daily percentage performance goal. In volatile times, for an ETN of TVIX’s size, this rebalancing can involve buying or selling hundreds of millions of dollars worth of hedging instruments (example). They can’t put the market makers on the hook for that, but if the market makers can get the hedging instruments at reasonable prices, Credit Suisse should be able to also.
In the interests of accuracy, I should point out that neither the volatility ETNs or ETFs are obligated to do their daily rolls or rebalancing in a certain way, or at all, based on what they say in their SEC documents. It is up to them how they manage this, and they aren’t obligated to reveal their hedging or risk management processes.
The Credit Suisse press release is silent regarding the “internal limits” that caused this mess in the first place. I’m assuming they won’t pull the plug again just based on fund size. Their additional restrictions give them an objective way to halt share creations if hedging costs go out of line, and an ever-present possibility of creation resuming should help keep the share price close to the indicative value.
Volatility as an asset class is showing some growing pains. People have flipped out because the futures rolling/hedging needs of the volatility ETN / ETFs now dominate the VIX futures market, and a lot of people have learned the hard way that a gap between the market value of an ETF / ETN and the indicative value can vaporize in an instant. But it doesn’t look like growth has changed the underlying structure of the market—the volatility marketplace does not show any objective signs of distortion. Sure the VIX futures term structure is in major contango, but most people feel the market is overdue for a correction, so that is not surprising.
Feel free to place your bets if you think those are distorted prices.