The VelocityShares Daily 2X VIX Short ETN (NYSEArca:TVIX - News) plunged more than 30 percent yesterday, as the product—which had been trading at a substantial premium to its underlying net asset value—came back to earth.
The story has been reported widely by everyone from us to Kid Dynamite , and its basic outline is well known. But there are some interesting new wrinkles to consider here.
On Feb. 21, Credit Suisse—the underwriting bank for the ETN—halted creations on the product. The ETN had seen significant inflows of new money, and Credit Suisse said it had burst through “internal limits” on its ability to hedge the underlying exposure. As a result, the firm said it would no longer issue new shares.
Demand for TVIX, however, continued, and as rising demand met a fixed number of shares, TVIX began to trade at a premium:first a little, and then a lot. By the time the market closed two days ago, TVIX was trading at a premium of nearly 100 percent:The product closed at $14.42 a share, but the actual net asset value was $7.81.
TVIX continued to trade at that premium until about 11:10 a.m. Eastern Time yesterday, when the product started to fall.
By noon, the price had fallen from $14.39 to $13.28—a drop of 7.7 percent. The selling accelerated, and TVIX closed the day at $10.20. By the time it was all over, $172 million had disappeared in the sell-off, and TVIX was down 30 percent.
To put this move in context, the ProShares Ultra VIX Short-Term Futures ETF (NYSEArca:UVXY - News) ended the day 2.2 percent higher at $18.17 a share. UVXY provides nearly identical exposure to TVIX; absent premium and discount issues, the two should track each other very well.
What Caused The Premium To Collapse?
Throughout the day yesterday, stories were circulating on what had happened in TVIX.
Everyone knew that the premium would collapse eventually — don’t they always? — but the question was, when?
Barron’s called it “ Thursday’s Oddest Trade ,” and wondered aloud about what could have caused the collapse.
At the end of the day, at 7:42 p.m. ET, we got our first hint:Credit Suisse issued a press release stating that it was temporarily reopening creations of the product. In other words, it was going to start issuing new shares.
Reopening the product for creations would inevitably cause the premium to collapse, as investors could arbitrage the difference between the price and the NAV.
But why did the premium start collapsing at 11:10 a.m., when Credit Suisse didn’t announce anything until 7:42 p.m.?
Based on our internal analysis, there were no SEC filings or press releases that would have precipitated the 11:10am sell-off. The only official notice was the press release at 7:42 p.m.
Bloomberg News’s Nikolaj Gammeltoft had one plausible explanation yesterday, quoting Chris Hempstead of WallachBeth, a leading market maker in ETFs:
“Short sellers may be accelerating bets against TVIX today on speculation Credit Suisse will permit issuance of more shares," said WallachBeth Capital’s Chris Hempstead.
But the question remains:Why Thursday? Is it coincidence that these “accelerating bets” happened the very day that Credit Suisse reopened the fund for creations? Or did news of Credit Suisse’s plans somehow leak into the market and cause the premium to collapse?
Enter The SHO List
One important wrinkle in the story is that TVIX hit the “threshold list” on March 20 for the first time since the fund closed creations on Feb. 21. It has remained on that list ever since.
The threshold list is a list of stocks that have experienced repeated “failures to deliver.” The list is often a list of heavily shorted securities, and it puts very specific requirements onto broker-dealers:
“Regulation SHO requires brokers and dealers that are participants of a registered clearing agency to take action to "close-out" failure-to-deliver positions ("open fails") in threshold securities that have persisted for 13 consecutive settlement days. Closing out requires the broker or dealer to purchase securities of like kind and quantity. Until the position is closed out, the broker or dealer and any broker or dealer for which it clears transactions (for example, an introducing broker) may not effect further short sales in that threshold security without borrowing or entering into a bona fide agreement to borrow the security."
Putting TVIX on the threshold list likely caused a large number of speculators to be “bought in” on Tuesday and Wednesday. This seems to be what caused the premium to “crash up” on those days, rising from around 50 to 90 percent-plus.
What does that have to do with the subsequent crash down? One argument is that, once these shorts were bought in, speculators figured the game was up. After all, there was no rational reason for TVIX to trade at ever-widening premiums. Investors who truly wanted access to inverse volatility exposure could use the competing product from ProShares (UVXY). Anyone buying TVIX was either ignorant of the premium issue, or (more likely), speculators betting the premium would rise further … perhaps because they anticipated the “crash up” once TVIX landed on the “threshold list.”
After that last catalyst happened, there was no reason to stay in VIX. The jig was up. And with no additional buyers, the premium collapsed.
But Why Did Credit Suisse Reopen The Note?
All of that makes sense, but it doesn’t answer the last question:Why, after all this happened, did Credit Suisse announce it was restarting creations?
Is it possible that what we saw yesterday wasn’t a leak of the information that CS was going to reopen the creation window, but actually the reason that CS reopened the creation window?
Such a scenario would go like this:Nobody likes it when their product is trading at a premium, precisely because they know it can’t last, and people will get burned.
Before TVIX was on the threshold list, perhaps CS could at least tell itself that the shorts would keep things from getting too out of control.
But then shares of the ETN become impossible to borrow, and the premium spiked to 90 percent-plus over fair value.
So, someone in the board room says:“OK, we need to make the stock available to short, because otherwise, this is going to get even uglier.”
So the company crafts a plan to make more shares available without having to be completely exposed. Instead of just opening the window, it would just issue shares to its brokerage firm, Credit Suisse First Boston, and let the brokerage lend the shares out.
It would make money on the rebate for loaning the shares, but since they technically still have the long exposure on their book, their exposure is balanced. In essence, their ETN promise-to-pay is just to themselves.
Then, if things settle down, it opens the window up to other creations, but only if people show up with a swap position already paid for that hedges Credit Suisse’s risk.
That is, in essence, what the press release last night says, although obviously the cause-and-effect here is pure speculation on our part.
Honestly, we’re not sure which to believe.
Clearly it’s hard to look at the tape and not think:“Gee, someone knew this was coming and traded ahead of it.” But it’s possible that what we’re seeing here is reactive, not causal.
Credit Suisse and VelocityShares have both declined to comment.
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