A quick thing on the long-awaited, entirely predictable ‘Volpocalypse’

A quick thing on the long-awaited, entirely predictable ‘Volpocalypse’

How many warnings did buyers of XIV, the volatility-linked exchange-traded note (ETN) note that went bust last week get? A lot.

First there was the prospectus itself, which spelled out wipe-out risk fairly clearly. Then, there were multiple articles from multiple financial news and analysis outlets, myself included.

There were also tweets!

Like, lots of them!

This tweet was from Jan. 31st — about five days before the actual blow-up! The only response I got to this at the time was from a guy complaining that he couldn’t see the x-axis so the chart was meaningless. That wasn’t the point! And if you don’t understand what a change in the shape of the VIX futures curve might mean for volatility-linked products, you probably shouldn’t be trading them!

I tried to some up just how telegraphed this was in a short note for our markets morning newsletter, which you can sign up for (for free) here.

I don’t mean this to sound callous to those who lost their shirts on this product, but neither do I want this to be spun as a failure on the part of forecasters and journalists etc. This was a well-telegraphed event that people saw a mile coming. That doesn’t mean there wasn’t failure somewhere. The fact that some retail investors seem to have been taken completely by surprise in the recent turn of events suggests they probably shouldn’t have been in these products in the first place. Whether that’s a failure on the part of the regulator, the ETN-issuer, the brokerages that enabled trading in the products, or some other party, I leave that to others to decide.

The benchmark index providers who rule the world

The benchmark index providers who rule the world

I find the intellectual questions thrown up by benchmark indices absolutely fascinating. Talk to the providers about what it is they do exactly and most of them will say they hold a mirror up to the investable world as it exists, while simultaneously acknowledging that their decisions can end up reshaping just what that reflection looks like. What everyone can agree on: their role in a market increasingly dominated by passive investing is growing.

So here are 2,000 words or so on the index providers who rule the world … as well as the people who want to unseat them.

Benchmark indexes trace their history to the late 1800s, when Charles Dow, co-founder of Dow Jones & Co., created the first as a way to gauge the general direction of the market (and to sell newspapers). Today the number of benchmarks outnumbers that of individual stocks. “The problem is that a lot of investors assume that the benchmarks are almost God-given and that they’re ­problem-free. Most of the time they’re not,” says Mohamed ­El-Erian, chief economic adviser at Allianz SE and a Bloomberg View contributor. “It’s a crucial issue. And it’s becoming even more important as more and more people migrate to passive products.”

Index Providers Rule the World—For Now, at Least – Bloomberg Markets Magazine

Did someone say something about synthetics?

Did someone say something about synthetics?

Two words excite me like no others.

They are synthetic securitisation (or, for the truly old-school, they are three words: regulatory capital trades). These deals usually involve repackaging loans on a bank’s balance sheet, then slicing them up into different tranches, and selling the exposure to a non-bank entity like an insurer, hedge fund, or asset manager through the use of credit derivatives.

In many respects, they hark back to the early days of securitisation, when JPMorgan first put together its BISTRO trades, otherwise known as the first synthetic CDOs. Banks may be genuinely offloading risk here, and the deals were called reg-cap trades precisely because they offered capital relief that’s so far been genuinely sanctioned by regulators. On the other hand, they seem to speak to some of the worst of the current environment: a pervasive search-for-yield that may see investors put their money in silly things at silly prices (for this reason, you will sometimes hear reg-cap specialists – usually hedge funds – gripe about the non-expertise of new entrants and the need to price the deals perfectly), as well as nagging concern that in fortifying the banking system post the financial crisis, we’ve simply offloaded a bunch of balance sheet risks onto other entities in a classic case of regulatory arbitrage.

In any case, I bring it up because in less than a week we’ve seen two stories published on the market, now said to be booming, first in the Financial Times and then in the Wall Street Journal. Both detail the rise of the market, with issuance described as having jumped by anywhere from 5.6 percent in the first quarter to at least 33 percent so far this year.

Those looking for a graphical representation of the recent rise of synthetic CDOs, could do worse than this chart from Deutsche Bank. It shows European deals only, but the direction of the trajectory is pretty obvious. The WSJ story also references some interesting figures from consultancy Coalition, pointing out that structured credit revenues at the top 12 investment banks more than doubled year-on-year to $1.5 billion the first quarter of 2017, exceeding the growth rate in more conventional trading businesses in the same period.

Growth in the business is not exactly a surprise, though.

More than five years ago I wrote in the FT about some of the bigger banks working hard to get the business going as a way of securing some new fees at a time when many of their other revenue streams were sluggish. In retrospect, that story’s now looking pretty prescient.

Big banks seek regulatory capital trades


Big banks are aiming to help smaller lenders cut the amount of regulatory capital they need to hold against loans in an attempt to make money from deals similar to those first created in the early days of securitisation more than a decade ago.

The big banks want to create so-called regulatory capital trades for smaller lenders as they expect demand for these kind of securitisation structures will rise ahead of regulations designed to provide more stability in the financial system.

Such trades, also known as synthetic securitisations, involve repackaging loans on a bank’s balance sheet, then slicing them up into different tranches.

The bank typically then buys protection on the riskiest or mid-level tranche from an outside investor such as a hedge fund, insurance company or private equity firm.

Doing so allows a bank to reduce the amount of regulatory capital it has to hold against the loans – a tempting prospect as banking groups are forced to hold more capital ahead of new regulation such as the forthcoming Basel III rules.

Some of the biggest global and European banks, including Barclays and Standard Chartered, are known to have recently built and used the structures to reduce the amount of capital they need to hold against corporate or trade finance loans.

But some large banks are now hoping to sell their structuring expertise and help distribute the resulting trades to buyers, investors in the trades say.

“The holy grail for some of the investment banks is to try to get some of the second and third tier banks involved, to get structuring fees,” said one investor. The trades hark back to the early days of securitisation in the late 1990s, which helped fuel the financial crisis.

“It’s almost as if you’re seeing the start of the securitisation market coming back in a very modest way,” said Walter Gontarek, chief executive of Channel Advisors, which operates Channel Capital Plc, a vehicle with $10bn in portfolio credit transactions with banks and has started a new fund dedicated to these structures.

Investors such as Channel Advisors say the yields on the deals are attractive compared with other debt securities on offer, and they are able to gain exposure to a specific portion of a bank’s balance sheet rather than invest in the entire thing. The insurers, hedge funds or private equity firms are not bound by the same, relatively onerous capital regulations as the banks. That makes it easier for them to write protection on the underlying loans in a classic case of regulatory arbitrage.”


Some more early coverage below, for those interested.

Synthetic tranches anyone? – FT Alphaville
Anti-Abacus, anti-BISTRO and anti-balance sheet synthetic securitisation – FT Alphaville
Big banks seek regulatory capital trades
– FT, April 2012
Banks share risk with investors – FT, September 2011
Balance sheet optimisation – BOOM! – FT Alphaville, 2010

Safe assets, revisited

Safe assets, revisited

The idea of a shortage of ‘safe’ assets is a favorite of mine, dating back from 2011 when I first wrote about a crunch in triple-A rated assets for FT Alphaville to more recent things such as this piece for Bloomberg, and sometimes even on this blog. So it was a pleasure to discover, courtesy of Simon Hinrichsen (a former Odd Lots guest whom you should definitely follow on Twitter), a new paper on exactly this topic from Ricardo Caballero, Emmanuel Farhi and Pierre-Olivier Gourinchas. Read it for rather glorious sentences such as this one: “What is relatively new, relative to post–World War II history, is that the global economy is going through a complex structural period where the standard valuation adjustment for safe assets— via interest rate changes—have run out their course.”

Here’s a summary I wrote as part of our morning ‘Five Things’ newsletter, which you can sign-up for here.

“Want a stylized prism through which to understand almost everything that’s happened in the global financial system over the past two decades? Then take a look at this paper on “The Safe Assets Shortage Conundrum.” In it, the authors argue that savers’ desire to put their money in a reliable instrument has created a need for ‘safe’ assets that the financial system has had various degrees of success in fulfilling. In the early 2000s, the private sector tried to fill that need by creating triple A-rated bonds out of subprime mortgages. We know what happened next. After that, safe financial assets became largely the purview of governments via the bonds they sell – first the eurozone (which then experienced its own ratings problems) and then the U.S. Supply has ultimately failed to keep up with demand, however, mostly because slower growth has meant ‘safe’ governments in the developed world have been unable to generate assets at a fast enough pace to satisfy savings from emerging markets. It’s a state of affairs that will probably stick around for a long time, and one that helps explain why bond yields continue to plumb new lows, seemingly without rhyme or reason. But seriously, go read the whole thing.”

A side note: I do wonder what might constitute safe in the current environment. Yes, government debt is the clear winner here but corporate debt issued by cash-heavy, investment grade, national champion corporates – think Apple – can’t be far behind…

Fair wages for robots

Fair wages for robots

No, seriously.* Hear me out.

Citi’s Willem Buiter offers one possible explanation to stubbornly low-inflation, and by extension, sluggish economic growth. Here’s the excerpt:

“We draw attention to one additional hypothesis: that we underestimate the amount of slack in the economy not primarily because we underestimate the amount of slack in the labor market or overestimate the degree of utilization of tangible capital but rather because potential output can be boosted greatly at effectively zero social marginal cost and without increased use of labor and tangible capital, through the use of new production methods based on recent advances in information technology, machine learning, artificial intelligence, big data, the internet of things, robotics, automation, autonomous machines and nanotechnology.

Because the value added in many of these new activities is mostly pure rents (returns to genius, luck and monopoly power) the distribution of income and wealth created by these activities is increasingly unequal. That weakens the aggregate marginal and average propensity to consume. Unless this shortfall of demand is made up for by increased consumer demand through fiscal redistribution towards households with higher marginal propensities to spend, or by capital expenditure, public consumption or net exports, some of the potential output gains may not materialize but turn into excess capacity and a growing (or at least larger than expected) output gap. Lower-than-expected inflation is the result.”

As Paul Caple pointed out on Twitter, there’s a simple mismatch at play here. Advances in technology mean you can boost potential output without the need for (mere) humans, yet consumption remains a human-driven activity. With more profits accruing to owners of capital — the Piketty-esque element in Buiter’s argument above — consumption drags. After all, there’s only so much a billionaire can spend, much as they might try. Meanwhile, the proximate cause of greater potential output is paid nothing, and presumably contributes nothing to consumer demand beyond potentially making goods more affordably or efficiently, which may or may not encourage people to by them (As the cycle of improvement continues there’s only so many times you’re going to upgrade your TV. iPhones appear to be the exception here).

The solution is simple: pocket money for robots.

A politically-unpalatable solution for sure, but think of the “fiscal redistribution” that could be achieved. The nuts and bolts spending, if you will. Unlike human beings, robots can also be programmed to spend consistently, thereby avoiding the over-savings problem that has plagued the 2000s. So long as the robot-owners don’t extract the wages as rent. And so long as the robots themselves don’t go off the rails: I can save I I everything else to me to me to me to me to me to me to me to me to me.

Fail GIF - Find & Share on GIPHY

*Readers assume all responsibility for taking this seriously.

Flows before pros?

Flows before pros?

A recent Barron’s interview with James Montier got me thinking. In it, the GMO man answers a question about lofty valuations across both bonds and stocks that have caused consternation for asset allocators seeking good value in the market. In response, he says: “The US market is at its second or third most expensive point in history. So people are saying, ‘I either don’t understand the world anymore, or I don’t think that valuation matters anymore.'”

I think he has a point but maybe not the one he means. Valuations do matter because in a world of inflated asset prices but suppressed actual price inflation or economic growth, they’ve become the easiest and most surefire way for investors to generate outperformance, and so, that is what they are chasing. I still think Citigroup’s Matt King put it best, when he argued two years ago that something fundamental had changed in the market’s behaviour.

The crux of this argument is that markets used to be self-limiting. Prices of securities would move up to a point where their yields would become unattractive, at which time investors would trim some of their positions, causing prices to go down and yields to recover. Now the intense search for returns has altered that dynamic, with investors chasing inflows as a means of getting higher prices and higher profits.

While the notion that  value investing is disappearing in a market that has moved ever upward for the past five years is not exactly new, King’s presentation here is stark. Investors have been moving in tandem, he says, making markets far more homogenous. The chart below shows investor positioning in credit markets, where the number of longs has vastly outnumbered the shorts, along with the International Monetary Fund’s herding metric. In short, investors across a number of asset classes are going mooo as one-way positioning dominates…

We often say the market can stay irrational longer than you can stay solvent. Maybe the updated version should be that the market can self-perpetuate for longer than expected.

It’s not just about the VIX

It’s not just about the VIX

There’s so much talk about volatility right now — and specifically the stubbornly low behaviour of the VIX  — that I thought I’d do a round-up of some of my previous pieces on it.

Please note, I’m in an anti-paragraph, anti-proofreading kind of mood today. So typos and big blocks of text are ahead.

1. On the VIX 

Let’s start with this one, from September 2013, about a new index trying to challenge the VIX, the index that most people associate with ‘volatility.’ For more than two decades, the VIX index run by the Chicago Board Options Exchange has been the financial industry’s go-to method for measuring expectations of volatility in the wider marketplace, with the CBOE turning the index into something of a cash cow thanks to the launch of futures tied to the gauge. VIX-related futures have in turn allowed a plethora of VIX-based exchange-traded products (ETPs) to also launch. With all that money benchmarked to the VIX, it’s no surprise that we have occasionally seen upstarts attempt to challenge it.

2. Selling volatility

Now let’s go here to this story from December 2014. About six years on from the financial crisis and deep in the era of monetary stimulus, investors are struggling to make returns and seize upon the realisation that selling volatility — whether that be through shorting the VIX or some other derivative-based method — can be a lucrative (if risky) strategy. This was the big shift in the volatility market. Instead of having a bunch of banks or hedge funds (or de facto, GSEs) sell volatility, you suddenly have a bunch of buy-side funds and retail investors who are interested and able to do so, the latter largely thanks to the explosion in VIX-related products. The big question, per the piece, is whether these new sellers of volatility are more likely to behave differently than traditional vol-sellers. Are they more or less likely to react to abrupt shifts in volatility?

3. Self-reflexive VIX

By September 2015, the VIX is again in the headlines after the unexpected devaluation of the Chinese yuan spooked markets. While the VIX did jump on this news, it was the VVIX (in effect, volatility of volatility) that reached an all-time record. Here’s my article about that: “When there’s a sudden spike in volatility, as occurred last month, the price of near-term VIX futures rises. Meanwhile, volatility players — notably hedge funds and CTAs — scramble to buy protection as they seek either to hedge or cover short positions, causing a feedback loop that encourages near-term futures to rise even further.” CFTC positioning data at the time did suggest a classic short squeeze as investors closed out their short vol positions post the spike. In effect there were said to be two major forces impacting the VIX, systematic volatility sellers as well as VIX-related ETPs that have to buy or sell futures to rebalance. This rebalancing act makes the VIX curve important, a point picked up on by Chris Cole of Artemis Capital in a story I wrote about a month later: “VIX term structure inverted at the greatest degree in history in August, so much so and so fast that many structured products that use simple historical relationships to gauge term structure switching and hedging ratios just couldn’t handle it,” he said. The concern is that the explosion in volatility-trading means more demand to buy or sell futures to rebalance, which could impact the shape of the curve itself.

4. VIX and beyond!

The proliferation of ETPs tied to the VIX is a concern insofar as it affects the volatility landscape, but it’s not the whole story. To explain, let’s go to Bill Gross, who became the poster child for volatility-sellers after publicly saying in June 2014 — while still at Pimco — that the company was selling “insurance, basically, against price movements” to juice returns in an era of low interest rates. Not once did he mention the VIX. It wasn’t until October 2014, after Gross’s abrupt departure from Pimco, that we got a better sense of what that insurance-selling strategy might mean when the U.S. Treasury market experienced a sudden melt-up, of sorts. At the time, there was plenty of talk that Pimco was liquidating some derivatives positions, which ended up having an outsized effect on the underlying cash market. The U.S. government’s report on the episode later mentioned that: “In particular, anecdotal commentary suggested that some dealers had absorbed a portion of the sizable ‘short volatility’ position believed to have been previously maintained by large asset managers. As volatility spiked on October 15, those positions would have prompted some dealers to dynamically hedge this exposure, exacerbating the downward move in yields.” Then, in August of last year, the BIS published a paper on asset managers dabbling in eurodollars including the example of Pimco in 2014, which I wrote up in a piece called “This is where leverage lives in the system.” That article contained a laundry list of potentially risky strategies across rates (viz eurodollars, futures, forwards), credit (using swaptions and swaps) as well as equities (options, VIX ETPs, etc.). What’s my point? I don’t mean to underplay what’s happening with the VIX, but my concern is that if we’re looking for potential flash points in the financial system then we may want to broaden our horizons.

On Twitter

On Twitter

The short version: I had a busy day on Twitter today.

The long version: About five years ago I had my first existential crisis with Twitter. An old-school American news editor did not seem to like the thing and could not understand his fellow journalists’ fascination with the product. Some six years into my career at that point, and three years on the platform, this was the first time I had heard an editor express a cogent argument about the negatives of social media use.

We were spending too much time on it at work, he said, repeating an obvious critique. But his idea that we were potentially prioritizing our opinions and personal brands at the expense of the wider newsroom was a new one to me. For years, as a young journalist working at a relatively tech-savvy media outlet, we had been told to do just that. Twitter was a way to get your name out there, build up a reputation that would ultimately reflect well on your news organization and – most importantly – maximize the number of people who would read and reflect on your work.

Fast forward to today and my second existential Twitter crisis, caused by watching a fellow journalist accumulate thousands of fake Twitter followers, seemingly with no one but myself actually noticing. This bothered me for a number of reasons which, in true meta fashion, I have tweeted about.

Since we’re talking social media; let’s start with me. I felt that accumulating fake followers undermined other journalists who had worked hard to build up an organic following. It also cast into serious doubt some career advice I had been giving already to younger journalists – namely that they could expand their horizons and job potential by building up influence via Twitter and other platforms. Finally, there’s the more lofty goal. In an age when the credibility of the media is under attack and the lines between ‘real’ and ‘fake’ news are increasingly blurred, it seems unlikely that  journalists teaming with bots to purchase influence will be well-regarded.

Reactions on Twitter ran the gamut from outrage to virtual shrugs.

While plenty of people seemed to share the concerns I had outlined above, many thought purchasing fake followers to be a legitimate social media strategy. A literal ‘fake it ’till you make it’ approach and one that could have a high likelihood of paying off as your robotic followers were gradually replaced with real ones. One person commented that he knew of people who had been rewarded for fake followings with internships.

Many also pointed out that you can ‘tell’ when someone’s purchasing fake followers. I don’t think that’s necessarily the case and, more importantly, I have rarely seen someone follow up the words “they have so many Twitter followers!” with “but their engagement is very low.” (I would probably hate this person but I would also appreciate their thorough social media analysis). Yes, a lack of retweets or likes contrasted with a huge following suggests some sort of discrepancy but nowadays you can buy engagement too. As I was about to find out.

David Taggart, of the Macro Trader, took it upon himself to teach me.

Using a site called Fiverr, David spent $5 dollars to send a bunch of retweets my way. I still don’t understand how this works. David’s description of the site – “For $5 you can freak people out. I love it” – differs somewhat from what Fiverr itself says: “Fiverr is the world’s largest freelance services marketplace for lean entrepreneurs to focus on growth & create a successful business at affordable costs.” Whatever the thing actually does, I can tell you that within a few hours my original tweet had been retweeted a couple thousand times, making it by far my most popular online musing ever and making my Twitter account guilty of the very thing I had been criticizing.

Who are the retweeters, you ask?

Well, there’s Lori Jean-simon, who seems to like both me and a carpet-cleaning company:

Or Donnette Blondell (great name) seems to be really into me and Mexican actresses.

And, of course, more eggs than you can take a crack at counting.

Here’s the thing. Influence has always been a tough concept to capture and the idea that we would be able to do so through a simple number – such as Twitter followers – is simplistic but enticing given the human mind’s need for certainty. I don’t have an easy solution to this. My busy day on Twitter meant that I learned an important lesson in the malleability of one of the world’s most popular social platforms (business model much?) while ultimately becoming the thing I so disliked.

Do I feel better about the journalist buying fake followers knowing that I could so easily do the same? Not really. There is one thing I do take some comfort in, however, and that is the knowledge that one of my real followers deemed me worthy of a little time and a few dollars.

Ultimately, only your real followers would be willing to buy you fake ones.

(Please don’t buy me any more fake followers though. Seriously).

An experiment

An experiment

I said earlier that I have a theory that you can replace the term “distributed ledgers” with “shared Excel sheets” in about 90 percent of talk about blockchain and finance. I wasn’t joking.

“A shared Excel spreadsheet is a record of transactions or other data which exists across multiple distinct entities in a network. The spreadsheet can be wholly replicated across participants, or segments can be partially replicated across a subset of participants. In either case, the integrity of the data is ensured in order to allow each entity to rely on its veracity and to know that data they are entitled to view is consistent with that viewed by others entitled to view the same data. This makes the shared Excel spreadsheet a common, authoritative prime record — a single source of truth — to which multiple entities can refer and with which they can securely interact.”

That’s from a certain blockchain paper. You could tweak the language to make it a little more accurate – “password-protected Excel spreadsheets whose earlier entries cannot be edited” or some such, but the point stands. The reason it stands is because it highlights a major issue with blockchain technologies when it comes to finance — what problem are you trying to solve here?

Centralized databases have existed for decades. Blockchain might be modestly more efficient, but the notion that it’s completely immutable and can never be abused seems open to questioning.

Here’s Christopher Natoli and Vincent Gramoli as written up by The Register:

“The problem: if everyone in a consortium trusts each other, they don’t need blockchains to protect themselves; if they don’t, current blockchain protocols have a flaw that allows a bad actor to game the system.”