Analysis: Out of control? Volatility ETN triggers risk concerns

NEW YORK Thu Feb 23, 2012 6:03pm EST

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NEW YORK (Reuters) - A surge in trading in a product used to make outsized bets on rising volatility has become the latest example of how exchange-traded securities are gaining a bigger grip on the U.S. stock market, in a growing headache for regulators.

Volume in a leveraged exchange-traded note that tracks futures contracts in the market's favored anxiety index, the VIX, soared in the last two weeks, as investors bet the recent calm in markets would not last.

It forced Credit Suisse, which offers the VelocityShares Daily 2x VIX Short-Term exchange-traded note, to stop issuing shares out of concerns that demand for the security would start to have an undue influence on the price of VIX futures, rather than tracking that market.

Investors have an increasing hunger for niche exchange-traded products that at times come to dominate trading in parts of the market.

It further highlights the dangers of ever-more complex leveraged exchange-traded instruments, which are currently the subject of U.S. Securities and Exchange Commission scrutiny, and suggests potential risks may not yet be fully understood.

Daily volume in TVIX over the past 10 trading sessions rose to 27.1 million shares on the expectation of rising volatility. Prior to January, the TVIX had never traded more than 10 million shares in one session.

"This is a dream product for speculative traders... especially if you are a short-term trader," said Dave Nadig, director of research at Index Universe LLC in San Francisco.

The action has taken place as the S&P 500 index has rallied to a 10-month high and the CBOE Volatility index VIX, the market's favored index of anxiety, has dropped 22 percent this year. The VIX tends to decline when stocks rise and jump when markets plunge.

Among the events that could derail the current U.S. stock market rally would be a further meltdown in the euro zone, an Israeli strike on Iran's nuclear facilities, or a sudden worsening in the Chinese economy.

Credit Suisse said Tuesday it will stop issuing new notes for the ETN, whose daily return is meant to be double the S&P 500 VIX Short-Term Futures index. The product is not designed for long-term investment.

The concern among investors is that this product and other volatility products could come to dominate a relatively small market such as the VIX futures market. That market is growing, but activity there pales in comparison to the S&P 500 stock futures or other markets, such as U.S. Treasury bond futures.

This problem has arisen in the past in other markets. In 2009, the U.S. Natural Gas Fund stopped issuing new shares out of concern that the ETF would influence the price of natural gas. Investors in gold and other metals have at times claimed that exchange-traded funds that buy those commodities are distorting the price of the underlying asset.

Credit Suisse cited "internal limits on the size of the ETN" as the reason for the halt. The firm would not say how long the suspension would continue. With supply limited and demand soaring, premiums on the product were rising.

"The potential issue is whether this is a symptom of the volatility-based exchange-traded products starting to outgrow the size of the VIX futures market," said Bill Luby, a private investor in San Francisco who writes the VIX and More blog.

Credit Suisse would not comment on whether the firm was concerned about its own exposure. With volume and demand soaring, the firm was in danger of taking up a big part of the VIX futures market - which only traded 811,000 contracts in January - just to meet the demands for the ETN. Some experts said that may have created anxiety about risks at the bank.

"The ETN has gotten far larger than expected, and since this is a day-trading product and not a buy-and-hold type, there is too much risk on (Credit Suisse's) hands. It has grown too much for the firm," said Nadig of Index Universe.

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Investors bet falling volatility won't last: link.reuters.com/tym76s

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Signs that this product could be influencing VIX futures can be seen in trading on February 10, 13, and 14. On those days, the stock market was relatively quiet, with the S&P 500 moving by no more than 0.7 percent in either direction.

But volume in VIX futures spiked to more than 100,000 contracts each day, according to CBOE data, the most since the August 2011 week when the United States had its credit rating downgraded from triple-A.

"These products are supposed to give exposure to VIX futures and with their rapid growth we think these products actually have an effect on the pricing of VIX futures. It's a bit of the tail wagging the dog scenario," said Phil Rapoport, a strategist at Macro Risk Advisors, an advisory and trading firm specializing in equity derivatives.

Trading volume in the TVIX peaked at 42.3 million shares on February 15 but has dipped a bit in the last few days, particularly after Credit Suisse suspended new share issuance.

Credit Suisse increased the share count several times in 2012. According to VelocityShares, which created the product, there are now about 40 million shares outstanding, making the ETN worth about $650 million.

Action in other volatility-linked products is rising too. ProShares Ultra Short-Term Futures VIX exchange-traded fund, another leveraged product, traded more than 5 million shares on Thursday, compared with a 50-day average of 700,000 shares.

Unlike exchange-traded funds, exchange-traded notes are not portfolios, but rather are debt obligations that are tied to the performance of a market index.

The SEC has been conducting a broad review of exchange-traded products, looking at transparency and liquidity levels to whether ETFs and ETNs may at times fuel market volatility.

Reuters reported on Wednesday that the inquiry has been widened to take a closer look at a possible connection between high-frequency traders and hedge funds jumping in and out of the instruments and instances where they fail to settle on time, according to a person familiar with the matter.

(Reporting By Angela Moon, Jessica Toonkel in New York and Doris Frankel in Chicago; Editing by David Gaffen, Martin Howell)

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