Stuart Barton, PhD, CFA I March 6, 2019
Volatility Exchange Traded Products (ETPs) have undergone a lot of changes in the last year or so. Following the after-hours spike in the VIX Index on February 5, 2018, four VIX products have been liquidated and two deleveraged. Credit Suisse liquidated XIV, Nomura terminated 2049:JP, REX Shares shuttered both their offerings VMAX and VMIN; and ProShares deleveraged both SVXY and UVXY. While you may not have ever heard of some of these products, XIV and SVXY had been two of the most popular and liquid VIX linked ETPs in existence. But liquidation and deleveraging were not the only changes to the volatility trading landscape last year.
FINRA Warns Broker/Dealers
Back in October 2017 the Financial Industry Regulatory Authority (FINRA) wrote to brokers and advisors reminding them of their 'sales practice obligations' when dealing with volatility-linked ETPs. In retrospect their reminder came at a good time, during a period of rapid growth in VIX ETP interest, and only four months before the implosion of the popular inverse VIX ETPs. Originally designed for sophisticated and institutional clients only, FINRA had noted that many VIX ETPs were being traded by far less sophisticated clients who they believed may not have fully understood their complexity.
FINRA's warning to the regulated community seemed clear: all recommendations to customers must be based on a full understanding of the terms, features, and risks of the products being recommended. But the problem with VIX ETPs is that very few brokers, dealers, or even advisors seemed to appreciate just how complex these products are, and this may explain why many brokers failed to react sooner. February 5, 2018 was a wakeup call for many.
I started my career as a derivatives trader with Barclays and contributed to the creation and popularity of numerous volatility linked products, including VIX futures and ETPs like the VXX (now VXXB). In 2017 I took to helping investors better understand these products and have written extensively on VIX products.
So are FINRA's warnings finally being heeded, and did February 5, 2018 convince people that products linked to VIX futures are more complicated and potentially more risky than they thought? Well, I think the outcome has been mixed. Some more conservative brokers have begun placing restrictions on VIX ETPs, and some retail investors have given up trading them altogether. But the market can have a short memory, and the interest in the popular short volatility trade using VIX ETPs is growing again, albeit under a few new caveats and restrictions.
First of all, some products no longer exist. XIV for example was retired on February 21, 2018 after Credit Suisse's CEO announced he believed it had very little chance of recovery. And other issuers have watered down their products by deleveraging them. ProShares for example reduced the leverage on their daily inverse ETF (SVXY) from -1x to -0.5x, and their leveraged long volatility product (UVXY) from +2x to just +1.5x.
Brokers Restrict VIX ETP Access
Added to this, some brokers have removed VIX ETPs from their platforms altogether. Merrill Edge, for example, has restricted trading in VIX ETPs, and after the events of Feb. 5, 2018 Fidelity temporarily restricted retail clients from opening new positions in the products - although continued to allow advisors to trade on behalf of their clients. On January 22, 2019 - Vanguard added itself to that list by announcing it would no longer accept orders to buy leveraged, inverse, and commodity ETPs, effectively eliminating VIX products from its platform altogether.
It is not clear whether these three more conservative brokers made these restrictions because of FINRA's warning, or because of the events of Feb. 5th - or indeed as the result of both - but it does show a trend towards increasing restrictions on VIX ETPs. FINRA's oversight and audit of brokers trading in VIX products has also risen since Feb. 5th, with FINRA issuing a Targeted Examination Letter on VIX-Linked Products in April last year. Like in their October 2017 note, they explained that their focus going forward would be on identifying and mitigating risk associated with sales to non-institutional purchasers of VIX-linked products.
But a broker’s ability to demonstrate their client’s 'full understanding of the terms, features and risks of the products' has proved to be a far from trivial matter and many are still considering their responsibilities under FINRA's guidance. The slew of legal complaints against ETP issuers and brokers following Feb. 5th will no doubt speed this process along, and may result in further brokers restricting access to VIX products, or limiting access to specialist advisors only.
But liquidation, deleveraging, and broker restrictions are not the only new complications to trading VIX ETPs. Many investors have in the past traded VIX ETPs in their IRA accounts, but some brokers are now restricting some of these products from retirement accounts altogether. Interactive Brokers (IB) for example has removed all ETPs set up as partnerships under the Securities Act of 1933, effectively removing the popular ProShares products from their IRA offerings. IB claim this is the result of client’s concerns about receiving K-1 tax forms, but looking deeper it appears to be part of a confusion between funds set up as ‘33 Act partnerships and the similarly structured Master Limited Partnership (MLP) products. Either way, the otherwise highly inclusive Interactive Brokers are seemingly shying away from the underlying complexity of VIX ETPs and others will no doubt follow.
Another new restriction is around portfolio margining. Under FINRA Rule 4210(g), ETNs are considered debt instruments and are usually not eligible for portfolio margining. One of the most popular VIX ETNs - the VXX (now VXXB) - falls into this group. There are some exceptions to this rule however, older ETNs that predate the implementation of the rule - like VIIX and ZIV - have been allowed to remain in the Options Clearing Corporation’s (OCC) portfolio margining program through a 'grandfathering in' agreement. While this may not restrict investors from products like VXXB altogether, the more capital efficient nature of VIIX over VXXB will no doubt shift interest for better informed and more sophisticated traders.
-1x Access Disabled
The retirement of XIV and the deleveraging of SVXY also brought about a further access problem - the disappearance of all -1x VIX ETPs. This has forced those looking to enter the previously available short vol trade to now borrow stock and take short positions in the long ETPs like VXXB and VIIX. While this strategy does restore access to a -1x type return, it does come with its own complications, including holding short positions, the cost of stock borrow, and the unlimited potential loss it places the seller under. While such strategies are obviously not advisable for risk adverse investors, options could always be used to cap losses, and, by finding cheap borrow, a short strategy may come to replace direct investments in SVXY. Credit Suisse has seemingly recognized this and ensured that the borrow cost on VIIX are kept lower than VXXB. This together with the its inclusion in OCC's portfolio margining program will make it a potential better choice for many investors.
Europe Restricts Access
A final restriction is related to the availability of VIX ETPs in Europe. On January 1, 2018 the European Commission adopted rules requiring Packaged Retail and Insurance-based investment products (PRIIPs) to supply a Key Information Document (KID) to investors before selling products in Europe. Each products’ KID needs to be three pages or less and clearly explain all the features and risks associated with the products. Because of the complexity of VIX ETPs, US issuers have decided that three pages is just not enough to explain their features, and none have been filed. While access in Europe doesn’t affect US investors directly, this further restriction will reduce liquidity in the products more generally.
So where does it all go from here? Well, it would seem there is a growing consensus about the complexity of VIX investment products and the regulators message is already starting to impact the design and availability of some products. Fidelity's move last year to restrict some VIX products from self directed trading but to continue to allow access through advisors shows their interpretation of the products as being useful in the right hands. FINRA's guidance that brokers ensure clients fully understand the terms, features, and risks of the products does the same, but puts the brokers under an obligation that it’s seemingly becoming less comfortable with. Merrill and Vanguard’s complete exclusion of the products from self directed trading is early evidence of this.
There is little doubt these products are complex. Very few for example understand the dynamics created by the daily rebalance of inverse and leveraged products, or the implications of the VIX futures being the only CFTC regulated futures listed on an intangible underlying - do the VIX futures track the uninvestable Index for example, or is it the other way around? I could go on.
It is unlikely that the popularity of these products will wane, despite regulatory pressure restricting access. It is more likely however that in time access will have to be gained through specialist advisors that can ensure investors understand the products before they invest. These advisors will add value through properly educating clients before investing, and through the risk management techniques they implement. This I think is FINRA's objective - not to restrict access to a potentially unique source of risk premium - but to ensure investors understand what they are investing in and appreciate the risks associated with them.
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