After the market storm, Wall Street's left picking over the role of volatility trades
Markets calmed yesterday, after a three-day storm that wiped out trillions of euro.
In its wake banks, regulators and investors are assessing how obscure investments linked to trading volatility contributed to the crash.
It was the hot trade on Wall Street, a seemingly sure thing that lulled everyone from hedge fund managers to small-time investors.
Now newfangled investments linked to volatility in the stock market - until a few years ago, obscure niche products - have exploded in spectacular fashion. The shock waves have only just begun.
How these investments proliferated is a classic story of Wall Street salesmanship and old-fashioned greed. In a few short years, financial engineering transformed expectations about the ups and downs of the stock market into an asset class that could be marketed and sold - as tradable as stocks but, it turns out, sometimes far riskier.
Call it the volatility-financial complex. All told, financial players have created more than $8b of products tied to one index alone. In a low-interest-rate world, investors desperate for returns snapped them up, and bankers collected fees along the way.
But, as with mortgage investments a decade ago, complacency - in this case, over a history-defying period of market calm - masked potential dangers.
No one is saying the wild swings of late presage a broad collapse like the one that hit in 2008. But the fallout nonetheless provides a glimpse into the myriad products, and growing complexity, driving global markets a decade after the last debacle.
The risks, in hindsight, were clear enough even before the Dow Jones industrial average plummeted nearly 1,600 points on Monday, snapped back, and then took a wild bungee jump of nearly 1,200 points on Tuesday.
The chief executive officer of Barclays Plc, which pioneered notes linked to US market volatility, warned only last month that investors might be losing their heads.
"If this thing turns, hold on to your hat," Jes Staley told a panel at the World Economic Forum in Davos, Switzerland.
Now, hats have been blown off by a whirlwind the likes of which Wall Street has never seen. To some, the volatility complex feels like a monster that's been lurking in the shadows.
Even one of the inventors of the VIX, Devesh Shah, is perplexed why these products exist in the first place.
"Everybody knew that this was a huge problem," said Shah, who was in his 20s when he helped create what's become the market's fear barometer. "Everybody knows that Inverse VIX is going to go to zero at some point, and all these inverse and leveraged products, not just in the VIX but elsewhere too, at the end of the day cost people a lot of money."
There's also the sobering fact that neither market strategists nor money managers nor bankers who've structured these products are quite sure just how big and pervasive the market is.
"The volatility product industry has in many ways taken over the risk product industry in the equity business," said Michael Schmanske, founder at Glenshaw Capital Management, who helped oversee the launch of some of the first exchange traded products linked to the VIX, the volatility index at the centre of many of these investments. "Volatility has absolutely and positively become an asset class in its own right."
It's too soon to know the extent of this week's damage. Losses will likely come down to how Wall Street managed its exposure to the products, which it typically hedge in the futures market. (Bloomberg)