Volatility Explodes in February Challenging Short Volatility Funds

The volatility genie has now been released and is unlikely to go back in the bottle as late cycle fiscal expansion in the US combined with higher global funding rates from the US Federal Reserve will have markets on their toes going forward.

The liquidation of the short volatility fund XIV (Velocity Shares Daily Inverse VIX) in February is a classic market moment and could well be the Bear Sterns peek behind the curtain before a larger Lehman crescendo. The now liquidated XIV product did exactly what it was designed to do, making a small amount of money each day being short volatility until in one single day everything was lost. Any ETF owners of riskt assets (particularly credit ETFs) should be wriggling in their chairs right now, for the XIV was a complete victim of its own success. Having a public mandate to be one way only in a risky market combined with very large amounts of money makes a product highly vulnerable to adverse market movements. The volatility community knew full well the thresholds required to trigger a XIV liquidation, and surely helped themselves to a grand feast pushing volatility higher and higher until the XIV fund was forced to enter the market and cover risk at one off spike high prices, thereby guaranteeing its own death spiral.