Obscure security linked to stock volatility plummets 80% after hours, sparking worries of bigger market effect

Volatility ETN crashes
Volatility ETN crashes

An exchange-traded security which is supposed to be a bet on calm markets was collapsing after hours.

The VelocityShares Daily Inverse VIX Short-Term exchange-traded note (XIV) is down more than 80 percent in extended trading Monday. The security, issued by Credit Suisse, is supposed to give the opposite return of the Cboe Volatility index (VIX), the market's widely followed turbulence gauge.

The VIX doubled during regular market hours Monday, causing obvious havoc for a product seeking to track its inverse return. Though, the XIV dropped just 14 percent during regular trading.

But then after hours trading began and the security, popular with hedge funds betting on an ever-placid market, was off by 80 percent in extended trading.

The move after hours sparked fear among traders that violent declines in exchange-traded notes like this one would cause market volatility measures to spike further and weigh on the broader market.

"After-hours, the VIX reached 38 and futures more than doubled—it is not clear at this point how this will reflect on various short volatility products (e.g., some volatility ETPs traded down over 50% after hours)," wrote Marko Kolanovic, J.P. Morgan's quantitative and derivative strategist, in a note to clients late Monday.

The drop also raised fears of big losses from hedge funds and other investors unfortunate enough to be holding this security and unable to unwind it after hours.

Larry McDonald, founder of the Bear Traps Report, warned that such a huge spike in volatility could have a cascading effect.

"Positioning in all sorts of VIX ETFs has increased 5-fold in recent years," McDonald said in an email. "Even a spike in volatility similar to August 2015, would force VIX ETFs to buy an incredulous $37 billion exposure in short-term VIX futures. Such a spike can even get more exacerbated in case liquidity dries up as the market realizes certain structures need to rush in and cover their shorts at whatever the cost."

McDonald told CNBC that the August 2015 VIX move was roughly 45 percent, while today's move was double that.

The XIV was last seen at 20.88 in postmarket trading, down 80 percent from its close at 99.

Credit Suisse: No material impact

Credit Suisse said late Monday New York time that the XIV's plunge would have no "material impact" on the Swiss bank itself. Shares of Credit Suisse slumped nearly 4 percent on Tuesday morning amid the wider sell-off in equity markets.

"The XIV ETN activity is reflective of today's market volatility," the bank said. "There is no material impact to Credit Suisse."

VelocityShares declined to comment on Monday's move.

The fund's prospectus states:

"The ETNs, and in particular the 2x Long ETNs, are intended to be trading tools for sophisticated investors to manage daily trading risks...The ETNs are riskier than securities that have intermediate or long-term investment objectives, and may not be suitable for investors who plan to hold them for longer than one day."

It is hard to tell who is exactly holding this short-term oriented security at this time. Filings from back in September show Credit Suisse, Deutsche Asset Management, Citadel Advisors, Flow Traders, and Two Sigma as the top holders.

But those old filings should not be seen by investors as indicative of the hedge funds' current positions. The funds may not be holding the security at all today since they trade in an out of these vehicles frequently.

Some hedge funds were caught holding the bag on this security. What they do next (or are forced to do) could determine what happens with the volatility trade and the overall market.

"Today's large increase of market volatility will clearly contribute to further outflows from systematic strategies in the days ahead (volatility targeting, risk parity, CTAs, short volatility)," added Kolanovic. "The total amount of these outflows may add to roughly $100 billion, as things stand."