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Wall Street's effort to turn 'volatility' into an asset class is partly to blame for this market chaos

Is volatility an asset class? You've heard people argue that it should be. I've heard people argue that owning some product that tracks market volatility — like a VIX exchange-traded note — have a place in your investment portfolio.

I've also heard people argue that bitcoin has a place in your investment portfolio.

Given what is happening in the last few days, let's hope not a lot of people are paying too much attention.

Traders reaching for protection against volatility was a major reason the markets moved so dramatically Monday and Tuesday.

We saw a volatility product blow up Monday night. The VelocityShares Daily Inverse VIX Short-Term ETNs was an inverse bet on volatility, in this case, a basket of volatility futures. If volatility went down, you made money. If volatility was down 5 percent, you were up 5 percent on a daily basis. But if volatility went up 5 percent, you went down 5 percent.

The problem is this: What happens if volatility goes up 115 percent as it did yesterday? You can lose everything.

And that's what happened. The firm backing this product, Credit Suisse, simply decided to close the fund.

There are some interesting repercussions. Look at the trade in CBOE, which is down 11 percent Tuesday. The exchange gets about 25 percent of its revenues from VIX options and futures, according to KBW. The biggest users are volatility ETFs and ETNs that use the VIX to hedge positions.

It's trading down, traders tell me, because there are concerns some VIX products could be banned or greatly curtailed by regulators. CBOE had no comment on the drop (The exchange's earnings are out on Friday).

It's not an unreasonable concern.

VIX products have been growing for years. There are ways to trade volatility on stocks, on gold, or on oil.

For all the reasons the options market is dangerous, the same can be said of volatility products, which can change very quickly. Should professional traders who want to trade these products be able to use them? Sure.

That's not the issue. The issue is, do these products represent some kind of systemic risk? You can argue that the money is small — a few hundred million dollars — and that doesn't sound like much.

But if there is one thing we have learned, it is that small effects can sometimes have larger repercussions.

And don't kid yourself: The blow-up of the XIV is going to have repercussions.

I don't care how long the prospectus was, or how many risks it covered, or how much Credit Suisse warned everyone, I wouldn't be surprised if there were lawsuits.

And you can bet that regulators are sitting up and paying attention.

The SEC and the CFTC has repeatedly warned about leveraged and inverse products, many of which are Exchange Traded Notes, which are not backed by any product but instead are backed by the assets of the company issuing the note (in the case of XIV it is Credit Suisse).

Here is a 2015 memo from the SEC to investors warning about the many risks of investing in these products.

The ETF community is also concerned. It's not an accident that the biggest ETF provider — BlackRock — tried to get out ahead of this last night with this statement: "Inverse and leveraged Exchange-Traded Products are not ETFs, and they don't perform like ETFs under stress. That's why iShares does not offer them. BlackRock strongly supports a regulatory classification system that would label levered and inverse ETPs differently than plain-vanilla ETFs in order to clarify for both regulators and investors the risks associated with those products."

Why does BlackRock care about a product they don't offer? Because they are concerned these niche offerings will somehow "taint" the plain-vanilla ETF universe, which is doing swimmingly and bringing in oceans of money: $500 billion last year alone.

And no one wants to upset that gravy train.

Still, this niche business is relatively lucrative and is in no danger of folding up completely. The XIV's competitor, the ProShares Short VIX, announced that they remained in business and opened for trading in the late morning, down more than 80 percent. That's not a typo: down 80 percent.

Look, I get it if professional traders want to play volatility. But volatility as an asset class, like equities, bonds, commodities, or even currencies? It doesn't have a place in the capital structure. Call it a subset of equities trading, a variant on prices. That's fair. But an asset class?

Please.

  • Bob Pisani

    A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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