Credit Suisse defends controversial financial product at the center of the market turmoil

Key Points
  • Credit Suisse is defending a controversial financial product it issued that played a role in staggering market losses, as experts question the logic behind such complex securities.
  • The bank said it is experiencing no losses from its financial instrument, as investors holding it bear the brunt of the fallout.
  • Credit Suisse says the XIV was by no means designed to produce long-term gains.
Credit Suisse's Chief Executive Officer Tidjane Thiam.
Fabrice Coffrini | AFP | Getty Images

Credit Suisse is defending a controversial financial product it issued that played a role in staggering market losses this week, as experts question the logic behind such complex securities.

The Switzerland-based bank said it is experiencing no losses from its financial instrument — known as the VelocityShares Daily Inverse VIX Short-Term exchange-traded note (ETN), or XIV for short. Instead, it appears the fallout will be squarely borne by investors holding the product.

On Monday, as markets sold off and the Dow Jones industrial average plunged nearly 1,600 points in its biggest drop ever, many analysts pointed to the XIV as having amplified selling. This is because the product, managed by Credit Suisse and of which it owns 32 percent, shorts volatility by betting on calm market conditions. It has increased in popularity in the past year as volatility in the Cboe Volatility Index (VIX) — a fear gauge for the stock market — reached historic lows.

Because the XIV was designed to produce opposite returns of the VIX, when the volatility index shot through the roof Monday — a record 118 percent — the XIV went through the floor, down a devastating 90 percent. The ensuing negative feedback loop of selling is believed to have seriously exacerbated Monday's market turmoil.

Reuters reported that the notes "were worth a combined $1.6 billion on Friday. ... But ended Tuesday at a more-than-92 percent discount to their closing value the prior day."

'No material impact'

On Tuesday, Credit Suisse announced that the ETN shares, which hurt many of its holders, would stop trading and the fund would close.

Yet the Swiss lender on Tuesday said it faced "no material impact" from the XIV's overnight plunge. It was investors who suffered the heavy losses if they had failed to hedge their positions.

The head of the European financial institutions group at Goldman Sachs, Jernej Omahen, said in a client note Wednesday: "All in, whilst the spike in volatility has reduced the value of 'XIV' by >80 percent, we do not see Credit Suisse's equity as having been impacted by this."

Rather, he said, "the holders of XIV are likely to bear the performance loss of the instrument ... Distribution of those is unclear at this time, though we see investment banks as comparatively less impacted."

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Credit Suisse hedged its own risk through its portfolio, bank spokesperson Nicole Sharp said via email. "We are the issuer of the ETN and, having issued it, we hedge the risk. We hedge XIV by trading VIX futures. ... The positions constitute part of a portfolio."

'The long-term expected value is zero'

A closer look at the XIV shows that it was by no means designed to produce long-term gains.

Bill Blain, a senior fixed income broker at Mint Partners, said the main issue with the ETN was "understanding the exact basis on which Credit Suisse has been selling these products."

And it turns out this understanding is absolutely crucial. The Credit Suisse XIV prospectus says on page 197: "The long term expected value of your ETNs is zero. If you hold your ETNs as a long-term investment, it is likely you will lose all or a substantial portion of your investment."

Blain said that if that has been "properly made clear to investors" then legally the bank will be covered. "However, it's not yet clear these products were marketed with that page 197 disclosure concisely explained," he added.

In response, Credit Suisse spokesperson told CNBC that the bank "clearly stated in the prospectus that this was meant for short-term holding" and that it was marketed exclusively to professional investors.

"It very clearly says this is not a security that you buy and hold. It is designed to be used on a daily basis," the spokesperson said.

A call for regulation

Unsurprisingly, the XIV fallout has garnered some critics.

BlackRock, the world's largest asset manager, issued a statement Tuesday saying: "BlackRock strongly supports a regulatory classification system that would label levered and inverse ETPs (exchange-traded products) differently than plain-vanilla ETFs (exchange-traded funds) in order to clarify for both regulators and investors the risks associated with those products."

"They lack essential elements of valuation clarity and access, and often are not backed by a portfolio of transparent assets," the fund said. "This is why BlackRock does not offer them."

Credit Suisse declined to comment on the statement from BlackRock.

Many market watchers have held for some time that the XIV was an "accident waiting to happen, serving no economic purpose," said Paul Gambles, co-founder of financial advisory firm MBMG Group. He added that this product is just "the highest profile and latest in a long list of devil's derivatives."

"Stamping a boilerplate warning that nobody reads or understands doesn't amount to disclosure," Gambles said. "You have to ask why regulators allow this to continue."

The prospectus from Credit Suisse states these products are intended as trading tools for sophisticated investors to manage daily trading risks and should be purchased only by "knowledgeable investors who understand the potential consequences" of investing in volatility indexes.

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Meanwhile, Brian Jacobsen, chief portfolio strategist at Wells Fargo Fund Management, believes the bank has not acted dubiously.

"I'm not surprised and it is very common," he said. "Credit Suisse is a bank. It's very common to hedge seed capital so the bank's health is not at risk."

Tom Hearden, a manager and senior trader at Skylands Capital, told CNBC he felt most investors were aware of the risks involved.

"I think there is an important distinction between being risky (and not having the risks fully understood) and being unfair or illegitimate," Hearden said. "The products in question are a derivative of a derivative of a derivative. It appears most did fully understand or vet what they owned."

"There was a prospectus, but I am sure it has risk and product details that were not understood," he added.

Rodney Hobson, financial columnist and author of "Shares Made Simple" was more critical, saying the basic flaw is that the product was designed to manufacture profits during stable markets.

"Markets over the years have become more volatile, thanks in large part to computer programs that spark panic sell-offs and equally sharp recoveries. Even when markets are going broadly sidewise they can swing up and down quite wildly before ending back where they started," he said.