The Dow closed about down 1800 points from its finish on Thursday. Global markets are in a tailspin. The Nikkei down about 1000. European markets are being hammered and the US futures markets are pointing towards further losses at the open as I write this.
What’s going on?
The short-short is that the global markets seem to be experiencing technical difficulties. A hedge fund of sorts – technically an ETN – referred to as XIV was created several years ago as a way for market participants to bet that the volatility of stocks would decline. The index of volatility is referred to as VIX. XIV then you see, is simply VIX spelled backward. This index, VIX, essentially measures how likely traders believe stock prices are to gyrate up or down.
Over the past year or two, its XIV been an exceptionally good performing ETF, delivering steady double-digit returns. Gyrations in the market have been few and far between. That all fell apart at the end of last week. Gyrations increased. The VIX rose and the XIV began to fall.
Making matters worse the collapse in XIV has lead traders to take various sorts of volatility. insurance contracts. Those contracts are in turn used to calculate the VIX itself. This creates a death spiral.
As, if that weren’t bad enough the VIX is an important constituent of many trading algorithms. As they see measured volatility spike, they retreat from “risky” positions like stocks into less risky positions like bonds.
This has caused both bond and interest rates to collapse. That itself inducing more selling and around and around we go. This means that the panic we see is likely to be short-lived, but it is an important reminder of how sensitive the financial system can become to very particular types of financial contracts, and why to operate it needs a strong regulatory and monetary authority like the Fed.