• Patrick Ling

Important Update on VXX

On 14th March 2022, Barclays announced that it had suspended any further sales and issuances of two ETNs one of which is the VXX, with immediate effect. You can refer to the link below for the announcement.


Barclays Suspends Until Further Notice Further Sales and Issuances of Two Series of iPath ETNs


This has a significant impact on VXX as it represents a sudden supply imbalance in the market. To understand why this is the case, let's look at how Barclays brought VXX to life.


iPath


iPath refers to a family of exchange-traded notes (ETN) issued by Barclays. iPath ETNs are senior, unsecured debt securities of Barclays Bank PLC. VXX is one such note issued by Barclays. This means that Barclays promise to deliver the returns of the note based on its stated goal, which is to track a constant 30-day VIX futures performance, in return for borrowing the proceeds from buyers of the note.


In order to hedge the risk of delivering the returns, Barclays then go to the futures market and buy a portfolio of front month and second month VIX futures in the right quantity that matches what it owes the buyers of the note. This is where the subtle difference between an ETN and ETF lies. An ETF behaves very much like a mutual fund whereby it owns the underlying assets and so doesn't bear the credit risk of the fund management company. However, ETNs doesn't own any underlying assets. It merely represents a promise by the issuer to pay which is as good as its credit. Hence, ETNs bear the credit risk of the issuer. In the event of a credit rating downgrade for the issuer, you can expect the value of the ETNs to be negatively impacted as well.


Anyway, back to Barclays. The ETNs issued by Barclays are treated by regulators as liabilities on their book which is correct since they represent debt securities. Hence, there is a limit to how much can be issued before Barclays hit the regulatory limit on their book. This is the likely reason why Barclays have to halt further issuances.


Normal Market Operations


Under normal conditions, the market price for VXX can deviate from its fair value in the secondary market based on its own demand supply dynamics. When VXX is trading below fair value, Barclays can buy VXX off the market and store in their own inventory, thereby driving VXX price up to fair value. Whenever VXX is trading above fair value, Barclays can either sell VXX off its inventory or create more units of VXX, thereby increasing supply and driving VXX back down to fair value. This operation is beneficial to Barclays as arbitrage profits can be made.


Issuance Is The Limiting Factor


As there is a limit to how much liabilities Barclays can chalk up on its book, in the extreme case whereby there is strong demand for VXX in the secondary market, issuance of new VXX units can become the limiting factor to maintaining the price of VXX close to fair value. When the issuance limit is reached, we effectively end up with a demand supply imbalance and VXX price will deviate sharply from fair value.


Short Squeeze


VXX is a popular instrument for market participants to short because it loses value over time.


VXX
VXX decay over time

As a result, when the announcement came out, panic gripped the short-sellers of VXX. They realized the supply imbalance and they scrambled to cover their shorts. Unfortunately, as what happens in a short squeeze, VXX shares were in short supply and they had to pay a huge premium to buy back VXX shares. At the same time, arbitrageurs who thought they can capitalise on the VXX premium by shorting VXX and buying VIX futures started piling in. However, the early ones also got caught when VXX continued to surge even higher and they too were forced to close their positions. This contributed further to the short squeeze.


It Happened Before


Although this event has created quite a fair bit of excitement especially for people who happened to be holding VXX, it is actually not new. In fact, a similar event happened back in 2012 to another volatility ETN. Back then, the ETN was TVIX and the issuer was Credit Suisse. We can look back at that event as a guide to what we can expect for the current situation with VXX.


On 22nd February 2012, Credit Suisse halted further creations on TVIX and this led to TVIX trading at a premium to fair value. At one stage, the premium was actually almost 100%. One month later on 20th March 2012, Credit Suisse announced resumption of the ETN creation and the premium disappeared over 2 days. Nothing illustrates better than this chart which I found from this website.


TVIX premium

What Can We Expect For VXX


If we project what happened to TVIX in 2012 to VXX today, we can expect VXX to continue to trade at a premium to fair value as long as the issuance halt is in place. This premium will go away in a jiffy the moment Barclays announce resumption of new issuance. The implication of this is that it is probably not a good idea to be holding on to VXX during this period as the risk of losing big from new issuance is significant.


But I Still Want To Be Long Volatility During This Period


A possible replacement for VXX to get long exposure to volatility during this period is the VIXY which is an ETF issued by ProShares. You can find out more about this ETF via the link below.

https://www.proshares.com/our-etfs/strategic/vixy


An advantage of VIXY is that it is an ETF and hence there is no credit risk associated with it. The downside is that it is not as liquid as VXX so it is a matter of choice.


In terms of performance, VXX and VIXY track each other well during normal times.


VXX and VIXY

You can hardly see two lines in the performance chart above which illustrates how closely VXX and VIXY move together. Hence, VIXY is a suitable replacement for VXX during this period.


 
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