XIV Post-Mortem: We Honor the Dead

I’m tempted to leave sorting through the short-vol/XIV wreckage to the rest of the financial blogosphere. I mean look, we’ve all been around the block--as Matt Levine at Bloomberg said, it isn’t that complicated, you bought a product that was short something, that something went up 100%. Your equity is wiped out. Thanks for playing, we have some lovely parting gifts for you.

This isn't shadenfreude.  I take no joy in the destruction. I simply find it amazing that someone with a ton of firepower figured out exactly how and when to crush the world’s most liquid market at just the right time, and in just the right way to trigger a massive vol puke. It was like a boxing match where there is little action for nine rounds, then one guy takes a punch, hesitates momentarily, and then gets clobbered by a vicious, match-ending combo.

Congratulations on your squeeze, whoever you are. It was a thing of beauty, and I’m sure there was champagne and steaks for all when the XIV-enemy was vanquished and victory was declared.  Just don't fool yourself into thinking you're creating any real value.

Meanwhile in risk-parity land, there were more than a few nervous managing directors as the financial media swarmed around the idea that robots triggered the meltdown. Just to be on the safe side, Bridgewater and AQR  put out a joint press release  were quoted in a WSJ article today in defense of risk-parity. “It is definitely not driving global asset prices. It just sits there like a turtle,” Bridgewater CIO Bob Prince said. “We have done pretty much no trading in risk parity” Cliff Asness of AQR said.

I’m sure that’s true, but it highlights how this was an orchestrated squeeze rather than a real crisis. Spoos may have taken a big dump, but market liquidity backstopped the selloff once strong hands figured out what was going on. So AQR and Bridgewater didn’t have to do anything--they just let their models keep doing their thing. They had little to fear from outflows or any type of financing squeeze for their leveraged positions. They won’t be so fortunate when this type of event happens in the midst of a real liquidity crisis that strangles financing capacity.

What happens next--there are a few points short term: The quant folks at JP Morgan think this shock to systematic trading/short vol “asset class” will generate as much as $100bn in outflows from these strategies. I don’t think that has a macro impact other than to leave less of an offer for vol when the market stress subsides. That means lower asset values and wider credit spreads at the margin, but not dramatically so. Second, I agree there is likely still a residual hedge to be unwound for whoever is wearing the position that Credit Suisse dumped on them when the market went berserk earlier this week. They will find a way to parcel it out over time--that’s what these guys do.

The mentality--or flows-- to make money from short gamma and/or tighter ranges within a rising, low-vol, risk-on market isn’t dead.   I continue to believe this event won’t permanently break the market, but I do believe it could be remembered as the event where we should all have known quant strats and yield-chasing have gone too far. It reminds me of mid-2007, when Northern Rock blew up.  I remember a prominent newsletter author saying at the time that the market had to give up a big whale….and Northern Rock was it. Well, the market had to give up a big whale alright, but it wasn’t Northern Rock.

XIV is far from a whale--heck, it isn’t even a Northern Rock. XIV is more like a small trout some big bank or hedge fund just pulled out of a river. This market isn’t out of kerosene quite yet.

Shawn
TeamMacroMan2@gmail.com
@EMInflationista