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Could Financial Engineering Crash The Market?

A decade ago, outside of investment banks, almost no one knew of derivatives.

Few people had heard of collateralised debt obligations (CDOs) or credit default swaps (CDSs).

It was only when the financial crisis nearly crippled global markets that these terms gained wider notoriety.

Banks used CDOs to make money from loans on their books, and CDSs to provide insurance from defaulting on debt.

At the time, Wall Street bankers must have congratulated themselves for finding a way to profit no matter what the markets did. Of course, history — and one giant bailout from the US Federal Reserve Bank — proves them wrong.

Thanks to the dummy spit the US market threw earlier this week, we got a glimpse at just how far Wall Street will go to make a buck — mostly at your expense, of course.

Not happy with giving the world layer after layer of debt, the masters of the banking industry found yet another way to make money.

Much like CDOs or CDSs, few people had heard of the Cboe Volatility Index, or VIX, prior to 2007. The VIX is also known as the ‘fear gauge’.

The VIX was set up to track the volatility of the stock market. The higher the reading, the more volatile the stock market. It’s supposed to be a forward indicator. A predictor of future market behaviour.

The value of the VIX comes from the price of options on the S&P 500. The formula then estimates how volatile the options will be based on the current data and the options expiry date.

During the financial crisis, the VIX shot up to a never-before-seen reading of 80.

Cboe Volatility Index 10-year chart

Cboe Volatility Index 10-year chart | 09-02-2018

Source: Cboe
[Click to enlarge]

On Monday and Tuesday this week, the VIX climbed from 17 to 50, before quickly crashing back down to 27.

The VIX is doing what it was designed to do. It’s measuring the ‘feel’ of the stock market.

Yet, as far as Wall Street goes, the problem isn’t so much the VIX itself. The problem is that you can’t trade the VIX.

And if you can’t trade it, you can’t make money from it.

Anything to make buck from you

To ‘fix’ this, Wall Street created something called the ‘inverse VIX’.

This way, using an inverse VIX, people would be able to trade the fear in the market. In order for it to be tradable, investment firms turned it into what’s called an Exchange Traded Product (ETP) before selling it to clients.

One of the more popular ones is the VelocityShares Daily Inverse VIX Short Term ETN [NASDAQ:XIV]. Notice the ticker? ‘XIV’.

The idea is simple: If the VIX falls, then any connected inverse VIX would rise in value.

In other words, as the fear in the market falls away, the inverse VIX would rise, giving holders a profit.

These financial engineering geniuses worked out how they could get investors to bet on how the market feels.

With this new product up and running, it was sold to investors as a way to ‘diversify’ their portfolio. Rather than clients having a boring ‘60/40’ mix of stocks and bonds, investment firms could recommend people ‘spread the risk’ by putting money into an inverse VIX.

In a bull market, this is great. The US market is trading at new highs each month. And volatility has fallen consistently for two years. In all that stock market sunshine, investors were more than happy to buy into the idea of an inverse VIX.

Yet the VIX has been consistently low for two years. That’s sent out the message to investors that the volatility was low. Meaning that markets are calm, and that risk is minimal.

The lower the apparent risk, the more that people wanted in. And it began looking like a no-lose offer for investors, encouraging even more people in.

Yet with the US market undergoing turmoil this week, the VIX has spiked again, and almost every major inverse VIX created has come crashing down in value.

Now, inverse VIXs aren’t new products. However, Bloomberg reports that the volatility investment complex — which didn’t exist in 2008 — may be worth as much as US$1.5 trillion.

Even in a raging bull market, one where the broader US market is up 50% in two years, investors are still encouraged into synthetic products in the name of bigger returns. A product that was supposed to smooth out and reduce risk in a client’s portfolio may have just shown itself to be a bigger problem than we realise.

And this is all because investment banks will do anything they can to make money. Financial engineering isn’t about helping people invest. It’s a desperate bid to make big banks richer. But they whack on labels like ‘spreading the risk’ and ‘diversifying’ and sell it off to unsuspecting investors.

I highly doubt this is what will be the undoing of the US market. Yet it’s another peek behind the curtain. A chance to observe the incredible money-making investment schemes Wall Street produce.

One thing you can be sure about, however, is that the financial engineering ingenuity of Wall Street has no limit. Not when it comes to making a buck from you.

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The Daily Reckoning's mission is to look at the investment world and the financial world in a sceptical and contrarian way. To do that day in and day out and tell you honestly what we see, even if it isn't always popular. If you'd like to subscribe to an alternative look at the mainstream interpretation of events, join for free here.



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