Barclay’s iPath S&P 500 VIX Short Term ETN (VXX) and iPath S&P 500 VIX Medium Term ETN (VXZ) are scheduled to mature after a volatile 10 year run with a final redemption date of January 30, 2019. ETN’s differ from ETFs as they are basically debt instruments with set maturity dates when the instrument expires and its “principal” or NAV is redistributed back to the long note holders versus an ETF which is a portfolio of assets with no defined maturity date.
Barclay’s has launched two replacement ETNs for investors to roll into, the VXXB and VXZB, which will have 30 year maturities. VXX and VXZ note owners can sell their positions ahead of their maturity date and simultaneously roll into replacement Exchange Traded VIX based Products (ETFs or ETNs) or wait till maturity, receive their predescribed cashflows and then buy replacement ETPs.
For long VXX and VXZ note holders the process is relatively secure and straightforward, but VXX and VXZ short sellers may be in for a more difficult time rolling their positions due to limitations in stock loan availability. The VXX ETF the largest of the 15 VIX based on both the long and short side, it makes up 34% of all long VIX ETP holdings and 71% of all short VIX ETP holdings. If all the VXX ETN longs and shorts roll into the VXXB ETN and VIXY ETF we would see an additional $570 million worth of long buying and $1.55 billion of short selling. Creating $570 million worth of new ETPs is not a problem, but creating enough stock borrow supply for an additional $1.55 billion of shorts will be.
First, we need to understand how the VXX ETF, or any security, has 40 million of shares shorted (stock loans) when VXX ETF shares outstanding is only 21 million shares. This occurs through the process of rehypothecation and stock lending\short selling. A long shareholder (A), who is in a stock lending program or is using margin, has their shares lent to a short seller (B) who uses them to settle a short sale in the market. If the buyer (C) of these shares is in a stock lending program or is using margin, these shares may be lent to a short seller (D) who will use them to settle a short sale in the market. And If the buyer (E) of these shares is in a stock lending program or is using margin, these shares may be lent to a short seller (F) who will use them to settle a short sale in the market. The buyer of that short sale (G) is not a lender and is in a non-margin account so no more stock loans are possible. The original long shareholder, through rehypothecation and stock lending\short selling, has turned into four long shareholders without shares outstanding increasing.
This buying – lending – selling – buying trade flow can go on for multiple iterations and create multiple long shares in excess of the underlying shares outstanding.
In the scenario above, one original long shareholder turned into four long shareholders due to rehypothecation and short selling. While the four long shareholders and three short sellers all incur the economic effect of stock price moves, only the long shareholder in possession of the “stock certificate” (Long G) and receives dividends from the underlying company. Dividends to Long A, C and E are paid by the short sellers who borrowed sock from them (Short B,D &F) as “manufactured dividends”.
It is obvious that the process of rehypothecating and lending shares to supply enough stock loans to cover more shorts than shares outstanding is a cumbersome and time consuming process, and if rehypothecation is not possible, then VXX shorts will not find enough supply to roll into VXXB and VIXY positions.
While longs can wait to roll their positions, VXX shorts should begin rolling into VXXB and VIXY as early as possible because stock borrow rates will probably increase as borrow supply diminishes, but most importantly, the roll may turn into a game of musical chairs with the last players standing losing their short VIX exposure altogether.
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Managing Director Predictive Analytics, S3 Partners, LLC
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