Over the past month the VIX (CBOE SPX Volatility Index) has had a rollercoaster ride, hitting its year-to-date low of 9.36 on July 21st and in less than three weeks hitting its year-to-date high of 16.04. Since then, VIX traders have had to keep their seatbelts tight with the VIX dropping 24%, to 12.21, in less than a week.
There are 19 active VIX based ETN’s, only two of which have AUMs over $1 billion, the iPath S&P 500 VIX Short-Term Futures ETN (VXX US) and the VelocityShares Daily Inverse VIX Short-Term ETN (XIV US) and only three VIX based ETN’s with short interest over $900 million, the VXX, XIV and the ProShares Short VIX Short-Term Futures ETN (SVXY US). In addition to these three large VIX ETN shorts, there are only five more ETN’s that have any significant short interest.
Over the past week, VIX ETN short sellers have moved in tandem, buying to cover their short inverse VIX positions and shorting more of the long VIX positions. In aggregate, short VIX ETN holders made their VIX exposure $393 million more bearish – they are looking for the VIX index to continue declining from its recent year-to-date high and settle back nearer its 10.79 July/August average.
Short sellers in the inverse VIX ETNs have outperformed their long VIX ETNs shorts. Inverse VIX ETN short sellers have made $314 million in mark to market year-to-date profits while long VIX ETN short sellers are down $90 million year-to-date.
The VIX ETNs are one of the few securities that at times have short interest which are larger than their AUMs. This happens primarily in ETNs and not ETFs because it is difficult for asset managers or brokers to create ETN shares on demand because their underlying assets are illiquid or expensive bilateral swaps or futures contracts, and not plain vanilla equities.
In order to satisfy stock borrow demand, an ETNs borrow supply initially comes from long asset managers in stock lending programs, or retail holdings in margin accounts. The secondary flow of stock borrow supply primarily comes from prime brokers rehypothecating shares that are in hedge funds’ or long asset managers’ margin/leveraged accounts.
The process starts with a trader getting a short locate from his broker to short an ETN. By settlement date the broker borrows the ETN from a lender to satisfy his short sale delivery. If the buyer is in a prime broker/broker margin/leveraged account then those settled shares can be rehypothecated and re-lent internally or to the street to cover another short. If the buyer on the other side of the “second” short sale is in a prime broker/broker margin/leveraged account then his settled long shares can also be rehypothecated and the process begins again. A single ETN, or equity, can be re-lent multiple times to cover multiple short sales, thereby creating multiple new “long” positions. If this happens often enough short interest can eventually become larger than a company’s float.
The initial and subsequent two short sales and their supporting stock borrows have effectively created three new long securities.
In 2007, Overstock.com’s (OSTK US) CEO Peter Byrne filed a $3.5 billion lawsuit against ten prime brokers claiming “stock market manipulation” when OSTK’s short interest exceeded its float. The suit ultimately failed when Byrne could not prove “naked shorting” or any violation of SEC Regulation SHO securities law. The process of brokers rehypothecating shares in margin/leveraged accounts and lending them to cover internal or street short sales remains a legal and acceptable activity.
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Head of Research, S3 Partners
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