Crack in the calm market of US stocks: VIX soared in one day, leveraged ETFs may become a new market risk.

The US stock market is currently not particularly turbulent, but it appears fragile. In the past two weeks, even though the S&P 500 index has been relatively stable, the volatility index has experienced violent increases and rapid falls. This has reignited discussions about market fragility - long periods of calm being suddenly interrupted by large fluctuations. The latest example occurred on October 16th. On that day, due to market concerns about regional bank loan losses, the S&P 500 index only fell by 0.6%, but the Cboe Global Markets Inc's volatility index (VIX) soared to a six-month high. According to analysis by UBS Group AG strategists, the increase in the VIX relative to the S&P 500 exceeded the volatility events of August 2024, the "Volmageddon" of February 2018, and the situation after the collapse of Lehman Brothers in 2008. By October 17th, the VIX quickly fell back to levels from days before - the levels seen before the market anxiety caused by US President Trump's threats to impose higher tariffs on China. UBS Group AG strategist Kieran Diamond and others pointed out that on October 16th, the market makers of S&P 500 index options became more "short" on volatility positions as the market fell, and when these positions were covered, it may have further amplified the surge in VIX. In addition, traders may have also held short positions on VIX call options, and the hedging of these positions also contributed to the increase in volatility. Strategists at Bank of America Corp stated in a report that the volatility on that day had more technical-driven characteristics. VIX-related exchange-traded products (ETPs) may not have played a major role, as investors took profits when VIX rose, while market makers covered their short positions. The strategists pointed out that in cases where VIX futures rose by 10 points the previous month, only about 17% of volatility long investors needed to sell positions to counteract traders' rebalancing behavior. This "sudden interruption of calm by volatility" pattern also highlights the market "tugging" phenomenon caused by the large growth of exchange-traded products. On one hand, there are funds that suppress volatility by selling options premiums; on the other hand, leveraged ETFs that track the returns of the S&P 500 index and the Nasdaq 100 index using swaps, or leveraged funds that hold a concentrated position in stocks with the most impact on the index. Garrett DeSimone, head of quantification at OptionMetrics, expressed concern about the surge in VIX on October 16th and the broader liquidity pressures associated with leveraged products, stating, "When I think about the violent swings in VIX and the broader liquidity pressures associated with leveraged products, what worries me the most is the potential risks of negative feedback loops triggered by 2x and 3x leveraged ETF rebalancing." Leveraged stock ETFs have become a hot topic of discussion, especially in stocks like NVIDIA Corporation (NVDA.US) and Tesla, Inc. (TSLA.US) which are popular among retail investors. The focus of the discussion is on the market impact of daily rebalancing trades of these funds, which typically occur around the market close, especially during periods of high volatility and low liquidity. According to Antoine Porcheret, head of structured products for Citi Group in the UK, Europe, the Middle East, and Africa, the nominal size of global leveraged ETFs is around $160 billion, with the top ten stocks accounting for about 65%. In cases of significant market fluctuations, the trading volume of certain individual stock funds can account for 100% to 200% of the "closing market price trading volume," which will obviously affect prices. He stated that banks face around $300 billion in stock risk exposure as the ultimate counterparties to these funds through swaps. However, this is not the only risk that banks face. They are also exposed to so-called "gap risk," which refers to potential losses that may occur when facilitating these trades. For example, if a company declares bankruptcy, its stock price theoretically could approach zero, resulting in a 2x leveraged ETF losing 100%. In such a scenario, the hedging positions held by banks would actually lose twice the amount. Banks typically hedge this gap risk by selling hybrid or standard derivative products to institutional clients. Unlike past crises, these risks do not necessarily linger on banks' balance sheets for an extended period, as was the case with large exposures from holding variance swaps and other derivatives during past crises. Today's risks resemble more of a "single-day fragility." In the current market structure, periods of long tranquility are often abruptly interrupted by flash crashes and rapid rebounds, potentially harming some participants. Garrett DeSimone stated, "I see several potential channels for contagion risk. Leveraged ETFs now manage massive assets, a significant portion of which are concentrated in the tech sector, which itself holds a considerable weight in the S&P 500 index."