Retail traders are now jumping on the iPath Series B S&P 500 VIX Short-term Futures ETN (VXX) to create explosive upward momentum
The iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX), an exchange-traded note that aims to closely track the price of the CBOE or VIX volatility index, appears to be gearing up for an explosive rally, amplified by retail traders congregate on the popular Reddit forum, WallStreetBets.
Before discussing the factors behind the ongoing bullish impulse in VXX, let’s take a quick refresher course. Exchange Traded Notes or ETNs are complex financial instruments issued by a number of megabanks around the world. These instruments are essentially a liability to the issuing bank, which creates synthetic ETN shares to provide investors with exposure to a particular ETN. Barclays created VXX to closely track the price of the CBOE Volatility Index, colloquially known as VIX. When investors buy VXX shares, Barclays buys an equivalent position in VIX futures. Presumably, the bank would also hedge its exposure to adverse price movements (more on that later).
So how does VXX follow the price movements of the VIX index? Answer: arbitration. Under normal conditions, if the price of VXX rises relative to the VIX index, investors can sell VXX while buying the VIX futures, eliminating the price gap between the two instruments.
Barclays has now landed its ETN VXX, setting the stage for a high-stakes battle with retail traders
This brings us to the crux of the problem. On Monday, Barclays suspended the issuance of new shares on two ETNs: VXX and the iPath Pure Beta Crude Oil ETN (OIL). This was a very surprising decision given that Barclays was far from breaching its issuance limit on both ETNs. By way of illustration, against an authorized limit of $8.16 billion, Barclays has so far issued VXX shares worth just $859.6 million, according to a FactSet chart and based on information available until last Friday.
Keep in mind that VXX has been in vogue for much of this year, as the VIX index has reasonably soared amid the carnage in the broader equity universe. In this context, Barclay’s seemingly impulsive decision to suspend the issuance of new shares on VXX is charged with the utmost significance. We’d hazard a guess that the megabank was insufficiently hedged against adverse price movements in the underlying VIX index, prompting it to attempt to limit exposure through Monday’s surprise move.
With the background out of the way, let’s discuss what happens next. With no new equity issuance, the price of VXX essentially broke away from the underlying VIX index. Indeed, it is now impossible to use arbitrage to attempt to bridge the price differential between the two instruments.
How high $VXX bonus goes nobody knows. Closed at 5% last night. The situation resonates $TVIX in 2012, it ended up reaching 90%. Who knows if that might also turn into a discount. The point is that price is on its own now with no arb to help it stay close to fair value. pic.twitter.com/qzvgaBlMbj
— Eric Balchunas (@EricBalchunas) March 15, 2022
Essentially, VXX is now a financial instrument with no theoretical price cap. Moreover, shorting the ETN is also currently almost impossible because the activity requires excess supply – supply that no longer exists. Consider the fact that VXX is up more than 10% right now while the VIX index is down about 2%.
This emerging paradigm around VXX has now caught the attention of retail traders on the Reddit-based WallStreetBets forum. You can read the relevant post, titled VXX or Opportunity of a Lifetime.
While it is not yet clear whether VXX will be able to attract enough retailer interest, the price dynamics around the instrument are extremely conducive to strong retailer participation, especially in light of a previous precedent. As an illustration, the now infamous TVIX ETN was originally designed to track the volatility of the S&P 500 Index. On February 21, 2012, the ETN’s issuing bank, Credit Suisse, suspended the creation new shares, causing a rise of 90% in one month. However, the underwriting bank decided to resume issuing new shares on March 22, causing a historic drop in the price of the instrument as well as a host of lawsuits.
Given this precedent and the specter of heavy lawsuits if Barclays replicates the TVIX playbook, the megabank is likely caught between a rock and a hard place.
2021 will be remembered for the stock meme mania. Will 2022 be remembered as the year VXX exploded? We will know soon.