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In this week’s MacroVoices podcast, host Erik Townsend interviews Chris Cole of Artemis Capital Management, who famously earned a profile in the New York Times last year after publishing an influential paper about the looming surge in volatility that looks set to upend eight years of relatively sleepy prosperity in financial markets…
In his paper, Cole famously compared financial markets to the ouroboros – the Greek symbol depicting a snake eating itself, which Cole leverages as a metaphor for the contemporary state of financial markets…
As Cole explains, there’s a dangerous feedback loop involving ultra-low interest rates, data expansion, central bank stimulus, and asset volatility. This in turn feeds into a system where funds embracing “risk parity”, “vol rebalancing” and other trend-following strategies can create a vicious feedback loop where rising volatility begets rising volatility until it snowballs into a Black Monday-style 20% crash.
Volatility across asset classes is at multi-generational lows. But there is now a dangerous feedback loop that exists between ultra-low interest rates, data expansion, central bank stimulus, and asset volatility. And then financial engineering that’s allocating risk based on that Volatility.
This is leading into a self-reflexive loop where lower volatility feeds into lower vol. But, in the event that we have the wrong type of shock to the system, I believe this can reverse violently where higher volatility then reinforces higher vol.
This is a much bigger risk in today’s market environment, and it’s one that is not being correctly discounted.
As Cole told the New York Times back in September, he has calculated that, globally, there is some $2 trillion in short volatility trades.
As traders sell volatility, it creates a kind of short gamma effect, whereby other traders must sell even more to get the same bang for their buck.
A few weeks ago, Goldman derivatives strategist Rocky Fishman pointed out that net positioning of VIX ETPs had become short during the preceding weeks for only the second time in their eight year history, prompting Fishman to ask – rhetorically, of course – should we worry?
The obvious answer is “of course we should” as such lopsided positioning means even a three-point jump in the VIX could trigger a cascading short squeeze, as these funds are forced to cover by piling into long-vol trades, potentially crashing the market.
As Cole explains:
This is all great as long as volatility is low or dropping, as long as markets are stable. But, in the event that we have a reversal in this, there’s two trillion dollars of equity exposure that self-reflexive-driving lower vol can reverse in a quite violent way. And this is just equity vol, mind you:
Moving on to another topic that Coletouched on in a paper he published entitled “Reflexivity in the Shadows of Black Monday 1987”Townsend asks him about corporate buybacks, and their presences as a type of “long-vol” influence on the market. As it happens, these buybacks are just one piece of a large, global “short vol” trade.
Townsend asks Cole to elaborate, and Cole explains that explicitly betting on short volatility by buying an inverse-VIX ETF, or directly shorting the underlying options yourself, is only one small component of the $2 trillion figure mentioned above.
The short-vol trade – if you look at short volatility and you think about what volatility really is – it’s a bet on stability. And when you’re betting on stability, that’s a myriad of different bets.
Part of that is the expectation that markets remain low volatility or low realized volatility. Part of that is short Gamma – so there is this implicit short Gamma exposure.
Part of that is a bet that correlations remain stable. Or that different market relationships remain anti-correlated with one another. Or that implied correlations are dropping. Or realized correlations are dropping.
And the other aspect of the short-volatility bet is that interest rates remain low or go lower.
So if we look at each of these different factors, these are the risk exposures that you will have when you own a portfolio of short options. And, if you own a portfolio of short options you are short Vega, you’re short Gamma, you’re short correlation, you’re short interest rates.
What we’ve seen now with this short-vol trade, explicitly and implicitly, is that various financial engineering strategies out there that have become dominant in the marketplace – we’re talking about the largest hedge funds in the world employ these strategies – that are just replicating the exposures of a short-options portfolio.
And of course the VIX trade gets a lot of attention, but it’s the smallest portion of the short-vol trade. This is what we call explicitly shorting volatility. This is where you’re literally going out and you’re shorting an option. Or you’re shorting a volatility future.
But in the VIX space, that’s only about $5 billion worth of short exposure. You have about $8 billion of vol-selling funds, according to Bloomberg. And then about $45 billion (estimated) in pension over-writing strategies, these short-port or short-call strategies the pensions are doing.
So, in total, there’s about $60 billion of explicit short volatility. Which is big. But that’s not the most concerning aspect.
The bigger aspect is this $1.4 trillion in implicit short volatility strategies. These are replicating the exposures of a portfolio of short options, even though they may not be directly selling derivatives or directly selling optionality.
Among these implicit strategies are the $600 billion worth invested in risk-parity strategies. $400 billion in volatility-control funds. And about $250 billion of risk premium strategies…
…and then there’s the equity exposure of the CTAs…
…Then, at the bottom of the short-vol pyramid, are corporate buybacks, which have helped prop up the market by BTFDing at every turn.
And it makes sense: How else can a CEO directly influence a company’s EPS? You can’t magically increase sales – there are too many factors that go into that.
But you can pick up the phone and call your broker.
But let’s think about what share buybacks do. If you’re a corporate CEO, you don’t have the ability to generate growth. You can’t generate sales. And you want to get your bonus. So if you can’t generate earnings, if you can’t help your top of the line, what you can do is reduce the number of shares. And this will artificially increase the EPS so you can hit your bonus target.
You go out and you issue debt and you buy back your shares. You’re leveraging the company up – which means that you’re exposed to interest rates, you’re exposed to market stability.
And then you’re buying back your shares, resulting in a price-insensitive buyer that is always underneath the market, resulting in this price-insensitive buyer always buying on market dips.
So, the result of this is that you’re artificially reducing realized volatility. The strategy is always to buy on dips. That is part of the replication strategy of the short-variance swap. Literally it’s
part of the replication of shorting vol.
When you add all of this exposure together, we have this self-reflexive short straddle of financially-engineered strategies in the market. And this really comes out to about $2 trillion worth of implicit and explicit short-volatility strategies. And then you can tack on the share buybacks. To some effect that is resulting in this.
Cole adds one more chilling fact:
Back in 1987, these strategies made up just 2% of the market.
Today, anywhere between 6% and 10% is held in these self-reflexive implicit and explicit short vol strategies.
Infer from that what you will…
Listen to the whole interview below:
The US Ambassador to Russia urged the Kremlin to react “calmly” to the U.S. Treasury Department’s list of “corrupt oligarchs” due Monday. The list is designed to “name and shame” elite Russians into thinking twice before engaging in business with Putin’s government. It will be up to Congress to decide whether the list should be published.
“I urge to take this report, based on its real and not a contrived essence and without emotions, because relations between our countries are far from being exhausted by this one legal act, and I was reminded about it in Washington, where I was two weeks ago,” – US Ambassador John Huntsman via –newsru (translated)
Kremlin spokesman Dmitry Peskov told reporters two weeks ago that Russia will react to any punitive measures against its businessmen, stating “The principle of reciprocity remains,” suggesting that Putin would employ a commensurate response to a U.S. crackdown on oligarchs.
As we previously reported, the list was created pursuant to an August, 2017 law requiring the Treasury and State Departments identify officials and oligarchs as determined by “their closeness to the Russian regime and their net worth” in order to penalize the Kremlin for its alleged meddling in the 2016 election.
The report is intended to “name and shame” Russia’s elite who prop up Putin, and to send a message “that Putin’s aggression in terms of Russian interference in our elections will be very costly to them,” said Daniel Fried, a former assistant secretary of State who led the State Department Russia sanctions office.
It is likely to signal to Russia’s political and business classes that they’d be better off maintaining a distance from the Putin government, and it could lead to further sanctions against individuals who participate in corruption, Fried said.
“The Russian elite reacted with something between anxiety and panic about the prospect of this list,” Fried said. “They focused on this immediately, and they’re very worried about it.” –USA Today
The list will include “indices of corruption with respect to those individuals,” along with any foreign assets they hold. According to Bloomberg, this sent Russian fat cats into a liquidation frenzy – with many scrambling to contact D.C. lobbyists in order to buy their way off the list.
Some people who think they’re likely to land on the list have stress-tested the potential impact on their investments, two people with knowledge of the matter said. Others are liquidating holdings, according to their U.S. advisers.
Russian businessmen have approached former Treasury and State Department officials with experience in sanctions for help staying off the list, said Dan Fried, who previously worked at the State Department and said he turned down such offers. Some Russians sent proxies to Washington in an attempt to avoid lobbying disclosures, according to one person that was contacted. –Bloomberg
The Treasury’s report must include “indices of corruption,” which will list any foreign assets next to an oligarch considered corrupt. “Because of the nervousness that the Russian business community is facing, a number of oligarchs are already beginning to wind back businesses, treating them as if they are already designated, to stay ahead of it,” said Daniel Tannebaum, head of PricewaterhouseCoopers LLP’s global financial sanctions unit.
Russia’s well-connected billionaires have hired law firms to try to keep them off the list, said Ariel Cohen, a Russia analyst at the Atlantic Council think tank. Russians believe the list is a first step toward increasing the current 29 Russians under U.S. sanctions by adding 40 to 400 names, Cohen added. –USA Today
Vladimir Putin has warned wealthy nationals over worsening U.S. sanctions, and provided them with a capital amnesty program designed to allow oligarchs to repatriate some of their overseas assets. Meanwhile, Putin has issued special bonds which will allow the wealthy to hold assets outside of the reach of the U.S. Treasury.
Separate sanctions handed down
As we reported earlier in the month, Treasury officials are concerned that people will confuse Monday’s list of corrupt oligarchs with separate sanctions handed down to Russians over the Ukraine crisis.
On Friday, the Treausry Department added 11 individuals to a “blacklist” which now contains 21 Russian or Ukraainian nationals and nine companies – most of which are power or energy firms. The Treasury’s announcement reads in part:
WASHINGTON –The U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) today designated 21 individuals and 9 entities under four Executive Orders (E.O.s) related to Russia and Ukraine, including three individuals and two entities related to Russia’s transfer of four turbines made by a Russian-German joint venture to Crimea. Today’s action is part of Treasury’s continued commitment to maintain sanctions pressure on Russia until it fully implements its commitments under the Minsk agreements. This action underscores the U.S. government’s opposition to Russia’s occupation of Crimea and firm refusal to recognize its attempted annexation of the peninsula. These sanctions follow the European Union’s recent extension of sanctions and reinforce our continued unity in supporting Ukraine’s sovereignty and territorial integrity.
As a result of today’s action, any property or interests in property of the designated persons in the possession or control of U.S. persons or within the United States must be blocked. Additionally, transactions by U.S. persons involving these persons are generally prohibited.
“The U.S. government is committed to maintaining the sovereignty and territorial integrity of Ukraine and to targeting those who attempt to undermine the Minsk agreements,” said Treasury Secretary Steven T. Mnuchin. “Those who provide goods, services, or material support to individuals and entities sanctioned by the United States for their activities in Ukraine are engaging in behavior that could expose them to U.S. sanctions.”
Today, OFAC also identified 12 subsidiaries that are owned 50 percent or more by previously sanctioned Russian companies to provide additional information to assist the private sector with sanctions compliance.
Relations between Washington and Moscow have deteriorated since 2014, when Russia annexed Crimea, sparking the conflict in Ukraine. Diplomatic ties have worstened between the two nuclear superpowers, with Washington accusing Moscow of interfering in the 2016 US presidential election.
In December 2016, President Obama closed two diplomatic compounds used by Russia in retaliation for “hacking the election,” expelling 35 diplomats amid fresh sanctions. Then in July 2017, the Senate voted to increase sanctions on Russia by a 98-2 margin, which Trump reluctantly signed off on August 2 – stoking fears over a trade war after comments by Russian prime minister Dmitry Medvedev that the law had ended hope for improving US-Russia relations.
Days after the Senate vote, Russia responded by expelling 755 US diplomats – to which President Trump thanked Putin for having “cut our payroll.”
“I greatly appreciate the fact that we’ve been able to cut our payroll of the United States,” Trump said, adding “we’re going to save a lot of money… there’s no real reason for them to go back.”
Q: Thoughts on Putin expelling US diplomats?
Trump: “I greatly appreciate the fact that they’ve been able to cut our payroll.” (via ABC) pic.twitter.com/iR5JbHLHZj
— Kyle Griffin (@kylegriffin1) August 10, 2017
Several weeks later in August 2017, the Trump administration “thanked” Russia again – giving them 72 hours to vacate three more diplomatic facilities in San Francisco, Washington DC, and New York City.
Towards the end of 2017, Washington took a series of steps to further vilify Russia, branding the country a “rival power” and “revisionist power,” while imposing new sanctions on several individuals linked to the Kremlin.
Trump’s Executive Order
Perhaps one of the main drivers behind Russian oligarchs shedding assets before the U.S. Treasury’s “indices of corruption” are released is an Executive Order signed quietly in Late December which freezes the U.S. housed assets of foreign government officials or executives of foreign corporations deemed to be corrupt.
In fact, anyone in the world who has “materially assisted, sponsored, or provided financial, material or technological support for, or goods or services” to foreigners targeted by the Executive Order is subject to frozen assets. This would apply to D.C. lobbyists working for corrupt Russian oligarchs, or U.S. government officials who have, say, effectuated a uranium deal deemed corrupt.
As such, tomorrow’s release of “corrupt oligarchs” by the US Treasury Department may have serious consequences for the finances of Americans who have done any type of business with any Russians deemed corrupt by the United States.
FTCR China Labour Index sees best January in three years but hirers say wages down
Russian security services have arrested a local hacker who planted malware at gas stations across Russia’s southern regions that had been cheating drivers out of the gasoline that they pumped in their cars in a major fraud scheme that later resold the stolen fuel.
Russia’s Federal Security Service (FSB) have arrested the creator of the malware, Denis Zayev, who had gas stations employees working with him to trick the software systems to selling less fuel to the customers, while reselling the fuel that was stolen.
This fraud was one of the largest such scams uncovered by the Russian services, a source in law enforcement told news outlet Rosbalt. The scheme extended to almost all regions in the south of Russia, with dozens of gas stations infected with the malware.
Zayev has created a “perfect virus” that couldn’t be detected by either security controls that oil companies have used to remotely monitor gas stations, or by specialists at the Ministry of Internal Affairs, according to the police source who spoke to Rosbalt.
The virus planted in the systems allowed the hacker and his accomplices to steal up to 7 percent of the fuel.
Zayev acted not only as the “seller” of the malware at some stations, but also as co-owner of the channel to steal fuel, and received a cut from the proceeds from the re-sale of the stolen fuel.
Schemes by hackers targeting gas stations are not new.
In early 2014, 13 people were indicted in the U.S. for allegedly using small Bluetooth-enabled skimmers to steal more than US$2 million from credit cards that customers used at gas stations in Texas, Georgia, and South Carolina in 2012 and 2013. According to the Manhattan District Attorney, the four main defendants had attached skimming devices at gas pumps at Raceway and RaceTrac to steal credit card information from customers.