BIS starts its analysis by pointing out that historically falls in equity prices tend to be associated with higher volatility and thus a rise in the VIX.
"But the increase in the VIX on that day significantly exceeded what would be expected based on the historical relationship," wrote the BIS analysts Vladyslav Sushko and Grant Turner. "In fact, it was the largest daily increase in the VIX since the 1987 stock market crash."
The pair make the point that the rise in the VIX on 5 February far exceeded the change in expectations about future volatility and suggest the spike was largely due to the internal dynamics in equity options or VIX futures markets.
ETFs were an important element of this dynamic with investors using a variety of products for either speculative or hedging purposes. It leads us to the leveraged volatility ETPs that hit the headlines in February and as the BIS team say, the assets of select leveraged and inverse volatility ETPs have expanded sharply over recent years, reaching about $15 billion at end-2017.
"Although marketed as short-term hedging products to investors, many market participants use these products to make long-term bets on volatility remaining low or becoming lower," they add. "Given the historical tendency of volatility increases to be rather sharp, such strategies can amount to 'collecting pennies in front of a steamroller'."
Sushko and Turner suggest that the systematic trading strategies of the issuers of leveraged and inverse volatility ETFs "appear to have been a key factor behind the volatility spike that occurred on the afternoon of 5 February."
One-way trafficA look at the complex trading patterns throughout the day suggests that both long and short volatility ETPs ended up on the same side of the trade at one point late in the afternoon, each trying to buy VIX futures. There were also signs that other market participants began bidding up VIX futures prices in anticipation of the end-of-day rebalancing by volatility ETPs.
"Due to the mechanical nature of the rebalancing, a higher VIX futures price necessitated even greater VIX futures purchases by the ETPs, creating a feedback loop," the analysts write.
A spike in trading volume followed, to roughly one quarter of market contracts being trading over the course of one minute later afternoon on the day. "The value of one of the inverse volatility ETPs, XIV, fell 84% and the product was subsequently terminated."
The BIS team add that spillovers back to the equity market on that day were also evident as the S&P fell 4.2% on the day. "Normal algorithmic arbitrage strategies between ETFs, futures and cash markets kept the related market dynamics tightly linked," they suggest.
The BIS team conclude: "Overall, market developments on 5 February were another illustration of how synthetic leveraged structures can create and amplify market jumps, even if the core players themselves are relatively small. For investors, this was also a stark reminder of the outsize risks involved in speculative strategies using complex derivatives."