(Bloomberg) — Leveraged ETFs that offer the tantalizing prospect of doubling or tripling the daily returns of an individual stock are famously risky for investors who buy them.
They’re also proving to be hazardous to market stability in South Korea, where regulators have stepped up curbs on retail investment in them to temper a violent bout of volatility.
What’s less obvious is how risky their growing popularity can be to the banks that provide all that leverage — and need to hedge swelling pools of tail risk attached to some of the world’s most volatile stocks.
The result has been a quiet surge of activity in an exotic corner of the derivatives market, where investment banks, hedge funds and other institutional investors trade what are often known as “crash puts” and sometimes referred to as cliquets or stability notes. While the over-the-counter nature of the unlisted products makes it impossible to quantify their growth, discussions with market participants and documents viewed by Bloomberg News illustrate just how hot the trade has gotten.
“I have never seen this level of demand in this product,” said Natasha Sibley, a portfolio manager in the diversified alternatives team of Janus Henderson.
One email from Goldman Sachs Group Inc. in May pitched a trade idea around “Expensive Crash Cliquet”: it meant to capitalize on “immense demand” to hedge the share prices of South Korea’s SK Hynix Inc. and Samsung Electronics Co., since a one-day share-price drop of 50% or more could wipe out the 2X ETFs tied to them. How expensive exactly? The proposed yields on offer for investors with the gumption to assume the tail risk for up to one year — and use leverage to amplify returns — ranged from 14.2% to 20%.
The trade “presents an opportunity for investors to act as the ‘insurer,’ selling this overpriced crash protection to earn a high premium,” the email read.
While one-day crashes of 50% are very uncommon for the stocks involved — the worst session on record for Hynix was July 13, when the shares fell 15.4% on a closing basis — such plunges are not completely unheard of. In the most recent example, US electric vehicle maker Lucid Group Inc. sank as much as 57% intraday on July 14 before trimming the drop to 16% by the end of the session. A levered ETF tied to the stock subsequently shut down.
For those involved in the trades, crash puts serve the useful purpose of allowing the banks that service ETF providers a chance to purchase disaster insurance from investors with enough assets and risk tolerance to take the other side of the trade.
“These products are very efficient, back-to-back risk-transfer tools,” said Ramon Verastegui, founder and chief investment officer at Kairos Investment Advisors. “Therefore, now banks are trying to develop the crash-put market in order to hedge all these leveraged ETFs.”
To understand the growth in demand for crash puts this year requires a look at the financial plumbing that allows these leveraged ETFs to exist.
To achieve a daily return that is two or three times that of the underlying stock, ETF issuers in the US and Hong Kong typically use total return swaps provided by banks or non-bank dealers. While specific arrangements differ case by case, the dealers provide the ETF its desired return on a daily basis, while hedging their own exposure — often by trading the underlying stocks, futures or options. The ETF pays the dealer a financing rate, typically a spread above the Secured Overnight Financing Rate, and other contract fees. The ETF posts collateral in the form of cash, Treasuries or similar liquid assets, and the swap is marked-to-market daily.
Still, the setup leaves banks exposed to what’s known as “gap risk.” If a stock falls sharply enough in a single session — roughly more than 50% for a 2X fund or 33% for a 3X fund — the ETF is at risk of losing an amount greater than its net assets, potentially strapping the banks with losses that the fund’s issuer can’t cover.
Even though the South Korea market has a 30% daily price limit and circuit breakers in place, a sharp multi-day move can still hit hard because crash puts calculate on an official close-to-close basis — so if a stock hits limit down and stays halted until market close, the move gets priced into the next session.
The chain of daily resetting, deeply-out-of-the-money crash puts are packaged in a product designed specifically to protect against that scenario for a set period of time.
While the structure itself is nothing new, what has changed is the additional use and groundswell of demand amid the growth of leveraged funds, said Kairos’ Verastegui, who has two decades of experience in the derivatives space.
Barclays Plc, Citigroup Inc., Goldman Sachs Group Inc. and Bank of America Corp. are among the most active players in providing swaps for US-listed leveraged index funds, each accounting for over 10% of market share measured by the total notional amount of swaps, according to data compiled by Asym Research based on regulatory filings.
Meanwhile, non-bank liquidity provider Clear Street is the largest player in swaps for leveraged single-stock funds, with about a 20% market share, followed by Nomura Holdings Inc. and Goldman, Asym data show.
Many large 2X leveraged single-stock ETFs track underlying shares that have three to five times the volatility of the Nasdaq 100 Index, according to Asym founder Rocky Fishman.
“So managing the risk of a fund-ending crash in them is qualitatively harder than in even a 3X long index ETF,” he said. “In a way they’re creating a high-yield bond: Investors collect a good coupon until something really bad happens, just in this case it’s an equity shock not a default.”
Unlike listed options, crash puts are highly customized with various strike levels, maturities and settlement terms.
At the same time, premiums can vary widely depending on an individual bank’s balance-sheet capacity, appetite for retaining risk and regulatory risk limits, as well as the market conditions for the underlying security and the size of the ETFs.
The dynamics have particularly picked up over the past few months. “Banks are all super keen to trade to hedge their risks and the yield is extremely attractive,” said Janus Henderson’s Sibley. “That higher return brings more people in to provide insurance.”
In a pitch from BNP Paribas in May, a daily gap put on SK Hynix, with a maximum maturity of six months and a strike price at 55% of the underlying stock, would pay up to 6.5% — and 5.5% for Samsung. The premium in March was 3.5% for Hynix and 2% for Samsung, according to another email from BNP viewed by Bloomberg News.
The higher premiums are in part a result of the surge in popularity of leveraged ETFs tracking both indexes and individual stocks. Globally, they hold assets approaching a quarter trillion dollars, with SK Hynix, Micron Technology Inc., Nvidia Corp., Tesla Inc. and Sandisk Corp. among the most popular underlying assets.
In the US alone, the ETFs now number more than 700. After reaching a peak in June of over $200 billion under management, the market has retreated to roughly $160 billion, data from Bloomberg Intelligence show.
These days, the type of income available from crash-put products isn’t only available to big funds: There are now ETFs that offer it. Janus Henderson launched two active structured income funds in April, JELH and JELM, which use stability swaps and equity-linked notes to package institutional structured-note strategies.
“It’s been great timing,” said Sibley. “When we designed these ETFs, we wanted to include stability notes in there along with autocallables. We were familiar with them in the index space and liked the pricing, but since then they have exploded in the single-stock space.”
Yet as the crash put market grows along with leveraged ETFs, the complexity and opacity of these niche products has raised concerns among critics.
“Any time you have financial innovation involving leverage and many counterparties exposed, that is a danger to financial stability,” said Owen Lamont, portfolio manager at Acadian Asset Management. “That is the type of thing that leads to bad outcomes: Overlapping leverage, perhaps hidden leverage, and many counterparties.”
–With assistance from Sangmi Cha, Christian Dass, Charlotte Yang, Athanasios Psarofagis and Weihua Li.
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