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Exotic ETFs Risk Banks' Stability
2 Aug
Summary
- Leveraged ETFs pose risks to market stability in South Korea.
- Banks face growing tail risk from volatile stock-linked ETFs.
- Demand for 'crash puts' and 'stability notes' has surged.
Leveraged exchange-traded funds (ETFs), designed to amplify daily returns, present significant risks not only to individual investors but also to market stability. In South Korea, the growing popularity of these risky ETFs has prompted regulators to implement stricter measures on retail investment to mitigate volatility.
More subtly, the increasing popularity of leveraged ETFs has also created substantial tail risk for the banks that provide the necessary leverage. This has fueled a quiet but significant surge in activity within the over-the-counter derivatives market. Institutional investors are actively trading products known as 'crash puts' or 'stability notes' to hedge against extreme market downturns.
Discussions with market participants indicate an unprecedented level of demand for these hedging instruments. For instance, an email from Goldman Sachs in May highlighted an "Expensive Crash Cliquet" trade focused on hedging SK Hynix Inc. and Samsung Electronics Co. The proposed yields for investors assuming this tail risk ranged from 14.2% to 20%, indicating the high premiums associated with such protection.
While extreme one-day stock drops of 50% are rare for these companies, such events are not entirely unheard of. A recent example involved US electric vehicle maker Lucid Group Inc., which experienced a significant intraday drop of 57% on July 14, leading to the shutdown of a leveraged ETF tied to its stock. The demand for these protective derivatives underscores the interconnectedness of complex financial products and market stability.
