Investment banks are quietly building a market in exotic "crash puts" to offload tail risk tied to leveraged ETFs, whose global assets now approach $250 billion.
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Banks Sell Crash Puts to Hedge $250 Billion Leveraged ETF Risk
Investment banks are quietly building a market in exotic "crash puts" to offload tail risk tied to leveraged ETFs, whose global assets now approach $250 billion.
Goldman Sachs Group Inc., Barclays Plc, Citigroup Inc. and BNP Paribas SA have all stepped up activity in the over-the-counter derivatives, which pay investors to absorb the risk of a catastrophic one-day plunge in a single stock. The trade has grown so hot that Goldman pitched clients in May on a leveraged strategy tied to SK Hynix Inc. and Samsung Electronics Co. crash puts offering annualized yields of 14.2 percent to 20 percent, according to an email reviewed by Bloomberg News.
"I have never seen this level of demand in this product," said Natasha Sibley, a portfolio manager in the diversified alternatives team at Janus Henderson.
The surge traces to the financial plumbing behind leveraged ETFs, which use total return swaps to deliver two or three times a stock's daily move. If an underlying share falls more than roughly 50 percent for a 2X fund — or 33 percent for a 3X fund — in a single session, the fund can lose more than its net assets, leaving the bank counterparty exposed to losses the issuer cannot cover. Crash puts, also called cliquets or stability notes, transfer that "gap risk" to outside investors who collect premiums for acting as insurers.
Demand has pushed premiums sharply higher. A BNP Paribas pitch in May priced a daily gap put on SK Hynix with a 55 percent strike and six-month maximum maturity at up to 6.5 percent, and Samsung at 5.5 percent — up from 3.5 percent and 2 percent respectively in March, according to another email viewed by Bloomberg News. The higher payouts reflect both the growth of leveraged funds and banks' eagerness to shed risk, Sibley said.
A Market Built on Volatile Single Stocks
The crash-put market has expanded alongside leveraged ETFs, which now number more than 700 products in the U.S. alone. Assets peaked above $200 billion in June before retreating to roughly $160 billion, according to Bloomberg Intelligence data. SK Hynix, Micron Technology Inc., Nvidia Corp., Tesla Inc. and Sandisk Corp. rank among the most popular underlying stocks.
Many 2X single-stock funds track shares with three to five times the volatility of the Nasdaq 100 Index, making a fund-ending crash "qualitatively harder" to manage than even a 3X index ETF, said Rocky Fishman, founder of Asym Research. "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."
South Korea has become a focal point for the risk. Though the market caps daily moves at 30 percent, crash puts settle on an official close-to-close basis, so a stock hitting limit-down and staying halted can compound losses into the next session. Regulators there have tightened curbs on retail participation in leveraged ETFs to temper volatility.
Risk Transfer, Not Risk Removal
The banks most active in providing swaps for leveraged index funds — Barclays, Citi, Goldman and Bank of America Corp., each with more than 10 percent market share by notional — are the same names building out crash-put books. In single-stock swaps, non-bank liquidity provider Clear Street leads with about 20 percent share, followed by Nomura Holdings Inc. and Goldman, Asym data show.
The trade is also becoming productized. Janus Henderson launched two active structured income ETFs in April, JELH and JELM, that package stability swaps and equity-linked notes for a broader investor base. "When we designed these ETFs, we wanted to include stability notes in there along with autocallables," Sibley said. "Since then they have exploded in the single-stock space."
Yet the opacity of the OTC market makes total exposure hard to measure, and some fund managers warn the layered leverage could amplify a shock. "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."
This article is for informational purposes only and does not constitute investment advice.
