The Derivative Project

A Guess at Why Larry Fink is Warning on Leveraged ETF’s

A Guess at Why Larry Fink is Warning on Leveraged ETF’s

A Guess at Why Larry Fink is Warning on Leveraged ETF’s

Larry Fink, CEO of Blackrock rattled the ETF business last week, pronouncing leveraged ETF’s have the capacity to blow up the system. Reuters describes Mr. Fink’s warning here this morning, Blackrock’s Fink jolts ETF business with blow-up warning

For background purposes, please read the Investment Company Institute’s write-up on closed end funds and their use of leverage, linked to linked to here.

What is behind this warning?

Uncertain. However, we agree with Mr. Fink, based on our first-hand experience with his leveraged closed end fund, HYV, on May 6, 2010. Perhaps Mr. Fink was scared to death on May 6, 2010, as we were.

Now that the closed end fund – HYV has merged with with other funds and asset holdings and market movements are buried for that date, he is free to speak out, without others pointing fingers at Blackrock and what really transpired on May 6, 2010, to his very own leveraged high yield fund.

Mr. Fink’s firm has packaged, for years, leveraged closed-end funds, such as the closed-end fund HYV, jammed packed with repos, sales of credit default swaps, foreign currency positions, Greek debt, derivatives, borrowings, and other other volatile goodies on very illquid securities. He now decries what he has being doing in closed-end funds –in ETF’s. Academic studies for years have been perplexed by the market sensitivity of leveraged closed-end funds and the influence of volatile markets on these funds.

Reuters writes today, “A systemic risk could emerge from packaging inherently hard-to-trade securities, such as leveraged bank loans, into ETFs. The value of the ETF could collapse if the market for the underlying assets freezes up. That could touch off a rout within the ETF industry if skittish investors decide that many other funds are too dangerous for them. ”

The Untold Story of Mr. Fink’s Leveraged Fund, HYV, on May 6, 2010 around 2:15 Eastern Time

Let’s first take a look at Blackrock’s time line of the sequence of events of the May 6, 2010 flash crash from its own White Paper

HYV and Blackrock’s Flash Clash Timeline

HYV Falls Close to 20% Before Crash

HYV Falls Close to 20% Before Crash

At precisely the time that Blackrock begins its timeline for the May 6th flash crash, its closed end fund, HYV began to drop precipitously to its low of the day, 9.07, close to a 20 percent drop in just a few minutes. Yes, before any of the S&P mini-futures drops.

The Derivative Project wrote on May 8, 2010 on this unusual drop of this leveraged closed end fund (HYV) at 2:10- 2:20 PM on May 6, 2010, (available in TDP Blog Archives tab for that date)
May 8, 2010 The Derivative Project wrote
An Unusual Sell-Off 20 Minutes Before the DOW was Down 1000
The Derivative Project normally does not comment on technical stock market movements. However, ironically The Derivative Project has been following the use of derivatives in Black Rock funds, particularly HYV.
As a shareholder in this fund, we have placed calls to Black Rock portfolio managers about certain derivative positions in HYV. They refuse to return our call.^TNX#chart4:symbol=^tnx;range=5d;compare=hyv+jnk+^dji;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

(Editor’s Note: Unfortunately Yahoo Finance will no longer link to this amazing graph of the divergence of HYV to JNK and TNX at 2:20 – 2:25 PM ET on May 6, 2010. We tried to recreate it, but most unfortunately, Blackrock consolidated HYV into HYT in 2013, as described in this SEC 2013 prospectus.

However, we were able to produce historical price movement for the TNX, 10 year Treasury Index and JNK for May 6, 2010, which supports our statements that Blackrock’s HYV diverged from other high yield funds and dropped close to 20%, while other high yield funds did not. Why?

The following images replace the link to the Yahoo Finance graph mentioned in the original May 8, 2010 Post.)

Blackrock HYV Performance

CBOE Interest Rate – 10 Year 5/06/10 TNX

Compare May 6th Movement of that of HYV

Compare May 6th Movement of that of HYV

JNK Barclay’s SPDR High Yield

Compare JNK Daily Movement on May 6th to that of HYV

Compare JNK Daily Movement on May 6th to that of HYV

At about 2:20 EST, HYV dropped precipitously, without explanation. As you can see at the link above to the inter- active chart HYV dropped without explanation, independently of other comparable high yield funds, like JNK. It dropped independently of the drop in ten year treasuries and the DOW. When The Derivative Project questioned Charles Schwab, (where this position is traded) about this unusual movement, their explanation was there was nothing unusual it tracked the decline in the 10 year note. Why is Charles Schwab misleading a “retail investor?” This decline did not track the drop in the 10-year treasury, this decline happened 20 minutes before, when Charles Schwab then shut down its trading desk for the rest of the day.
As the attached link to HYV(Black Rock High Yield), JNK(Barclays High Yield), THX (Ten Year Note) and DJI (DOW) indicate the precipitous drop in HYV was 20 minutes before the drop in JNK, THX and DJI.

The Derivative Project made a trade in HYV at Charles Schwab at 2:15- 2:20 PM ET on HYV. At 2:45 EST, The Derivative Project tried to close out some positions during the 1000 DOW decline. Charles Schwab had shut down its online trading, its phone lines and calls to a local branch said “Sorry, but no one can trade.”
The Derivative Project contacted Charles Schwab yesterday to try to reach an agreement for a settlement for the harm caused by the inability to trade from 2:45 to 4:00PM EST. Charles Schwab’s response was “sorry, tough luck , that is not our problem.” We can shut down our trading operations whenever we please.
For those readers that are not aware, Black Rock was selected, without competition to manage the disposition of the government “inherited positions” in CDO’s.
Here’s a link to a March 2010 article on Blackrock from the blog Naked Capitalism.–-blackrocks-larry-fink-as-hero.html

The Derivative Project is not a hedge fund. The Derivative Project exists to ensure a fair market place for all and an economy that is no longer based on a GDP that is dependent on income from senseless synthetic trades, that cause more harm to the fabric of our society, than income they deliver to our “bottom line.”
Can you imagine the cries of foul if any large trader was blocked out of the markets from 2:45 to 4:00 PM EST on Thursday, May 6?
Based on Charles Schwab’s actions and the most unusual, unexplained movement in HYV, something is clearly “rotten in Denmark.”

End of May 8th 2010 Post

HYV was leveraged. It held very illiquid securities, including Greek Debt and Countrywide paper and significant foreign currency exposures. It was short credit default swaps.

Now take a look at look the CFTC’s / SEC’s report of the May 6, 2010 Flash Crash, to the Senate Banking Committee.

“Findings Regarding the May 6, 2010 Market Events”
jointly produced by the CFTC and the SEC. You can observe there is no discussion in the report to the Senate Banking Committee on the severe market drops of leveraged closed end funds, such as HYV, in the market report. Why did it focus solely on equities?

Should Mr. Fink explain this precipitous drop in his own leveraged closed end fund and put it on his own May 6, 2010 timeline and help academics and all market participants understand what happened to leveraged funds, ETF’s or closed end, on May 6th, 2010? Mr. Fink could deliver a valuable service to all market participants to explain why HVY, a leveraged closed end fund, diverged significantly from other high-yield products on this historical date.

Was it the leverage? Was it simply the Greek exposure? Was it the foreign currency exposures? Was it the repos? Margin calls?

HYV dropped close to 20% Before the Market Rout on May 6

A drop in HYV of 20% preceded the rout in the equity markets on May 6. The SEC report and Blackrock’s white paper both fail to discuss this significant fact.

Mr. Fink’s explanation here could do much more than a scary warning on leveraged ETF’s blowing up the market. An examination of an actual leveraged fund’s behavior, compared to ETF’s, in a volatile market, will go much further in helping the markets prevent other precipitous drops in leveraged funds, like HYV.

A leveraged closed end fund, HYV, blew up on May 6, 2010, dropping over 20% in seconds. We executed the trade at Charles Schwab at the bottom, prior to the E-Mini trade that was said to spur the Flash Crash. We, like we assume Mr. Fink was, were scared to death. We had never seen anything like this swift decline, with no market commentary during the decline or after. Quite frankly, we find it very odd that no one has commented on the behavior of this leveraged closed end fund and the timing of the close 20% decline on May 6th.

We asked Charles Schwab to unwind this trade, since just after the sale was made in HYV, Schwab closed their trading desk to retail investors for the rest of the day, yet forced the losses and the inability to re-establish the position. FINRA refused to investigate. The SEC refused to investigate.


Mr. Fink has more explaining to do on HYV’s movement prior to the flash crash on May 6 and the role of leveraged closed end funds in relationship to leveraged ETF’s. Why did HYV drop close to 20% prior to the Flash Crash? Did closed end leveraged funds play a role in the May 6th Flash Crash? Why weren’t retail investors compensated for this precipitous drop in HYV, when they traded, and then the inability to trade after 2:30 PM ET on May 6, 2010?

Charles Schwab has shown they have no accountability when the markets crash. The retail investor is shut out and forced to accept losses due to systemic risks, while larger players are compensated. The SEC has not implemented any protections for the retail investor, following the May 6th Flash Crash, nor looked at the influence of leveraged closed end funds on May 6, 2010 in precipitous declines.

We close with shots of our emails with Brandon Hemley, Schwab’s General Counsel on May 6, 2010, pleading for the ability to trade, following the sale of HYV at around 2:20 PM ET at Charles Schwab.

We urged him, as Schwab’s Corporate Counsel, to take unprecedented action to enable retail investors to trade. We felt there were legal issues, closing out our ability to trade, that needed to be addressed for retail investors.

Schwab’s online system was down after 2:35 PM ET until the market close and one could not get through to FCs on phone lines. The ability to trade for retail investors never reopened after 2:35 on May 6, 2010.

Schwab simply did not care and did not take any action to assist the small retail investor. Schwab did not exercise any accountablity. (Note: email addresses have been deleted for privacy purposes and time stamp is PT, reflecting Charles Schwab’s time zone.)

We wrote Schwab’s General Counsel on May 6 at around 2:50 PM ET:

RE: Schwab System hs been Down for 15 minutes

Spoke to FC. Schwab’s systems are down. We cannot trade, phone lines are down.

Brandon Hemley wrote at 12: 12 PT Time or 3:12 ET on May 6th:

Your FC should be able to take your order. I cannot. I am not a registered rep.

Mr. Hemley’s email on May 6, 2010 clearly reflects the Charles Schwab “no accountability” to retail investors. Mr. Hemley was informed all Schwab trading systems were down and refused to bring in assistance at Schwab headquarters. This is the plight of every retail retirement investor at Charles Schwab today.

We hope the SEC will ensure retail investors will have recourse now and in future volatile markets that favor the institutional investor and shut out the retail investor, causing unnecessary losses. In addition, the SEC should provide substantive comment on the unexplained movements of certain leveraged, closed end high yield funds on May 6, 2010, such as Blackrock’s HYV.