LONDON Aug 24 Forget short-selling. The villain of the piece in this summer's market slide is called a variance swap -- effectively a bet on a quiet holiday period.
The theory goes that banks helped exacerbate painful slumps in shares prices -- including their own -- because their derivative trading desks were forced to unwind massive bets that August would be a quiet month.
"It would be hard to say that it was the overwhelming reason for the fall, but it was certainly a contributing factor," said Shalin Bhagwan, at Legal and General Investment Management, Britain's biggest manager of pension fund assets.
"No doubt when you have those kinds of positions in the market, they do tend to exacerbate and exaggerate movements one way or the other," he said.
European shares have lost 14 percent so far this month, and bank shares were even harder hit, shedding a fifth. The STOXX Europe 600 Banking Index fell 7 percent on Aug. 10 alone, and another 7 percent on Aug. 18.
Many fund managers say a sudden early-August spike in a widely used gauge of how volatile markets are expected to be -- the Chicago Board Options Exchange Market Volatility Index was the start of the trouble.
The jump caught out investment banks and a group of hedge funds who were betting that this fear gauge would stay at moderate levels, forcing them to reposition and take a negative view, and pushing equity markets down further in the process.
Trading desks can be vulnerable to a sudden market move if they have written options that give investors the right to buy or sell shares at a pre-agreed price -- effectively an insurance against market swings which they find themselves paying out on.
They can also be caught out by their own direct speculation that markets will remain quiet. This is done using variance swaps -- derivatives that bet on the volatility of an asset such as a stock index.
In the past, these have been an astonishingly profitable play, because asset price volatility in the main turns out to be far lower than feared.
"In the period from January 1990 to December 2009, trading a variance swap would have yielded an average return of 26 percent per month," said Andrea Vedolin, a lecturer at the London School of Economics and an expert on derivatives.
That compares to a monthly 0.4 percent gain in the S&P500 share index in the same period, she said.
But when the betting on a quiet period is heavy and fear creeps back in, trouble looms.
Exactly that happened around the start of this month, when the VIX hit its highest level since the collapse of Lehman Brothers. Political haggling about U.S. debt levels and concerns over global growth hurt markets were the triggers.
"During the past couple of weeks, I am speculating, the market for variance swaps dried up completely," said Vedolin.
When that happens, the only way for a bank to limit its losses is to replicate the swaps in the options market, Vedolin said. That exposes traders to the underlying asset, forcing them to dump futures when the market continues to fall.
"This fear factor and the necessity to cover in essence shorts (in volatility) would have led to selling of S&P futures which in turn spikes volatility and feeds back into the loop," said Sanjay Joshi at investment manager London & Capital.
"The situation was most likely complicated by a feeding frenzy where high frequency traders began to behave in a herd instinct," he said. "Additionally, real money investors ... were probably forced into some form of hedging."
Stock options are traded in huge volumes. Last year, the total volume was $130 trillion, according to the World Federation of Exchanges. Just $6.7 trillion of that was in single stock options, the rest in options in indices.
Regardless of how much impact variance swaps have had this summer, the evidence that short-selling is not the real villain looks increasingly compelling.
Europe's markets watchdog was quick to slam the practice -- borrowing of shares to sell them and later scoop them up at a lower price, on the basis that it exaggerates a market fall.
Short-selling is a common way for hedge funds to bet on falling share prices, and Europe's newly established financial market regulator, the European Securities and Markets Authority (ESMA) called the practice "clearly abusive" when used in combination with spreading false market rumours.
But the percentage of shares out on loan -- a reliable indicator for short-selling activity -- stayed modest for even the hardest-hit bank stocks, data have shown.
And shares continued to slide after France, Italy, Spain and Belgium banned short-selling financial stocks on Aug. 12.
Variance swaps are traded over-the-counter only -- meaning they are not listed instruments traded on an exchange -- and there are no numbers for their volumes, or on who the biggest participants in the markets are.
Among banks, Goldman Sachs , JP Morgan and Morgan Stanley are among the biggest players in the options market. All three declined to comment.
(Additional reporting by Luke Jeffs; Editing by Andrew Callus)