With the VIX slammed at the close of trading on "quad-witch" Friday, sending it just shy of single-digits once again and pushing stocks back in the green in the last seconds of trading, the much discussed topic of (near) record low volatility simply refuses to go away, which means even more attempts to i) explain it, ii) predict what ends the current regime of "endemic complacency" and iii) forecast the "catastrophic" damage to markets when it does finally end as JPM's Kolanovic did earlier this week, when he set the bogey on a modest increase in the VIX from 10 to just 15.

Overnight, applying his typical James Joycean, stream-of-consciousness approach to capital markets, Deutche Bank's derivatives analyst Aleksandar Kocic penned his latest metaphysical essay on this topic, which covered most of the above bases, and which postulates that far from "stable" the current market equilibrium is one which can be described as "metastable", the result of widespread complacency, and which he compares to an avalanche:"a totally innocuous event can trigger a cataclysmic event (e.g. a skier’s scream, or simply continued snowfall until the snow cover is so massive that its own weight triggers an avalanche."

He also inverts the conventionally accepted paradigm that lack of volatility means lack of uncertainty, and writes that to the contrary, it is the ubiquitous prevalence of uncertainty that has allowed vol to plunge to its recent all time lows, keeping markets "metastable."

How does the regime change from the current "metastable" regime to an "unstable" one? To Kocic the transition will take place when uncertainty, for whatever reason, is eliminated: "Big changes threaten to explode not when uncertainty begins to rise, but when it is withdrawn." He also points out that while there is punishment for those who seek to defect from a "complacent regime"...

Complacency encourages bad behavior and penalizing dissent – there is a negative carry for not joining the crowd, which further reinforces bad behavior. This is the source of the positive feedback that triggers occasional anxiety attacks, which, although episodic, have the potential to create liquidity problems. Complacency arises either when everyone agrees with everyone else or when no one agrees with anyone. In these situations, which capture the two modes of recent market trading, current and the QE period, the markets become calm and volatility selling and carry strategies define the trading landscape. But, calm makes us worry, and persistent worrying causes fear, and fear tends to be reinforcing.

... such "metastability" is in itself unstable: "Persistence of low volatility causes misallocation of capital. This is how complacency leads to buildup of risk – it is the avalanche waiting to happen."

Unlike Kolanovic who quantifies the "metastable" regime's thresholds in terms of VIX (warning of catastrophic losses for vol sellers once VIX rises above 15), Kocic instead merely qualifies the factors that build up in the final phase of the "metastable" regime, eventually spilling over (as shown in the chart above), forcing its end in a violent burst of volatility (and a market crash):

Endemic complacency, which continues to take hold of the markets, is likely to play an increasingly adverse role the longer markets continue to operate as they recently have. However, although volatility remains depressed, the risk continues to be pushed to the tails. This is a buildup of metastablity. The longer the stick remains still, the more surely it will fall.

The simplest analogy to "Austrians" like Mark Spitznagel, is the lack of controlled "forest fires" to eliminate old trees (i.e., systemic excess and "zombie corporations" from central bank intervention and record liquidity), ultimately resulting in a catastrophic conflagration of epic proportions -  a lack of "creative destruction" sowing the seeds of the system's collapse, as Schumpeter would put it:

In the financial forests of our own making, suppression is particularly problematic — and even deadly. Excess and malinvestment thrive for a time, only to be destroyed by ravages caused by their own vulnerability. Yet, as we will see, even such high-intensity "fires" (of the forest and financial varieties) will has up and redistribute resources; in the case of the market, it releases capital to areas previously avoided the to the myopic distortions of monetary intervention. (The Austrian School naturally understood this well, as explained by the Austrian Business Cycle Theory.)

To Kocic, the natural equivalent is an avalanche. Whether one uses a raging inferno, however, or an avalanche as the analogy of what will eventually happen to the market, the message is clear - every passing day that the market remains "metastable" adds to the violent whiplash that will be unleashed once markets inevitable revert back to their "unstable" disequilibirum in the near future.

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Below we excerpt select sections from Kocic's full essay:

Metastability

Big changes threaten to explode not when uncertainty begins to rise, but when it is withdrawn. Excessive determinism is almost always the biggest enemy of stability. This seeming contradiction is behind the concept of metastability which captures the mode of market functioning in the last years.

Imagine you have to balance a long stick on your finger. By placing it vertically on your fingertip, the stick could fall either left or right from its initial position because standing upright is unstable. However, in trying to keep the stick vertical, you instinctively (and randomly) wiggle your finger. The added randomness (noise) acts as a stabilizer of an otherwise unstable equilibrium. So long as the noise is administered carefully, the stick remains vertical, or metastable. The withdrawal of noise becomes destabilizing.

In general, there are three types of equilibria to distinguish: stable, unstable and metastable. The bottom of the valley is stable; top of the hill is unstable; a dimple at the top of the hill is metastable (Fig). Metastability is what seems stable, but is not -- a stable waiting for something to happen. Avalanche is a good example of metastability to keep in mind -- a totally innocuous event can trigger a cataclysmic event (e.g. a skier’s scream, or simply continued snowfall until the snow cover is so massive that its own weight triggers an avalanche).

Complacency is a source of metastability. It has a moral hazard inscribed into it. Complacency encourages bad behavior and penalizing dissent – there is a negative carry for not joining the crowd, which  further reinforces bad behavior. This is the source of the positive feedback that triggers occasional anxiety attacks, which, although episodic, have the potential to create liquidity problems. Complacency arises either when everyone agrees with everyone else or when no one agrees with anyone. In these situations, which capture the two modes of recent market trading, current and the QE period, the markets become calm and volatility selling and carry strategies define the trading landscape. But, calm makes us worry, and persistent worrying causes fear, and fear tends to be reinforcing.

Persistence of low volatility causes misallocation of capital. This is how complacency leads to buildup of risk – it is the avalanche waiting to happen. For a given level of uncertainty, on the risk/reward curve investors settle at a point that corresponds to their risk limits. This position is determined by the volatility cone on the risk frontier, its width commensurate with volatility.

As volatility declines, the cone shrinks and returns decline. This compels investors to move across the frontier towards higher risk in order to enjoy the same return.

Endemic complacency, which continues to take hold of the markets, is likely to play an increasingly adverse role the longer markets continue to operate as they recently have. However, although volatility remains depressed, the risk continues to be pushed to the tails. This is a buildup of metastablity. The longer the stick remains still, the more surely it will fall.

In the past, (in rates market) we did not have to worry about this issue (until it became too late): Mortgages are negatively convex and that risk was transmitted from homeowners to capital markets through MBS hedging. As a consequence, rates market was negatively convex which maintained support for gamma and provided residual volatility. Mortgage convexity hedging practically disappeared after 2008 with convexity risk moving to the Fed’s balance sheet. The transmission mechanism between homeowners and capital markets was severed. This extinguished realized volatility and encouraged further volatility selling. Any attempt to own volatility was penalized by negative carry.

This change caused the major refunctioning of the rates derivatives market, from an extension of the MBS to an insurance market, and with this the action moved from at-the-money to out-of-the money. This was another blow to realized volatility (a 25bp decline of the mean, from 105bp to 80bp) which dragged down implieds as well.