Regulatory Action on Leveraged Crypto ETFs
Federal regulators have halted a series of aggressive cryptocurrency exchange-traded fund (ETF) applications this week, informing three prominent issuers that their proposed products contravene long-standing investment regulations.
On Wednesday, the Securities and Exchange Commission (SEC) dispatched warning letters to Direxion, ProShares, and Tidal. These letters addressed plans to introduce funds offering 3-5x leverage on digital assets. The SEC cited the Investment Company Act of 1940, a piece of legislation that imposes limitations on the level of risk investment funds can undertake through borrowed exposure.
According to existing regulations, investment funds are prohibited from exceeding a 200% risk profile relative to an unleveraged version of the same assets. Regulators have instructed these firms to reduce their leverage targets before their applications can be considered further.
SEC's Swift Response and Investor Protection
The timing of this action indicates a sense of urgency from the SEC. Officials made the rejection letters publicly available on the same day they were issued to the applicants. This unusually rapid turnaround, as noted by Bloomberg, suggests a significant concern for safeguarding retail investors from potentially hazardous financial products.
Impact of Leverage on Crypto Markets
The cryptocurrency markets experienced substantial damage due to leverage in October. A sudden market downturn at that time triggered approximately $20 billion in forced liquidations, marking the largest single-day financial wipeout in the industry's history. Data from Glassnode indicates that daily liquidation volumes have nearly tripled when compared to the previous market cycle.
Currently, average daily forced closures stand at roughly $68 million for long positions and $45 million for short positions. This contrasts with approximately $28 million and $15 million, respectively, in prior years. Analysts from The Kobeissi Letter commented on the SEC's intervention, observing that leverage has evidently escalated beyond control.
Interest in leveraged cryptocurrency funds saw a surge following the 2024 presidential election. Investors were anticipating a more favorable regulatory environment under the forthcoming administration. While leveraged ETFs do not face the immediate risks of margin calls and automatic liquidations associated with derivatives, they can still lead to severe portfolio losses during market downturns, as losses are amplified at a faster rate than gains.