SEC pushes back on leveraged ETF bids over 200% VAR limit

SEC Objects to Proposed 3x and 5x Leveraged ETFs

The U.S. Securities and Exchange Commission (SEC) has issued a strong warning to applicants of 3x and 5x leveraged exchange-traded funds (ETFs), stating that such products will not be permitted under current legislation if they attempt to bypass federal leverage limits.

On Tuesday, the SEC’s Division of Investment Management communicated a "point of concern" to Stacy L. Fuller, an attorney representing Direxion Shares ETF Trust. Direxion Shares had submitted post-effective amendments on October 3 and October 10, aiming to register new leveraged series.

Eric Balchunas, a senior ETF analyst at Bloomberg, shared a copy of the correspondence. In it, the regulator formally objected to the trust’s proposed fund structures, expressing concerns about registering ETFs that aim to provide more than 200% (2x) leveraged exposure.

The trust had filed amendments on Form N-1A in October for several traded funds. However, the SEC stated that it would not proceed with a full review of these filings until the leverage issues highlighted in its correspondence were resolved.

Regulators Cite Rule 18f-4 as Core Obstacle

The SEC's letter specifically referenced Rule 18f-4 under the Investment Company Act of 1940, often referred to as the Derivatives Rule. This rule imposes limits on an open-end fund's risk exposure by ensuring its Value-at-Risk (VAR) does not exceed 200% of a designated reference portfolio risk.

Under these conditions, any ETF seeking more than 2x leverage must either meet very specific alternative testing requirements issued by the SEC or withdraw its application. The SEC's correspondence requested the issuer to "revise the obj and strategy to be consistent with 18f-4 or withdrawal," remarks that were also noted in Eric Balchunas's X post on Bloomberg.

The crypto ETF analyst pointed out that several issuers had attempted to exploit a loophole to exceed the 200% VaR limit while submitting filings to the SEC, aiming for more "favorable" outcomes.

Balchunas commented, "Honestly, it’s for the best. I’m as libertarian as they come, and I think 2x is plenty of heat; any more and we’d have termination events regularly, which would be a constant distraction."

Ultra-Leveraged Filings in October Yet to Be Approved

The regulator’s recent objections follow public warnings issued in October. At that time, the SEC indicated it was "unclear" whether numerous highly leveraged ETF applications filed in the preceding weeks could adhere to federal limits.

Brian Daly, director of the SEC’s division of investment management, informed Reuters that during a U.S. government shutdown, ETF applicants had submitted a significant volume of filings for leverage products.

"The agency has received a large number of registration statements for ETFs seeking to offer 3x and 5x leveraged, equity-linked exposure, but the question is whether these ETFs would comply with the Derivatives Rule (Rule 18f-4), which generally limits leverage to 2x," Daly stated.

ETF issuer Volatility Shares had submitted proposals for 27 ultra-leveraged ETFs, including what would have been the first 5x leveraged ETF in the United States had the SEC approved it. Given that the SEC has never approved a single-stock product with leverage greater than 2x, Volatility Shares' proposal was considered ambitious, and by some accounts, audacious.

One member on Crypto Twitter remarked, "Killing the loophole probably saves normies from getting 3x rekt on 5x copium," referencing the SEC's enforcement of Rule 18f-4.

Leverage ETFs Pose Risks Due to Liquidation Possibilities

According to Morningstar ETF analyst Bryan Armour, more than half of single-stock funds launched over three years ago have been shut down, with 17% losing over 98% of their value during their operational lifespan.

Armour believes that volatile price swings and decaying value, exacerbated by daily resets, would expose investors in leveraged products to "max pain."

"This SEC administration has been more amenable to new strategies coming to market, but 5x leveraged single-stock ETFs will test those limits," he told Reuters.

Furthermore, Balchunas conducted an independent data review in October. His findings revealed 350 instances in the past five years where one of the 66 stocks included in recent 3x ETF filings experienced a daily swing of 33% or more. Such a swing would be substantial enough to completely erase the value of a 3x leveraged product.