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

The US Securities and Exchange Commission (SEC) has warned 3x and 5x leveraged exchange-traded funds applicants against attempting to work around federal leverage limits, saying they will not be permitted under the current legislation.

On Tuesday, the SEC’s Division of Investment Management sent a “point of concern” email to attorney Stacy L. Fuller of K&L Gates LLP, the representative of Direxion Shares ETF Trust, which submitted post-effective amendments on October 3 and October 10 in an attempt to register new leveraged series. 

According to a copy shared by Bloomberg senior ETF analyst Eric Balchunas, the regulator used the correspondence to formally object to the trust’s proposed fund structures, stating “concerns regarding the registration of exchange-traded funds that seek to provide more than 200% (2x) leveraged exposure.”

The trust had filed amendments on Form N-1A back in October for several traded funds listed in an attached appendix. However, the SEC countered that it would not complete a full review of the filings “until the leverage issues outlined in its correspondence were resolved.”

Regulators cite Rule 18f-4 as core obstacle

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

Any ETF seeking more than 2x leverage under these conditions must either meet very concise alternative testing requirements issued by the SEC or withdraw the application entirely. In its correspondence, the US securities regulator asked the issuer to “revise the obj and strategy to be consistent with 18f-4 or withdrawal,” comments that were cited on Bloomberg’s Balchunas X post. 

The crypto ETF analyst mentioned several issuers had tried to exploit a loophole to exceed the 200% VaR limit while submitting filings with the SEC to make it more “favorable.”

“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,” Balchunas wrote.

Ultra-leveraged filings in October yet to be approved 

The regulator’s latest objections follow several of its public warnings issued in October, when the SEC said it was “unclear” whether dozens of highly leveraged ETF applications filed in the preceding weeks could comply with federal limits. 

Brian Daly, director of the SEC’s division of investment management, told Reuters at the time that during the shutdown of the US government, ETF applicants had flooded their tables with 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.”

ETF issuer Volatility Shares submitted proposals for 27 ultra-leveraged ETFs, including what would have been the first 5x leveraged ETF in the United States if the SEC had provided a greenlight. Since the SEC has never approved a single-stock product with leverage greater than 2x, Volatility Shares’ proposal was ambitious, and by some measure, audacious. 

“Killing the loophole probably saves normies from getting 3x rekt on 5x copium,” said one Crypto Twitter member, referring to the SEC’s enforcement of Rule 18f-4.

Leverage ETFs risky due to liquidation possibilities

According to Morningstar ETF analyst Bryan Armour, among single-stock funds launched more than three years ago, more than half have shut down, while 17% lost over 98% of their value during their lifetime. 

Armour believes volatile price swings and decaying value caused by daily resets would expose leveraged product investors 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.

Moreover, Balchunas also conducted an independent data review in October, finding 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, large enough to erase a 3x leveraged product entirely. 

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