TL;DR
- The SEC’s Division of Investment Management warned Direxion against trying to circumvent federal leverage limits.
- The regulator cited Rule 18f-4, known as the Derivatives Rule, which imposes a risk exposure cap of 200% of VAR.
- Market experts support the SEC’s stance, arguing that leverage above 2x carries extreme liquidation risks.
Scrutiny on the exchange-traded products market has intensified on the part of the U.S. Securities and Exchange Commission (SEC). The agency sent a warning to exchange-traded fund (ETF) applicants seeking leverage exceeding 2x. The regulator reported that 3x and 5x leveraged fund structures will not be permitted under current legislation, citing serious concerns about investor risk.
The SEC’s Division of Investment Management sent a “point of concern” email to the legal representative of Direxion Shares ETF Trust, which had filed post-effective amendments in October to register new highly leveraged series. The SEC’s formal response is based on the intention of these funds to “provide more than 200% (2x) leveraged exposure.”
The regulatory entity requested the issuer to “revise the objective and strategy to be consistent with Rule 18f-4 or otherwise withdraw” the application.
The Derivatives Rule: The Core of SEC Restrictions on Leveraged ETFs
Rule 18f-4 is the basis of the regulator’s restrictions on leveraged ETFs, under the Investment Company Act of 1940. This rule, known as the Derivatives Rule, limits the risk exposure of an open-end fund by ensuring that its Value-at-Risk (VAR) does not exceed 200% of the risk of a designated reference portfolio. Any ETF seeking more than 2x leverage must meet very specific alternative requirements or withdraw its application.
The SEC’s stance was supported by industry analysts. Among them, Eric Balchunas, Bloomberg senior ETF analyst, commented that 2x is sufficient leverage and that a higher level would result in “regular termination events,” which would create constant market distraction.
The warnings from the U.S. entity come after an increase in ultra-leveraged ETF filings in October, including an ambitious proposal from Volatility Shares for the first 5x leveraged ETF in the country.
Regarding this, Morningstar analyst Bryan Armour pointed out that volatile price swings and the loss of value caused by daily resets expose investors in leveraged products to “max pain,” a risk that the SEC seeks to mitigate with these SEC restrictions on leveraged ETFs.
In summary, the rigorous application of Rule 18f-4 seeks to protect retail investors from products that have proven to be extremely volatile and unsustainable in the long term.
