(Bloomberg) — As MicroStrategy Inc.’s stock soared last month, Matt Tuttle received bad news from his prime broker about the rapid growth of leveraged ETFs tracking the crypto-focused company’s stock.
Most Read Articles on Bloomberg
Prime brokers, the division within banks that work with customers on activities such as securities lending, have reached a limit in the amount of swap exposure they provide to his month-old fund, the T-Rex 2X Long MSTR Daily Target ETF. was. (Ticker MSTU) At the time of its creation, it was, by some accounts, the most volatile exchange-traded fund to ever appear on Wall Street.
The ETF offers double the return of the highly volatile MicroStrategy stock, which skyrocketed in mid-October and attracted hundreds of millions of dollars. To achieve the big returns he was promised, Mr. Tuttle bought swaps through prime brokers, a typical tactic. However, given the turmoil at MicroStrategy, the largest Bitcoin holder, only three companies agreed to work with him, and all three were beginning to reach the limits of their production capacity.
At one point, he needed $100 million worth of exposure, but companies only offered $20 million total. So, to fulfill the fund's mission, he turned to buying call options.
“If this was a Procter & Gamble fund, you could get as much swap exposure as you wanted,” Tuttle said. “But MicroStrategy is a different beast.”
The message is that this unprecedented boom in highly leveraged ETFs is testing the risk appetite of some major Wall Street players, namely prime brokers. And while buying options to achieve a fund's goals is uncontroversial, it does illustrate the hurdles that must be overcome to meet the burgeoning demand for the product.
The situation was similar for Mr. Tuttle's rival, the Defiance Daily Target 2X Long MSTR ETF (MSTX), which debuted in August. Sylvia Jablonski, chief executive officer of Defiance ETF, said that shortly after the ETF was launched, it began using options to meet its stated leverage. The fund initially offered leverage of 1.75x, but that was increased to 2x after Tuttle introduced ETFs.
These episodes also reflect the very turbulent nature of MicroStrategy itself. Shares fell as much as 22% on Thursday after Citron Research announced it was betting on the company.
“That should make us question: Have ETFs jumped the shark?” said Dave Mazza, CEO of ETF issuer Roundhill Investments. “We're at the point where we're pushing the limits of what the market will tolerate.”
high octane
As of Thursday's close, the two 2x MicroStrategy funds had combined assets of about $4 billion. MSTU has risen over 600% since its launch through Thursday, while MSTX has risen 480%. Sustaining these high levels for ETFs has become even more difficult since Donald Trump's election victory, as investors took advantage of his pro-crypto stance to push Bitcoin to record highs. MicroStrategy announced its largest Bitcoin purchase in history this month, and its stock price has risen more than 70% since Nov. 5 as of Thursday's close.
“When something goes parabolic, that's when things go all crazy,” Tuttle said. The days of needing $100 million exposure now seem quaint to him. Recently, it sometimes required five times that amount.
A market maker involved in MicroStrategy's swap business for these two leveraged ETFs, speaking on condition of anonymity, said the funds are testing the risk limits of prime broker desks, especially as the products continue to grow. According to the person, due to the high volatility of ETFs, a large down payment is also required. Tuttle said the volatility of the underlying stocks explains why swap counterparties are increasing margin requirements.
As of Thursday, the prime brokers listed on MSTU and MSTX were Cantor Fitzgerald, Marex and Clear Street, according to data compiled by Bloomberg. Mr. Kanter and Mr. Mallex declined to comment. Clear Street did not respond to a request for comment.
From MSTX's inception in mid-August to Wednesday, the stock price soared nearly four times faster than the digital currency, suggesting leveraged bets may have fueled the stock's rise. . In the year to July, MicroStrategy progressed just twice as fast.
retail lottery
Leveraged single-stock ETFs will become available to U.S. investors in 2022 amid warnings from regulators about their risks, and they tend to attract retail investors sometimes looking for quick returns. There are currently more than 90 single-stock leveraged or inverse ETFs, according to data compiled by Bloomberg Intelligence's Athanasios Sarofagis-Shaw.
For ETF issuers, the use of options can introduce complications, such as the need to track the theoretical percentage change in a derivative's price as the underlying stock changes. Tuttle is currently spending part of his afternoon working with traders and market makers to evaluate options needs, with amounts determined by ETF flows and MicroStrategy stock movements.
Defiance's Jablonski said banks consider broad exposure to a particular security across multiple desks, as well as risks and balance sheet-related constraints, when evaluating limits for such instruments. said it was necessary.
“When dealing with more volatile assets, such as MicroStrategy, cryptocurrencies, and high-growth stocks, this risk assessment process tends to be even more rigorous,” she said. “With a better understanding of how to effectively manage and hedge these products, new players may become increasingly willing to collaborate in trading activities.”
