SEC Issues Warnings to Major ETF Providers
(Bloomberg) — The U.S. Securities and Exchange Commission has recently sent out a series of warning letters to several leading exchange-traded fund (ETF) providers. This action effectively stops them from launching new products aimed at delivering returns that are three to five times greater than the daily performance of various stocks, commodities, and cryptocurrencies.
In nine nearly identical letters released on Tuesday, the SEC informed companies like Direxion, ProShares, and Tidal that it would not proceed with any launch plans until specific issues are addressed. The crux of the regulators’ worries lies in the potential risk exposure of these funds, which might surpass the SEC’s established risk parameters for fund assets. Consequently, the letters requested that fund managers either revise their investment strategies or formally withdraw their applications.
Following this news, ProShares announced on Wednesday that it would be withdrawing applications for multiple 3x funds that incorporated 3x leveraged cryptocurrency products.
The SEC’s letters specifically expressed apprehension regarding funds that aim to provide over 200% (2x) leveraged exposure to their underlying indices or securities.
This decision represents a notable pause in a previously lenient approval period for U.S. investment funds, which has seen the introduction of a wide array of cryptocurrency-based ETFs, private asset offerings, and increasingly sophisticated trading strategies. The funds currently under scrutiny are at the cutting edge of this trend, featuring high leverage, daily trading resets, and exposure to some of the most volatile market segments, such as individual stocks and digital currencies.
The SEC’s primary concern appears to be that these funds may be gauging risk against benchmarks that do not adequately capture the volatility of the assets involved.
“Issuers are clearly trying to push past the 2x limit, which isn’t sitting well with the SEC,” commented Todd Thorne, a senior ETF strategist at Strategas. “They’ve been looking for ways around certain language, but there’s a kind of loophole in how a fund’s ‘reference asset’ is defined.”
Some of the funds identified in the SEC’s correspondence include those from Volatility Shares, which is attempting to launch a 5x leveraged ETF aimed at enhancing daily returns from particularly volatile assets, including individual stocks like Tesla and Nvidia and cryptocurrencies like Bitcoin and Ether. At this point, there are no 5x or even 3x single-stock ETFs permitted in the U.S., as SEC guidelines have historically limited leverage to 2x.
Leveraged products tend to draw interest from investors seeking quick profits, especially since trading volumes have surged during the pandemic, with total assets climbing to $162 billion as traders hunt for advantages in fast-paced markets. However, these products have faced criticism for potentially luring novice investors into risky, non-transparent investments. For example, GraniteShares had to cease sales of its 3x Short AMD ETF in October when a sudden spike in Advanced Micro Devices Inc.’s stock price eroded the value of the product overnight.
Interestingly, the SEC’s Division of Investment Management issued the letter on the same day it was written, signaling a strong desire to address these concerns without delay. Typically, the agency would take about 20 business days to communicate with companies post-review.
An SEC representative noted that the agency does not discuss ongoing registration issues. Meanwhile, representatives from Direxion, ProShares, and Tidal have yet to respond to inquiries for comments. A lawyer for Volatility Shares indicated that the company is in conversations with regulators but did not disclose additional details.
