Market News

BY Denitsa Tsekova and Nicola M White

(Bloomberg) -- The US Securities and Exchange Commission has issued a flurry of warning letters to some of the country’s most prolific providers of high-octane exchange-traded funds, effectively blocking the introduction of products designed to deliver three and even five times the daily returns of stocks, commodities and cryptocurrencies.

In a set of nine almost identical letters posted Tuesday, the SEC told firms including Direxion, ProShares and Tidal that it would not move forward with reviewing proposed launches until key issues are addressed. At the heart of the regulator’s concern is that the funds’ risk exposures may exceed SEC limits on how much risk a fund can take on relative to its assets. The letters direct the fund managers to either revise their investment strategies or formally withdraw their applications.

At least one issuer has acted since the letters were published. On Wednesday, ProShares asked to withdraw its application for various 3x funds, including triple-leveraged cryptocurrency products.

“We write to express concern regarding the registration of exchange-traded funds that seek to provide more than 200% (2x) leveraged exposure to underlying indices or securities,” the SEC wrote to all nine applicants.

The move marks a rare pause in an otherwise permissive stretch for US fund approvals, which has seen a green light given to crypto-linked ETFs of all stripes, private-asset vehicles and increasingly complex trading strategies. The funds now under scrutiny are on the extreme edge of that trend — combining high leverage, daily trading resets and exposure to some of the most unstable corners of the market, including single-name stocks and digital tokens.

A central concern for the SEC is that the funds appear to be measuring their risk against a benchmark that may not fully reflect the volatility of the assets they aim to amplify.

“The issuers were aiming to go beyond the 2x limit allowed and the is SEC clearly not comfortable with that,” said Todd Sohn, a senior ETF strategist at Strategas. “Issuers were trying to get a workaround in some of the language, loopholes in a sense on what the ‘reference asset’ was on the funds.”

Some of the funds mentioned in the letters are by Volatility Shares which filed to launch ETFs with five times leverage. The funds were aimed at boosting the daily return of some of the most volatile assets including single stocks like Tesla Inc. and Nvidia Corp., as well as cryptocurrencies such as Bitcoin and Ether. No 5x — or even 3x — single-stock ETF currently exist in the US, with SEC rules having long kept a lid on such exposure effectively capping it at 2x leverage.

Leveraged products use options to amplify returns, and they’re popular with investors because they can offer big profits quickly. Trading volumes have boomed since the pandemic as traders look for a new edge in fast-moving markets while assets have climbed to $162 billion. Leveraged ETFs have endured their share of criticism in recent years, with skeptics saying they tempt amateur investors with products that are both risky and opaque. In Europe, GraniteShares was forced to shutter its 3x Short AMD exchange-traded product in October after a big one-day surge in the shares of Advanced Micro Devices Inc. wiped out its value.

Staff in the SEC’s Division of Investment Management publicly posted the letters the same day they were written — an unusually speedy move that suggests the regulator wants to get its concerns out fast. The agency typically posts correspondence with firms 20 business days after wrapping up reviews.

An SEC spokesperson said the agency doesn’t comment on active registration matters.

Representatives of Direxion, ProShares and Tidal didn’t respond to requests for comment. A representative for ETF Series Solutions declined to comment. An attorney for Volatility Shares said the company was in discussions with the regulator but couldn’t provide further details.

--With assistance from Isabelle Lee.