SEC Issues Warning Letters to ETF Providers Regarding Excessive Leverage

The U.S. Securities and Exchange Commission (SEC) has issued warning letters to multiple exchange-traded fund (ETF) providers, putting a halt to applications for leveraged ETFs that offer more than 200% exposure to underlying assets.

Key Takeaways

The SEC issued warning letters to ETF providers over leveraged ETFs exceeding 200% exposure.
Legal restrictions from the Investment Company Act of 1940 limit risk exposure to 200%.
The recent crypto market experienced significant liquidations, raising concerns about leverage.
Current cycles have seen nearly triple the liquidations compared to previous ones.
Demand for leveraged crypto ETFs surged post-2024 U.S. presidential election, attracting investor interest despite potential risks.

SEC sends warning letters to ETF issuers targeting untamed leverage

ETF issuers such as Direxion, ProShares, and Tidal are among those who have received these letters, which reference legal provisions from the Investment Company Act of 1940. According to this law, the exposure of investment funds is capped at 200% of their value-at-risk, which is defined by a "reference portfolio" of unleveraged underlying assets or benchmark indexes.

SEC, Ethereum ETF, Bitcoin ETF, ETF _SEC warning letter sent to Direxion. Source:_SEC

The SEC has instructed these issuers to reduce the leverage amount to comply with current regulations before their applications can be reassessed. This move is significant as it impacts the availability of 3-5x crypto leveraged ETFs in the U.S.

The SEC's quick publication of these warning letters on the same day they were sent indicates a strong intent to communicate concerns about leveraged products to investors, as noted by Bloomberg.

The crypto market faced a sharp decline in October when a flash crash led to $20 billion in liquidations, marking the most severe single-day liquidation in crypto history. This event has raised alarms among analysts and investors concerning the risks associated with leverage and its impact on the crypto market.

Related: Vanguard’s 50M+ clients will soon have access to crypto ETFs

The Rising Impact of Leverage on Crypto Markets

"Leverage is clearly out of control," remarked analysts from The Kobeissi Letter in response to the SEC's recent warnings. According to the crypto analysis platform Glassnode, crypto liquidations have nearly tripled this market cycle compared to previous cycles.

SEC, Ethereum ETF, Bitcoin ETF, ETF _24-hour liquidations in the crypto derivatives market. Source:_Coinglass

During past cycles, liquidations in the crypto futures market averaged around $28 million for long positions and $15 million for shorts each day. In contrast, the current cycle is recording approximately $68 million in long liquidations and $45 million in short liquidations daily, as per Glassnode's analysis.

The demand for leveraged crypto ETFs spiked following the 2024 U.S. presidential election, fueled by hopes for a more favorable regulatory environment for cryptocurrency in the country.

While leveraged ETFs do not face margin calls and automatic liquidations like leveraged crypto derivatives, they can substantially affect investor capital, especially in bearish or stagnant market conditions. Losses tend to accumulate more rapidly than gains, making these investments highly risky for investors.

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