Effective December 1, the Financial Regulatory Authority (FINRA) will implement new margin requirements for leveraged ETFs and uncovered options overlying leveraged ETFs. Under Regulatory Notice 09-53, which was first released in August of this year, margin requirements for leveraged and inverse leveraged funds will increase significantly beginning on Tuesday.
“In general, FINRA is increasing the maintenance margin requirements for leveraged ETFs and associated uncovered options by a factor commensurate with their leverage,” reads the notice. Prior to the change, the maintenance margin for any long ETF was 25% of its market value and the margin for any short ETF was 30% of its market value. Under the new rules, these margin requirements will increase by a percentage commensurate with the leverage of the ETF, not to exceed 100% of the value of the fund.
In the notice, FINRA notes that NASD Rule 2520(f)(8)(A) allows the organization, in response to market conditions, to prescribe higher initial and maintenance margin requirements. “In view of the increased volatility of leveraged ETFs compared to their non-leveraged counterparts, FINRA believes higher margin levels are necessary,” reads the notice.
Since FINRA announced its intentions to raise margin requirements nearly four months ago, the firestorm of controversy surrounding leveraged ETFs has subsided considerably. Much of the focus on these funds has centered on their performance when held for multiple trading sessions. Because they focus on delivering daily returns equal to an amplified daily result on an underlying index, leveraged ETFs can see “return erosion” in oscillating markets.
During the unprecedented volatility in late 2008 and early 2009, the compounding of daily returns led to big losses for both bull and bear leveraged funds. But as volatility has returned to a normal level, the frequency and severity of these occurrences has declined significantly, and many investors have seen compounding work for them in trending markets.
What It All Means
Beginning on December 1, margin requirements for leveraged ETFs will increase significantly, and will range from 50% for 2x long funds to as high as 90% for 3x inverse funds.
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The impact of the changes will take some time to evaluate, but we wouldn’t be surprised if the impact on day-today trading is minimal. Ideally, the new regulations would help to ” trim down the field of investors and test for suitability,” wrote Don Dion when the announcement was initially made.
Earlier this year, several brokerages discontinued use of leveraged ETFs in client portfolios, citing the disconnect between long-term strategies and the short-term focus of the funds. Many thought this would lead to a significant decline in use of leveraged ETFs, but trading volumes didn’t drop at all, leading us to believe that the vast majority of ETF investors are sophisticated individuals and institutions who understand the nuances of leveraged funds and know exactly what they’re doing. ProShares and Direxion, the leaders in the leveraged ETF space, saw aggregate cash inflows of more than $2 billion to their funds in September and October, another indication that this corner of the ETF industry will continue to be embraced by risk-hungry investors.
We’re keeping a close eye on volumes this week and next as the changes take effect – be sure to check back for an update on how this situation plays out. For all the news on the ETF industry delivered to your inbox, sign up for our free ETF newsletter.
For more information on the upcoming regulatory changes, see the official FINRA document.