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FINRA Imposes New Margin Requirements For Leveraged ETFs

The controversy surrounding leveraged exchange traded funds (ETFs) shows no sign of letting up, and on Sept. 1, the Financial Industry Regulatory Authority (FINRA) announced plans to raise margin requirements for leveraged ETFs beginning Dec 1. FINRA’s Regulatory Notice 09-53 states that the “inherent volatility” of leveraged ETFs is one of the reasons for the new requirements.

The change in regulations comes on the heels of a lawsuit filed by a group of investors in August against ProShares and one of its leveraged inverse ETFs. The investors allege that ProShares misrepresented the UltraShort Financials ProShares Fund and that they were never informed shares in the fund should not be held for more than one single trading day.

Leveraged ETFs are considered a subset of traditional ETFs and attempt to generate multiples (i.e. 200%, 300% or greater) of the performance of the underlying index or benchmark they track. Some leveraged ETFs are “inverse” funds, which means they try to deliver the opposite of the performance of the index or benchmark they track. Leveraged ETFs can include among their holdings high-risk derivative instruments such as options, futures or swaps.

The complexity and potential risks associated with leveraged ETFs have garnered both the media spotlight and the attention of regulators who contend many retail investors do not fully understand how the products work. Both FINRA and the Securities and Exchange Commission (SEC) recently issued warnings highlighting the risks for investors in leveraged ETFs, particularly those who invest for the long term. In response, some brokerage firms announced new sales limits on client investments in leveraged ETFs, while others halted sales altogether.

In July, Massachusetts’ Secretary of State William Galvin launched an inquiry into how three leveraged ETF providers – Rydex, ProShares and Direxion – marketed and sold leveraged ETFs, as well as what they were telling brokers who sold the funds to clients. Detractors of leveraged ETFs, including FINRA and the Securities and Exchange Commission (SEC), contend retail investors may not fully understand the complexity of ETFs nor realize the products must be monitored on a daily or near daily basis.

Three years ago, there were no leveraged ETFs in existence. Today, there are more than 140 leveraged ETFs with about $30 billion in assets.

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