October 23, 2021
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US regulator warns leveraged ETPs pose systemic risk to markets

By on October 6, 2021 0

A leading US regulator has warned that leveraged exchange-traded products pose a risk to the stability of financial markets and called for stricter rules to be applied to such complex vehicles.

Gary Gensler, chairman of the Securities and Exchange Commission, said Monday he supports the introduction of the new rules. The statement followed warnings from US regulators dating back more than a decade about the risks to individual investors posed by leveraged ETPs.

Last year, the SEC forced three investment advisory firms and two brokers to reimburse a total of $ 3 million for violations related to inappropriate sales of complex ETPs between January 2016 and April 2020.

“I think potential regulation could strengthen investor protection around these products. [Leveraged ETPs] can present risks even to sophisticated investors and can potentially create system-wide risk by operating in unanticipated ways when markets experience volatile or stressful conditions, ”Gensler said.

Leveraged exchange-traded products use derivatives to multiply the day-long performance of a benchmark, such as the S&P 500, but these bets get worse when investors hold them for more than one session. trading so that they can also multiply losses.

Global assets held in leveraged and reverse ETPs stood at $ 112 billion at the end of August, up from $ 80.8 billion at the end of 2017, according to ETFGI, a London-based consultancy firm. Reverse ETPs and leveraged reverse ETPs allow investors to profit if the underlying index falls.

Allison Herren Lee and Caroline Crenshaw, two of the five SEC commissioners, also released a joint statement on Monday, supporting Gensler’s push for tougher rules.

They said the SEC should relaunch its plan to require brokers and investment advisers to perform checks to ensure their clients fully understand the risks before allowing retail investors to buy and sell ETPs. leveraged.

Proposals to restrict sales were dropped last year following an outcry from investors who sent more than 6,000 letters of comment to the SEC. All of the comment letters except 70 dealt with the proposed selling restrictions.

“SEC commissioners continue to be concerned that the risks associated with leveraged ETPs are not fully understood. They are likely to make purchasing these products more difficult for independent investors. While these ETPs are only a small portion of the market, they often generate considerable interest from tactical investors, ”said Todd Rosenbluth, head of ETF and mutual fund research at CFRA.

U.S. regulators have long suspected that leveraged ETFs could have a destabilizing impact on financial markets, especially in times of stress when asset prices fall sharply.

An academic study published last month looked at the rebalancing activity of leveraged ETFs and combined it with an analysis of the behavior of market makers who trade options to assess how these two channels have interacted for the past 30 years. critical minutes of each U.S. equity trading session between 2012 and 2020.

The study’s authors found that rebalancing by leveraged ETFs “always leads to additional momentum” – in fact amplifying the upward or downward movement of the US stock market in the last 30 minutes of negotiation.

The buying and selling activity of options market makers can also provide additional impetus to the dynamic effects created by leveraged ETFs.

The two channels – rebalancing by leveraged ETFs and the activity of options market makers – can also amplify the effect of each other if both buy or sell at the same time.

“The effects can be significant. The regulator needs to pay attention, ”said Andrea Buraschi, professor of finance at Imperial College Business School and one of the study’s authors.