Leveraged ETF Margin Rules to Change

NEW YORK ( TheStreet) -- In what could be be a major blow to ultra-long and utra-short ETFs, the Financial Industry Regulatory Authority announced Tuesday that it would be raising margin requirements for leveraged ETFs on Dec. 1.

In Regulatory Notice 09-53, FINRA notes that it will be implementing increased customer margin requirements for leveraged ETFs and uncovered options overlying leveraged ETFs.

Leveraged ETFs like the Direxion Daily Financial Bull 3X ( FAS) and Direxion Daily Financial Bear ( FAZ) have become increasingly popular with investors over the last year. These funds use derivatives like futures and swaps to achieve ultra-long or ultra-short exposure to their underlying indices.

FINRA notes the "inherent" volatility of leveraged ETFs as the reason for the new requirements. Since many of the leveraged ETF funds are designed to give investors 200% or 300% exposure to their underlying indices, the funds can swing violently depending on the direction of the market.

Citing NASD Rule 2520, FINRA says that "in response to market conditions," it will "prescribe higher initial and maintenance margin requirements." FINRA also is careful to distinguish the "increased volatility of leveraged ETFs compared to those of their non-leveraged counterparts."

Currently, in a strategy-based margin account, the maintenance margin requirement is 25% of the market value for any long ETF, and generally 30% of the market value for any short ETF. The new margin rules will require that margin requirements increase by "a percentage commensurate with the leverage of the ETF, not to exceed 100% of the value of the ETF."

Investors in the ProShares UltraShort Financial ETF ( SKF), for example, would be subjected to twice the margin requirement due to the fund's 200% leverage. Investors in Direxion's Daily Emerging Markets Bear 3X Shares ( EDZ), would require triple the current margin requirement.

In its regulatory release, FINRA notes that it "recently reminded firms of their sales practice obligations with respect to leveraged and inverse ETFs, including the risks caused by the fact that most of these funds are designed to achieve their stated performance on a daily basis."

FINRA's June notice to firms set off a wave of attacks against the leveraged fund industry, as issuers like ProShares, Rydex and Direxion scrambled to increase disclosure ahead of regulation. A recent lawsuit also claimed that ProShares UltraShort Real Estate ( SRS) also engaged in misleading sales practices.

It was just a matter of time before this logical answer to the leveraged ETF problem was put into place. New margin requirements will have the same effect as banks cutting credit. It will trim down the field of investors and test for suitability.

This regulatory measure is an important step for the booming ETF industry. Non-traditional ETF funds should require a separate set of regulations than their traditional peers. A continued coordinated effort from regulatory agencies will be an important step in protecting investors.

-- Written by Don Dion in Williamstown, Mass.

At the time of publication, Dion did own any of the ETFs mentioned in the article.

Don Dion is president and founder of Dion Money Management, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.

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