SEC Cracks Down on ETF Issuers! Leverage Out of Control Triggers $20 Billion Liquidation Crisis

The U.S. Securities and Exchange Commission (SEC) has issued warning letters to several exchange-traded fund (ETF) providers, suspending applications for leveraged ETFs with more than 200% exposure to underlying assets. In October, a flash crash in the cryptocurrency market triggered $20 billion in leveraged liquidations, raising the SEC’s concerns about leveraged products. Glassnode data shows that the current cycle sees daily long liquidation amounts of approximately $68 million, a threefold increase from the previous cycle.

SEC Warning Letter Reveals: 1940 Investment Company Act Becomes Regulatory Weapon

(Source: SEC)

The U.S. Securities and Exchange Commission has halted multiple ETF application filings, as these ETFs planned to use 3x to 5x leverage on their underlying assets. ETF issuers Direxion, ProShares, and Tidal received letters from the SEC, citing legal provisions of the 1940 Investment Company Act. The act stipulates that the risk exposure limit for investment funds is 200% of their risk value, with risk value defined by a “reference investment portfolio” composed of unleveraged underlying assets or benchmark indices.

In its warning letter, the SEC stated: “The fund’s designated reference investment portfolio provides an unleveraged benchmark for comparing the fund’s leveraged portfolio, so that leverage risk can be determined under this rule.” This seemingly technical statement actually reveals the core logic behind the SEC’s regulation of leveraged ETFs: no ETF’s leverage multiple may exceed twice the value of its underlying assets.

This means that all 3x to 5x leveraged crypto ETF applications in the market violate current regulations. The SEC instructed issuers to reduce leverage according to existing rules before their applications would be considered, which puts a damper on the development of 3x to 5x leveraged crypto ETFs in the U.S. According to Bloomberg, the SEC issued these warning letters to issuers on the very same day the letters were released, an “unusually swift move” that signals officials’ eagerness to communicate their concerns about leveraged products to the investing public.

Such rapid and clear regulatory action is rare in SEC history. Typically, the SEC’s review process takes weeks or even months, but this time, warning letters were sent out on the day of application, showing the regulators’ heightened vigilance toward leveraged ETF risks. This also reflects the SEC’s attempt to find a balance between supporting innovation and protecting investors amid the Trump administration’s pro-crypto policies.

It is noteworthy that the SEC has not completely banned leveraged ETFs but requires compliance with the 200% cap. This means that existing 2x leveraged Bitcoin and Ethereum ETFs are unaffected, but any attempt to launch higher-leverage products will face regulatory hurdles. This incremental regulatory approach preserves room for market innovation while setting a risk firewall.

$20 Billion Liquidation Event Rings Alarm Bells

(Source: Coinglass)

In October, the cryptocurrency market experienced a flash crash that led to $20 billion in leveraged liquidations, the most severe single-day liquidation event in crypto history, sparking discussion among analysts and investors about the dangers of leverage and its impact on the crypto market. Analysts from the “Kobeissi Letter” commented on the SEC’s warning letter, saying, “Leverage has clearly gotten out of control.”

According to Glassnode, a cryptocurrency analytics platform, the number of crypto liquidations has nearly doubled in the current market cycle. In the previous cycle, the crypto futures market averaged daily long position losses of about $28 million and short position losses of about $15 million. Glassnode data shows that in the current cycle, daily long liquidation amounts are about $68 million and short liquidations are about $45 million.

The surge in liquidation scale reveals a structural change in the use of leverage in the crypto market. In the current cycle, institutional investor participation has increased significantly, with large leveraged positions established via ETFs and the futures market. Compared to retail investors, institutions trade in larger sizes, so when the market experiences sharp volatility, the chain reaction of liquidations is even more intense.

Comparison of Liquidation Scale (Daily Average)

Previous Cycle: Longs $28 million, Shorts $15 million

Current Cycle: Longs $68 million, Shorts $45 million

Increase: Longs up 143%, Shorts up 200%

Behind these numbers are real losses for tens of thousands of investors. During October’s flash crash, many high-leverage investors lost all their principal within minutes. Worse yet, slippage and liquidity shortages during extreme market conditions caused actual liquidation prices to be much lower than theoretical prices, amplifying losses.

Leverage in the crypto space is increasingly intense, magnifying gains and losses and exacerbating market volatility. This phenomenon is known as a “leverage spiral”: when prices rise, leveraged longs profit and add to their positions, pushing prices up further; when prices fall, leveraged longs are forced to liquidate, accelerating the decline. This positive feedback mechanism makes crypto market volatility much greater than that of traditional financial markets.

Hidden Dangers of Leveraged ETFs and Derivatives

After the 2024 U.S. presidential election, the market expects the U.S. crypto regulatory environment to improve, boosting demand for leveraged crypto ETFs. Many investors believe leveraged ETFs offer a “safer” way to take high risks, since they don’t require managing margin accounts or facing forced liquidation risk like futures or perpetual contracts.

However, the SEC’s warning letter points out a widely overlooked fact: leveraged ETFs, unlike leveraged crypto derivatives, do not require margin calls or automatic liquidations, but in a bear market or even a sideways market, the speed at which losses accumulate outpaces gains, seriously eroding investors’ capital. This phenomenon is known as “leverage decay” or “compounding loss.”

Leveraged ETFs operate by rebalancing daily to maintain their target leverage multiple. Take a 3x leveraged Bitcoin ETF as an example: if Bitcoin rises 1% today, the ETF should rise 3%. But if Bitcoin falls 1% the next day, the ETF will fall 3%. After these two days, Bitcoin’s price is nearly unchanged (up 1% and then down 1% is roughly back to the original price), but the ETF’s value has dropped: $100 becomes $103 on the first day, then drops 3% to $99.91 on the second day.

This effect is especially deadly in sideways markets. Even if the underlying asset’s price remains flat over time, the value of a high-leverage ETF will continually decay due to daily volatility. This is why the SEC is particularly wary of products with more than 200% leverage—the higher the leverage multiple, the faster the compounding loss.

By contrast, traditional leveraged derivatives may carry forced liquidation risk, but if the price recovers and the investor hasn’t been liquidated, they can fully recover. However, leveraged ETF decay is irreversible—even if the price returns to its starting point, the investor has already incurred a permanent loss.

Tightened Regulation’s Long-Term Impact on the Crypto Market

The SEC’s restrictions on leveraged ETFs mark a new phase in U.S. crypto regulation. While the Trump administration is generally pro-crypto, firing anti-crypto SEC Chairman Gary Gensler and pushing for a national Bitcoin reserve, these restrictions on leveraged products show that regulators have not abandoned their fundamental responsibility to protect investors.

This “selectively friendly” regulatory stance may become the norm: supporting institutional crypto adoption and innovation while remaining vigilant toward high-risk products. For ETF issuers, this means they must strike a balance between product innovation and regulatory compliance. Issuers seeking to launch extremely high-leverage products will face stricter scrutiny.

For investors, the SEC’s warning letter should be seen as an important risk education message. Leveraged products are not a “get rich quick” shortcut, but complex tools that require a deep understanding of their mechanisms and risk characteristics. In pursuit of high returns, one must also recognize the corresponding high risks and potential for permanent loss.

From a market structure perspective, leverage limits may help reduce systemic risk. When the market is flooded with high-leverage products, even minor fluctuations can trigger a chain of liquidations and cause flash crashes. Capping leverage can slow this positive feedback loop, making the market more stable and mature.