Leveraged Crypto ETFs in Limbo: Decoding SEC Rule 18f-4 for 3× & 5× Funds

Title: Leveraged Crypto ETFs in Limbo: Decoding SEC Rule 18f-4 for 3× & 5× Funds

Introduction: A Regulatory Flashpoint On October 16, 2025, at a public SEC roundtable, Director Brian Daly admitted it was “unclear” whether the surge of 3× and 5× leveraged crypto ETF filings could satisfy the agency’s Derivatives Rule (Rule 18f-4), which generally caps leverage at 2× of a reference portfolio. Amid government-shutdown staffing cuts, the SEC has paused review of dozens of proposals—including Volatility Shares’ ambitious 27-fund package, featuring the first U.S. 5× single-stock ETF. This moment crystallizes the tension between market demand for turbocharged crypto exposure and rigorous risk controls.

Understanding SEC Rule 18f-4 and Leverage Limits To grasp the compliance challenge, recall that Rule 18f-4 (effective October 2020) modernized derivatives oversight for registered funds under the Investment Company Act. Its core provisions:
• Derivatives Risk Management Program: appoint a derivatives risk manager (DRM) for board-approved policies, daily stress tests/backtests, and escalation procedures.
• VaR-Based Leverage Cap: conduct daily relative VaR tests (≤200% of a reference portfolio’s VaR) or absolute VaR tests (≤20% of net assets).
• Limited-User Exception: bypass full VaR regime if total derivatives exposure ≤10% of net assets via written policies.
• Grandfather Relief: pre-October 28, 2020 leveraged/inverse funds with prospectus disclosure may continue leverage >200% without daily VaR but must meet other duties.
These rules effectively limit new leveraged ETFs to 2× daily unless they qualify for the 10% exception—casting doubt on bona fide 3× and 5× crypto ETFs.

Proposed 3× and 5× Leveraged Crypto ETF Filings and Structural Dynamics Volatility Shares filed on October 14 for 27 ETFs targeting 3× or 5× daily exposure to Bitcoin, Ether, Solana, XRP and major U.S. stocks via futures, swaps, and options. If cleared, they could trade on Cboe BZX or NYSE Arca as early as December 29, 2025. Yet under Rule 18f-4’s VaR ceiling, compliance hinges on final SEC review.
Moreover, these ETFs use daily reset compounding: rebalancing each day to maintain leverage, which induces “volatility drag” in choppy markets. Synthetic exposure through OTC swaps adds counterparty-default risk—mitigated but not eliminated by posted collateral.

Operational Mechanics & Risks: Risk Management, Counterparty Exposure and Decay Having outlined the structural mechanics, we turn to both regulatory safeguards and performance drift.
• Derivatives Risk Management: the DRM must run daily VaR tests, weekly stress tests, daily backtests, and enforce escalation procedures for breaches—retaining all records for SEC inspection.
• Counterparty Considerations: physically backed ETFs avoid default risk; synthetic funds must diversify counterparties and overcollateralize to meet board-approved guidelines.
• Tracking Error & Decay: beyond compliance, leveraged ETF returns deviate from target multiples. A simplified model for compounded return R over n days is:
R ≈ M×μ − ½M²σ²
where M=leverage multiple, μ=average daily return, σ=volatility. High σ and compounding amplify decay—e.g., a 3× ETF on a flat but volatile index (σ=1.5%) can lose >10% over 10 days.

Possible SEC Pathways: Legal Experts Weigh In With compliance still pending, practitioners foresee three outcomes:

1. Conditional Approvals: carve-outs requiring stricter VaR thresholds, enhanced daily NAV transparency or elevated collateral standards—analogous to the 19b-4 commodity ETP framework.
2. Enhanced Disclosures: expanded prospectus and marketing mandates, including volatility-drag warnings and stress-scenario tables as proposed by market-practices rule-makers.
3. Outright Rejections: strict enforcement of the 200% VaR limit under Rule 18f-4 and Section 6c-11, aligning with the SEC’s cautious stance.
   Each pathway will signal the SEC’s tolerance for stretching traditional leverage boundaries in crypto.

Trading Strategies in an Uncertain Launch Timeline While the SEC deliberates, disciplined traders can mitigate regulatory and market risks:
• Hedged Pair Trades: long a 3× Bitcoin ETF versus short a 1×/2× Bitcoin ETF (or futures) to neutralize directional exposure and capture volatility arbitrage.
• Options Overlays: employ short-dated credit spreads or protective puts on 0DTE ETF options to earn time decay while capping losses.
• Intraday Scalps: exploit heightened opening volatility in crypto-leveraged ETFs using breakout signals and rapid exits to sidestep weekend gaps and extended drag.

Conclusion: Navigating the Limbo The fate of 3× and 5× crypto ETFs rests on the SEC’s final reading of Rule 18f-4. Whether through conditional approval, tougher disclosure or outright rejection, issuers and investors must account for daily compounding decay, counterparty intricacies, and stringent risk controls. In the meantime, hedged, options-based and intraday strategies offer calibrated exposure to turbocharged crypto markets as the SEC determines how much leverage the market can safely bear.