(Bloomberg) — Amid a red-hot run in the shares of MicroStrategy Inc. last month, Matt Tuttle got some bad news from the prime brokers for his booming leveraged ETF linked to the shares of the crypto-centric company.
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The prime brokers — units within banks that work with their clients on activities like securities lending — had reached their limits on how much swap exposure they were willing to offer for his roughly month-old fund, the T-Rex 2X Long MSTR Daily Target ETF (ticker MSTU), which by some measures was the most volatile exchange-traded fund to ever hit Wall Street at the time of its launch.
The ETF, which offers double the return on the highly turbulent shares of MicroStrategy, was surging in mid-October, luring hundreds of millions of dollars. To achieve the juiced-up returns he was targeting, Tuttle had been buying swaps via his prime brokers — a typical tactic. But only three firms had agreed to work with him given the gyrations in MicroStrategy — the largest publicly traded corporate holder of Bitcoin — and all three started to reach capacity constraints.
At one point, he needed $100 million worth of exposure and the firms were only offering a total of $20 million. So, to fulfill his fund’s mandate, he turned to buying call options.
“If this was a fund on Procter & Gamble, I could get as much swap exposure as I wanted,” said Tuttle. “But MicroStrategy is a different beast.”
The message is that the unprecedented boom in such a highly leveraged ETF is testing the risk appetite among some key Wall Street players — the prime brokers. And while buying options to fulfill a fund’s goals isn’t controversial, it shows the hurdles that had to be overcome to meet the surging demand for the product.
It was a similar picture at Tuttle’s rival, the Defiance Daily Target 2X Long MSTR ETF (MSTX), which debuted in August. Sylvia Jablonski, the chief executive officer of Defiance ETFs, said she started using options to help meet the ETF’s stated leverage soon after its launch. The fund began by offering 1.75 times leverage, before boosting it to two times after Tuttle introduced his ETF.
The episodes can also be chalked up to the extremely turbulent nature of MicroStrategy itself. The shares slumped as much as 22% on Thursday after Citron Research said it’s betting against the company. On Friday, it was up as much as 8% in morning trading.
“It should be making us question: Has the ETF jumped the shark?” said Dave Mazza, chief executive officer at ETF issuer Roundhill Investments. “We’re at a point where we’re pressing the boundaries of what the marketplace will allow.”
High Octane
The two 2x MicroStrategy funds now have assets of roughly $4 billion combined as of Thursday’s close. MSTU is up more than 600% from its launch through Thursday, and MSTX has gained 480%. Maintaining these high-octane ETFs has become even harder since Donald Trump’s election victory, as investors have seized on his pro-crypto stance to push Bitcoin to a record high. MicroStrategy this month announced its largest-ever Bitcoin purchase and its share price has added more than 70% since Nov. 5, as of Thursday’s close.
“When something goes parabolic, that’s when things get all out of whack,” said Tuttle. The days of needing $100 million of exposure now seem quaint to him. These days, there have been times he’s needed five times that amount.
A market-maker associated with the MicroStrategy swap business for these two leveraged ETFs and who spoke on the condition of anonymity says the funds are testing the risk limits of prime-broker desks, especially as the products keep growing. The ETFs’ volatility also requires large margin down-payments, the person said. Tuttle says the volatility of the underlying stock explains why swap counterparties are raising margin requirements.
Cantor Fitzgerald, Marex and Clear Street were the prime brokers listed for MSTU and MSTX as of Thursday, data compiled by Bloomberg show. Cantor and Marex declined to comment. Clear Street didn’t respond to a request for comment.
From MSTX’s inception in mid-August through Wednesday, the stock soared almost four times as quickly as the digital currency, suggesting that the levered wagers may have amped up the share rally. In the year through July, MicroStrategy’s advance was only twice as fast.
Retail Draw
Leveraged single-stock ETFs became available to US investors in 2022, amid warnings from regulators about their riskiness, and they tend to attract individual investors who are sometimes chasing quick profits. There are now more than 90 leveraged or inverse ETFs based on a single stock, data compiled by Bloomberg Intelligence’s Athanasios Psarofagis show.
For the ETF issuers, using options can introduce complexities, including having to track the theoretical rate of change of the derivative’s price as the underlying shares fluctuate. Tuttle now devotes part of his afternoon to assessing his option needs, working with his traders and market-makers, and the amount depends on the ETF flows and movement in MicroStrategy shares.
When banks are evaluating their limits for financial products like this, they have to take into account broad exposure to a particular stock across multiple desks, or constraints related to risk and balance sheets, said Jablonski at Defiance.
“This risk-assessment process tends to become even more stringent when dealing with more volatile assets, such as MicroStrategy, cryptocurrencies or high-growth stocks,” she said. “With an improved understanding of how to manage and hedge these products effectively, new players may increasingly be willing to collaborate in trading activities.”
