Investment banks like Goldman Sachs and BNP Paribas are developing and marketing exotic "crash puts" to help other banks manage the significant "gap risk" associated with leveraged exchange-traded funds (ETFs). These derivatives are designed to hedge against extreme single-day drops in underlying assets, which could cause a leveraged ETF to lose more than its net assets, leaving banks on the hook for the difference. For example, Goldman Sachs pitched an "Expensive Crash Cliquet" offering yields between 14.2% and 20% for assuming tail risk for up to a year on South Korean stocks like SK Hynix Inc. and Samsung Electronics Co. BNP Paribas offered daily gap puts on SK Hynix with a maximum maturity of six months and a strike price at 55% of the underlying stock, promising up to 6.5%, and 5.5% for Samsung. These premiums are higher due to the growing popularity of leveraged ETFs, which now hold assets approaching a quarter trillion dollars globally, with over 700 in the US alone managing about $160 billion after peaking at over $200 billion in June.
Leveraged ETFs, especially those tracking individual stocks like SK Hynix, Micron Technology Inc., Nvidia Corp., Tesla Inc., and SanDisk Corp., have become a significant market segment. Issuers of these ETFs, particularly in the US and Hong Kong, use total return swaps from banks or non-bank dealers to achieve their daily return targets. The dealers hedge their exposure by trading underlying stocks, futures, or options, while the ETF pays a financing rate and posts collateral. However, this structure exposes banks to "gap risk" if a stock falls sharply enough in a single session—over 50% for a 2X fund or 33% for a 3X fund—which could exceed the ETF's net assets. Despite South Korea having a 30% daily price limit and circuit breakers, crash puts are calculated on an official close-to-close basis, meaning a halted stock still poses risk.
South Korean retail investors have been particularly active in leveraged US ETFs, especially in chip stocks. They were net buyers of $4.67 billion in US stocks in July. However, these investors have suffered substantial losses; Citi estimated that Korean retail investors lost approximately $38.7 billion on single-stock leveraged ETFs tied to Samsung Electronics and SK Hynix in one month. For instance, investors poured nearly $4 billion into SOXL (Direxion Daily Semiconductor Bull 3X Shares) in June and July, but the value of their holdings only increased by $460 million, from $5.35 billion to $5.81 billion. Korean authorities have tightened regulations on single-stock leveraged ETFs, introducing measures like higher minimum deposits and proposed caps of 20% of total investment assets, which has led to a significant drop in trading activity in these domestic products. Trading in TIGER SK Hynix and TIGER Samsung Electronics leveraged ETFs saw massive declines, from trillions of won to hundreds of billions after the new rules were implemented, suggesting risk-seeking investors may increasingly turn to overseas markets. Regulators are also seeking emergency powers to intervene during extreme volatility.
While the article headline references "A Quant and a Korean Dentist Push the Limits of Leveraged ETFs," the content available focuses on the broader market dynamics of leveraged ETFs, the risk management strategies employed by banks, and the impact of these products on South Korean investors and regulators. It details how investment banks are actively facilitating the transfer of tail risk through sophisticated derivatives. It also highlights the substantial losses incurred by retail investors, particularly in South Korea, and the subsequent regulatory crackdown aimed at curbing speculative trading in these high-risk products.
