Record levels of leverage are sweeping through the entire financial system, impacting everyone from retail investors to hedge funds, banks, and even money market funds.
On July 2, macro strategist Simon White issued a warning that the risks of this leverage binge extend far beyond leveraged ETFs. He highlighted that leverage has deeply penetrated the broader financial system through bank balance sheets. Should a deleveraging process begin, a feedback loop could transform banks from "shock absorbers" for market volatility into "amplifiers."
Retail demand for leveraged ETFs has surged to historic highs, experiencing exponential growth particularly after the earnings expectations for stocks like Micron Technology exploded in April this year. Concurrently, bank exposures to hedge funds have ballooned from around $2 trillion a few years ago to approximately $4.5 trillion. The average total leverage ratio for US hedge funds has nearly doubled since 2022.
Simon White pointed out that the current cost of financing is already elevated, and the loan collateral often consists of the same high-volatility AI stocks that have been driving the recent market rally. He noted that this combination has historically appeared near market tops on multiple occasions. He emphasized, "Leverage creates wealth at the speed of sound but destroys it at the speed of light."
Banks: The Central Hub of Leverage Transmission
White argues that to understand the current risks, one must first comprehend the role banks play in the entire leverage chain.
Taking the rapidly expanding leveraged ETF market as an example, the leverage behind these products is almost entirely provided by banks. Banks typically offer 2x, 3x, or even higher multiples of exposure to ETFs through Total Return Swaps, while holding underlying stocks and derivatives for hedging. These cash stocks are then often re-lent out in the repo market, creating layers of leverage.
Data shows that the scale of banks' stock repo positions closely aligns with the total market capitalization of leveraged ETFs (non-leveraged), indicating that banks remain the core providers of funding in this market.
It is noteworthy that from the end of last year to early April this year, while leveraged ETFs experienced capital outflows and shrinking market caps due to market adjustments, bank stock repo volumes continued to rise. This suggests another type of investor was picking up the leverage slack—hedge funds filled this gap by significantly increasing their long equity positions.
Hedge Fund Leverage: Multifaceted Accumulation on a Staggering Scale
The leverage risk for hedge funds is not confined to equities. Basis trades—buying Treasuries while shorting futures—are a major source of leverage risk for hedge funds. Estimates from Federal Reserve data suggest this activity reached approximately $2.4 trillion by the end of last year.
Furthermore, hedge funds are likely also more actively engaged in swap spread trades, betting on a widening of the swap spread by purchasing Treasuries and paying on interest rate swaps. Hedge funds repo these Treasuries to dealers and prime brokers to obtain cash while also receiving other secured loans from prime brokers. Combined, these activities contribute to the roughly $4.5 trillion exposure banks have to hedge funds.
The average total leverage ratio for US hedge funds has nearly doubled since 2022. This layering of leverage further magnifies what are already substantial nominal exposures.
Private Credit and Insurance: Hidden Vulnerabilities
The opacity of the private credit sector may be concealing significant leverage levels. According to Moody's estimates, bank loans to private credit firms stand at around $300 billion. Including undrawn commitments raises the figure to about $640 billion, and adding loans to private equity pushes it over $900 billion. This indicates that private credit is not isolated from the broader economic system.
The insurance industry is also a cause for concern. Data shows that leverage ratios for insurers have risen to their highest levels in at least 25 years, further broadening the scope of potential systemic risk.
Money Market Funds Are Not Immune
Even investors who choose to avoid risk by placing funds in money market funds are not entirely insulated. As explained by the Dallas Fed, due to balance sheet constraints, dealers cannot serve as the ultimate source of cash for funds via repo transactions. Instead, they pass this demand extensively to money market funds, which then provide the funding for bank repo trades.
Data indicates that hedge funds' repo borrowing and money market funds' repo lending have climbed almost perfectly in sync since the late 2010s. This means that when system-wide risk-taking is this aggressive, "cash on the sidelines" is not as safe as it might appear.
Financing Costs and Short-Term Rates: Critical Warning Signals
Simon White recommends focusing on two key indicators to gauge when leverage risks might begin to materialize. The first is the financing cost for stock leverage: the cost for banks to provide equity leverage is already high and is likely to increase further as loan collateral often consists of increasingly volatile AI stocks. The carrying cost of the current record $1.4 trillion in margin debt is also elevated, a condition historically associated with market tops.
The second indicator is short-term interest rates and swap spreads, which can serve as early warning signals for bank stress. Although major banks have improved their capital adequacy ratios compared to the past, the sheer scale of the aforementioned exposures is significant. Should banks begin to contract their supply of leverage, it would push financing costs higher and switch the financial market's response to volatility from the current "shock absorption" mode to an "amplification" mode. Liquidations and margin calls would create a mutually reinforcing feedback loop, intensifying market swings.
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