Leveraged ETFs are just the tip of the iceberg: from retail investors to money market funds, systemic risk is quietly spreading.

Record-high leverage is sweeping through the entire financial system, sparing no one from retail investors to hedge funds, banks, and even money market funds.

On July 2, Bloomberg macro strategist Simon White warned that the risks of this leverage feast go far beyond leveraged ETFs, deeply penetrating the entire financial system through bank balance sheets. Once the deleveraging process begins, feedback loops will turn banks from "shock absorbers" of market volatility into "amplifiers."

Retail demand for leveraged ETFs has surged to historic highs, growing exponentially especially after Micron Technology and other individual stocks saw explosive earnings expectations in April this year. Meanwhile, bank exposure to hedge funds has expanded from about $2 trillion a few years ago to about $4.5 trillion. The average gross leverage ratio of US hedge funds has nearly doubled since 2022.

Simon White pointed out that financing costs are already at elevated levels, and the loan collateral often consists of highly volatile AI stocks that have driven this rally—a combination that has historically appeared near market tops multiple times. He emphasized, "Leverage creates wealth at the speed of sound but destroys it at the speed of light."

Banks are the Core Hub of Leverage Transmission

White believes that to understand the current risks, one must first understand the role of banks in the entire leverage chain.

Take leveraged ETFs, which have expanded rapidly in recent years—virtually all of their leverage is provided by banks. Banks typically offer ETFs 2x, 3x, or even higher exposure through total return swaps, while holding cash stocks and derivatives for risk hedging. These cash stocks are then lent out again via the repo market, creating layers of leverage.

Data shows that bank stock repo positions are highly correlated with the total market cap of leveraged ETFs (unleveraged), indicating that banks have always been the core liquidity providers in this market.

Notably, from late last year to early April this year, while leveraged ETFs saw outflows and shrinking market caps due to market corrections, bank stock repo positions continued to rise. This means another class of investors is taking over the leverage—hedge funds have filled the gap, significantly increasing long stock positions.

Hedge Fund Leverage Accumulates at Multiple Points, Scale Alarming

Hedge fund leverage risks are not limited to equities. The basis trade—buying Treasuries while shorting futures—is a major source of hedge fund leverage risk. According to Fed data estimates, its scale had reached about $2.4 trillion by the end of last year.

Additionally, hedge funds may now be more actively engaging in swap spread trades, buying Treasuries and paying interest rate swaps to bet on widening swap spreads. Hedge funds repo Treasuries to dealers and prime brokers for cash, while also obtaining other secured loans from prime brokers. Together, these form bank exposure to hedge funds of about $4.5 trillion.

The average gross leverage ratio of US hedge funds has nearly doubled since 2022. The compounding effect of leverage further amplifies the already massive notional exposure.

Hidden Risks in Private Credit and Insurance

Opacity in the private credit sector may mask significantly high leverage levels. According to Moody's estimates, bank loans to private credit firms amount to about $300 billion, rising to about $640 billion when including undrawn commitments, and exceeding $900 billion when adding loans to private equity. This suggests that private credit is not isolated from the broader economic system.

The insurance industry cannot be ignored either. Data shows that insurance company leverage has risen to its highest level in at least 25 years, further expanding the coverage of systemic risk.

Money Market Funds Are Not Immune

Even investors who choose to avoid risk by parking cash in money market funds are not completely safe. As explained by the Dallas Fed, due to balance sheet constraints, dealers cannot act as the ultimate source of cash for repo transactions to funds. Instead, they pass this demand heavily to money market funds, which then provide funding for bank repo trades.

Data shows that hedge fund repo borrowing and money market fund repo lending have risen almost in lockstep 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 seems.

Financing Costs and Short-Term Rates Are Key Early Warning Signals

Simon White suggests focusing on two types of indicators to gauge when leverage risks begin to materialize. First, the financing cost of stock leverage—the cost for banks to provide stock leverage is already high, and with loan collateral often being increasingly volatile AI stocks, costs will rise further. The current record $1.4 trillion in margin debt carries high holding costs; historically, such high costs often appear near market tops.

Second, short-term interest rates and swap spreads can serve as early warning signals for bank stress. Although large banks' capital adequacy ratios have improved compared to the past, the scale of these exposures is not negligible. Once banks contract leverage supply, it will push up financing costs and switch financial market volatility from the current "damping" mode to "amplifying" mode, with liquidations and margin calls forming a mutually reinforcing feedback loop that intensifies market volatility.

Risk Warning and Disclaimer

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