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

Record-breaking leverage is sweeping across the entire financial system, from retail investors to hedge funds, banks, and even money market funds—none are spared.

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

Retail demand for leveraged ETFs has soared to historic highs, especially since April this year, following an explosion in earnings expectations for stocks like Micron Technology, showing exponential growth. Meanwhile, banks’ exposure to hedge funds has swollen from about $2 trillion a few years ago to around $4.5 trillion, with the average total leverage ratio of U.S. hedge funds nearly doubling since 2022.

Simon White points out that financing costs are now at high levels, and loan collateral is often the highly volatile AI stocks driving this market rally—a combination that has appeared near market tops many times in history. He emphasized, "The speed at which leverage creates wealth is like the speed of sound, but the speed at which it destroys wealth is like the speed of light."

Banks are the core hub for leverage transmission

White believes that understanding current risks requires first understanding the role banks play in the leverage chain.

Take the rapidly expanding leveraged ETFs as an example: their underlying leverage is almost entirely provided by banks. Banks typically use total return swaps to give ETFs double, triple, or even higher exposure, while holding cash equities and derivatives to hedge risks. These cash equities are again re-lent out via the repo market, adding leverage layer upon layer.

Data shows that the size of bank stock repo positions aligns closely with the total market capitalization of unleveraged ETFs, indicating that banks are consistently the primary funders of this market.

It is noteworthy that from the end of last year to early April, although leveraged ETFs saw capital outflows and shrinking valuations due to market adjustments, the size of bank stock repos continued to rise. This means another type of investor is taking on the leverage—hedge funds filled this gap by significantly increasing their long stock positions.

Hedge fund leverage is accumulated at multiple points, with staggering scale

Hedge fund leverage risks are not limited to equities. Basis trades—buying Treasury bonds while shorting futures—are a major source of hedge fund leverage risk. According to Fed estimates, as of the end of last year, these reached about $2.4 trillion.

Additionally, hedge funds may currently be more aggressively engaging in swap spread trades by buying Treasuries and paying swap rates to bet on widening swap spreads. Hedge funds repo Treasuries out to dealers and prime brokers to obtain cash, and also get other secured loans from prime brokers, with both totaling about $4.5 trillion in bank exposure to hedge funds.

The average total leverage ratio for U.S. hedge funds has nearly doubled since 2022; the cumulative effect of leverage further amplifies their already sizeable nominal exposures.

Private credit and insurance sectors also harbor hidden risks

The opacity of the private credit sector may mask extremely high leverage levels. According to Moody’s, loans from banks to private credit companies total about $300 billion, rising to $640 billion if undrawn commitments are included, and exceeding $900 billion if loans to private equity are added. This shows private credit is not isolated from the broader economic system.

The insurance industry too should not be ignored. Data shows that insurers’ leverage is now at its highest level in at least 25 years, further broadening the scope of systemic risk.

Money market funds are not exempt either

Even investors trying to avoid risk by placing funds in money market funds cannot entirely stay out of harm’s way. The Dallas Fed explains that due to balance sheet constraints, dealers cannot provide cash to funds via repo trades as the ultimate source, instead transmitting this demand en masse to money market funds, which then supply funds for bank repo transactions.

Data shows that hedge funds' repo borrowings and money market funds’ repo lending have risen almost in lockstep since the late 2010s. This means that when risk-taking behavior is so aggressive throughout the system, "off-market cash" is not as safe as it seems.

Financing costs and short-term rates are vital warning signs

Simon White suggests focusing on two indicators to gauge when leverage risks might surface. The first is the financing cost of stock leverage: the cost of bank-provided equity leverage is already high, and as collateral—mainly highly volatile AI stocks—becomes riskier, costs will climb further. The $1.4 trillion in margin debt is also costly to hold, and such high costs have historically appeared near market tops.

The second is short-term interest rates and swap spreads, which can serve as warning signs of bank stress. While large banks’ capital adequacy has somewhat improved, the above exposure size remains significant. If banks reduce leverage supply, it will drive up financing costs and shift financial market volatility from “shock absorber” mode to “amplifier” mode; forced selling and margin calls will reinforce each other in a feedback loop, intensifying market volatility.

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