Leverage Fuels Market Swings: Wall Street Warns of AI Rally Risks

Wall Street is sounding alarms over the escalating use of leverage in financial markets, warning that it is amplifying stock price volatility, particularly in the AI and semiconductor sectors. This surge in borrowed funds is creating new risks across the broader market.

Data reveals that US margin debt, the amount investors borrow from brokerages to buy securities, hit a record $1.4 trillion in May, a 54% increase from the previous year. Simultaneously, high-risk leveraged exchange-traded funds (ETFs), which aim to track underlying assets at two or three times their normal return, are experiencing rapid growth. Assets under management in these ETFs surged to a record $220 billion by early June, nearly doubling since late March.

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Leverage is building up in the market that is not properly recognized.

The Korean stock market is cited as a prime example of leverage risk materializing. The Korean market, heavily influenced by semiconductor stocks, saw significant price swings and even circuit breakers triggered during downturns, fueled by a large influx of leveraged investors. In recent weeks, leveraged ETFs accounted for up to half of the average daily trading volume for major companies like Samsung Electronics and SK Hynix, exacerbating price volatility.

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If you have to liquidate these positions in a short period of time, it's a terrifying amount.

Financial authorities are concerned. Lee Chan-jin, head of the Financial Supervisory Service in Korea, expressed regret over not preventing the launch of single-stock leveraged funds, noting that approximately 92% of holders are individual investors despite the high risk. Wall Street's deeper concern lies not just in potential investor losses but in leverage beginning to dictate market movements itself. Analysts describe a "triple or quadruple layering" of leverage, with margin debt used to buy options on leveraged ETFs.

Barclays estimates that ETF providers have purchased an additional $300 billion in derivatives since late March to increase investment exposure. Market makers, in turn, bought more common stocks to hedge derivative risks, further fueling the rally in AI and semiconductor stocks. The danger escalates during market downturns, as leveraged ETFs may sell common stocks to meet their target returns, potentially accelerating declines. Alexander Peltzman, global head of equity strategy at Barclays, called the potential for a rapid unwinding of these positions "terrifying" and the "biggest non-discretionary risk factor in the market right now." Concerns are rising about a "tail wagging the dog" phenomenon, where leveraged ETF volumes become so large they influence stock prices directly, distorting the market through predetermined buying and selling patterns.

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Too much money is flowing into leveraged single-stock products.