The evolution of hedge fund financing since the global financial crisis has shifted risk away from banks’ balance sheets but concentrated it within highly leveraged investment vehicles.
Situational Awareness’s recent meteoric rise and then seismic blowup took the hedge fund world by storm. Run by the enigmatic Leopold Aschenbrenner, the fund accrued gains of more than 1,000% since inception.
Aschenbrenner, like others riding the AI wave, took positions juiced by high levels of brokerage lending to elevate gains. He was operating at close to 400% leverage before Citadel stepped in to acquire much of its public portfolio, valued at $16bn. Leverage acts like a pendulum: the further it swings with you, the further it swings against you. The episode has exposed a deeper shift: leverage is no longer something the biggest firms reach for to get ahead, but something they now need just to stay competitive.
The linear growth of the AI trade encouraged many funds to double down and keep adding leverage to inflate positions. Banks extending credit to a trading novice like Aschenbrenner is not unusual. Despite several funds choosing to scale back exposure in recent weeks after the market whipsaw, borrowing has only dropped back to about the middle of its recent range, according to Vincent Lin, co-head of prime insights and analytics at Goldman Sachs. Running at high leverage has become standard practice across much of the industry; according to the Office of Financial Research, broker loans to hedge funds are now worth about 10% of the US GDP.
Wall Street banks’ Q2 earnings reinforced this notion: Goldman Sachs’ net revenue in Equities was $7.4bn, a 72% year-on-year increase, driven predominantly by higher revenues in Equities financing, while JPMorgan Chase’s were up 86%. Chris Kotowski, Managing Director at Oppenheimer, believes the recent results are unprecedented. “The last time we saw this kind of move upward – other than between 2019 and 2020 – was 2006, where we knew significant proprietary bets were going on.” During this period, Wall Street was running large balance-sheet-heavy bets which were fragile and got exposed in the market pullback of 2008.
While a sharp reversal might not be immediate and bank balance sheets remain well capitalised, debt still needs to be repaid if stock prices tumble. An S&P Global analysis of BNP Paribas, Barclays, Goldman Sachs and Morgan Stanley found that industry-wide gross leverage climbed roughly eight times NAV. This scale and interconnectedness of leverage means that any tightening of fund conditions or a sharp equity drawdown could result in a rapid deleveraging.
To mitigate this dynamic, funds, including Situational Awareness, try to control exposure by adding shorts elsewhere, options overlays, or uncorrelated positions financed with borrowed money. However, leverage is not just isolated and is often multi-layered within the portfolio, sometimes spread across equity relative value, macro, and rates trades. Trades meant to be independent end up correlated through leverage – a loss in one position triggers forced selling across the book, undermining a diversification thesis as it collapses under pressure rather than protecting it.
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Post-GFC regulation restricted how much risk banks could hold on their own balance sheets, pushing leveraged trades towards hedge funds instead. Fuelling the use of leverage, not abating it.Â
The change in capital flow coincided with the rapid proliferation of these investment vehicles; according to the Financial Stability Board, hedge funds manage 15 times as many assets as they did in 2008. Darrell Duffie, Senior Fellow, Stanford Institute for Economic Policy Research, articulates the potential squeeze more clearly: “Since the GFC and shift in regulation post-2008, there’s been a reduction in the amount of capital in the largest banks. In terms of total capitalisation, there’s been a drop, which makes the system less safe.”
Reduced capital means there is less of a buffer to absorb losses. Since banks are the primary lenders to hedge funds, their losses could have potentially larger systemic consequences if not managed prudently. Kotowski notes that Situational Awareness’s private investment vehicle arm – the firm holds a position in Anthropic – probably saved them from following a similar path to previous funds: “The precedents of Long-Term Capital [Management] and Archegos show what can happen when a fund gets into trouble and then it spills over into the banks. Even banks just sensing leverage concerns could trigger a rapid unravelling and cause immense pressure on the system.”
Central banks have begun to notice this friction. The BoE recently announced plans to curb fund borrowing levels in the gilt market, after strategy unwinds were seen as exacerbating any bond market sell-off. Michael Gray, President of Gray Capital Management, notes how vigilance towards leverage is growing across the financial ecosystem. “The Fed puts out its financial stability report, and this year they highlighted a concern about the increase in hedge fund leverage as a primary concern. Funds are using borrowing for investments, but if these investments are illiquid, they are getting stuck.” Kotowski adds that the question always comes back to how “sustainable this dynamic across the system is; it might be premature to call this a problem, but some activity is hard to explain.”
Meanwhile, several allocators also view leverage as no longer a peripheral concern but a primary consideration when assessing managers. Marcus Storr at FERI cited some positions taken by the largest multi-manager platforms as being up to 10x levered. Edoardo Rulli, Head of Hedge Funds at UBS, also noted that multi-strat growth over the past decade has coincided with a sharp uptick in leverage across the system, as borrowing goes hand in hand with capital being deployed in a multitude of directions.
Despite Situational Awareness’s blowout posing a warning about the dangers of trade bullishness morphing into recklessness, borrowing is now viewed as a necessity to stay competitive in a market so concentrated. “Stock price increases are not growing as quickly as margin lending,” concludes Duffie. When so many managers follow the same pattern, the risks associated with funds can spread beyond a case-by-case basis and pose questions on the fragility of the market.Â
