Original author: Zhang Yaqi

Original source: Wall Street Watch

Global stock markets have repeatedly hit new highs driven by the AI wave, but the fuel supporting this rally has become increasingly dangerous – from the United States to South Korea, financing balances and the scale of leveraged ETFs have both reached historical limits, and the pro-cyclical nature of leverage itself is multiplying the tail risks of market volatility.

The margin debt in the U.S. soared 54% year-on-year in May, reaching a historic peak of $1.4 trillion; at the same time, the total asset size of leveraged ETFs nearly doubled in less than 70 days, breaking through $220 billion around June 3 (FactSet data). The risk of this leveraged frenzy has manifested first in the South Korean market: after the KOSPI index plummeted 10% last week, triggering a trading halt, it quickly rebounded, only to halt trading again, causing significant fluctuations that affected the pullback of AI-related stocks in the U.S. market.

Alarms have started ringing on Wall Street. Barclays analyst Alexander Altmann warned clients this week that leveraged funds have accumulated approximately $300 billion in derivatives linked to individual stocks and indices since the end of March; if this scale needs to close positions in a short time, "the impact will be chilling," characterizing it as "without a doubt the largest source of non-autonomous risk in the current market." Morgan Stanley also issued a warning on June 15, pointing out that marginal buyers of U.S. stocks are more dependent on leveraged financing than ever, and this financing is becoming more expensive and scarce. One of the largest brokerage firms in the U.S., Charles Schwab, has tightened margin requirements this month and issued margin calls to clients exceeding the new thresholds.

All of this points to the same logic: when the leverage-driven rise reaches its limit, the backlash of deleveraging will proportionally magnify the decline.

U.S. Stock Leverage: Scale and Intensity Set New Records

The enthusiasm of American investors for borrowing to invest in stocks has reached unprecedented heights.

Data from the Financial Industry Regulatory Authority (Finra) shows that in May, the U.S. stock margin balance grew 54% year-on-year, reaching $1.4 trillion. Alongside this, the leveraged ETF market has seen explosive expansion – these products typically track double or triple the daily fluctuations of the underlying assets. According to FactSet, from March 30 to June 3, the total assets of leveraged ETFs surged from around $115 billion to $220 billion.

The most sought-after products are concentrated in technology stocks and semiconductor stock indices, as well as individual stocks like Tesla and Nvidia, and even the recent SpaceX leveraged funds. The Direxion three-times leveraged ETF tracking the semiconductor index has seen a cumulative increase of about 700% from late March to late June – however, on June 5 alone, it plummeted by 31%, amplifying the decline of the benchmark index threefold.

From hedge funds to retail investors opening accounts on Robinhood, all types of investors are flooding in. Nationwide Investment Management Group's chief market strategist, Mark Hackett, expressed concern:

"I worry that we are accumulating a form of latent leverage that is not fully understood. Some people, with a lottery mindset, are borrowing to buy options on leveraged ETFs – it’s already three or four layers deep."

Derivative Mechanism: Pro-Cyclical Amplifier

The danger of leveraged ETFs lies not only in their own profit and loss amplification mechanisms but also in the fact that they can distort the stock price movements of the assets they track – known in market terms as the "tail wagging the dog" effect.

Barclays estimates that to absorb the continuous influx of new funds, leveraged funds have accumulated approximately $300 billion in derivative contracts linked to individual stocks and indices since the end of March. After market makers take on these contracts, they must buy the corresponding spot stocks to hedge their own exposure, further boosting the gains of technology and semiconductor stocks this year.

The problem is that this mechanism also applies when the direction reverses and has a self-reinforcing characteristic. Once the underlying stocks decline, the assets of leveraged funds shrink, forcing them to reduce positions, which then depresses stock prices and triggers further redemptions and position reductions, creating a negative spiral.

ETF.com research director Dave Nadig issued a warning:

"Any market with known, price-insensitive buyers and sellers will create problems. I am genuinely worried that as more money flows into this leveraged single-stock product system, the stronger this pro-cyclical trading effect will become."

South Korea's Warning: Extreme Concentration Combined with High Leverage

The recent events in the South Korean market are seen by market participants as a stress test model for reference.

According to CICC research report, the KOSPI index has accumulated an increase of 87% this year, leading the world, mainly driven by the storage chip leaders like Samsung Electronics and SK Hynix. However, the highly concentrated holding structure and extreme leverage have sharply increased market vulnerability: on Tuesday, due to concerns about the storage chip expansion plans and news discussions in South Korea about taxing unrealized gains, the KOSPI plummeted 10% in one day, triggering a trading halt; it then strongly rebounded back above 9000 points within the next two trading days, only to trigger a halt again on Friday.

CICC estimates that the current in-market leverage multiplier in South Korea is between 2x to 5x, with a broad leverage scale reaching 271 trillion won, an absolute level that has hit historical highs – theoretically, a drop of 16% to 36% in the underlying assets could trigger margin calls. According to the Wall Street Journal, leveraged fund-related transactions tracking Samsung and SK Hynix recently accounted for as much as 50% of the average daily trading volume of those two stocks, significantly disturbing stock prices in both directions.

The head of South Korea's Financial Supervisory Service, Lee Chan-jin, openly expressed regret last week at a press conference for failing to stop the issuance of leveraged single-stock funds: "These are all high-risk products, with about 92% of the holders being retail investors. Despite consumer warnings, trading enthusiasm remains unabated."

Surging Financing Costs: Borrowing to Trade Stocks Is Becoming More Expensive

According to a previous Wall Street Watch article, Morgan Stanley's analysis reveals pressure accumulation from another dimension.

The key indicator for measuring stock financing costs – the AXW futures (which tracks the spread between the implied financing rate of the S&P 500 total return futures and the benchmark rate SOFR) – soared to +140 basis points last Monday for a one-month contract expiring in June, and even though the S&P 500 has since declined from its historical peak, this indicator remains at extremely high levels, marking its highest record since December 2020 (excluding the special year-end period).

Meanwhile, data from the New York Fed shows that as of the week ending on June 3, 2026, primary dealers in the U.S. held equity assets valued at $223 billion through securities financing methods such as repos, a historic high. The "stock financing dependency" indicator constructed by Morgan Stanley – calculated by dividing the stock repurchase scale of primary dealers by the free float market capitalization of the S&P 500 – has soared nearly 50% in the past year, approaching the historic peak in mid-March this year, indicating that the amount of borrowed funds behind each dollar of market value has increasingly intensified.

This financing demand is highly concentrated in a few sectors. Morgan Stanley's industry breadth data shows that in the past three months, only the information technology sector outperformed the S&P 500 among 11 GICS sectors, with a gain of 24.2% and excess returns of 13.3%; for about 70% of the trading days over the past year, the number of outperforming sectors has not exceeded five. This means that the overall market rise is actually supported by the leveraged funds of a very small number of sectors, and once this portion of capital begins to withdraw, the impact on the overall market will be magnified concurrently.

Once Deleveraging Starts, the Impact Will Be Multiplied

Morgan Stanley warns that the current situation constitutes a potential nonlinear risk: high financing costs force leveraged buyers to stop accumulating positions, the disappearance of marginal buyers causes the market to lose upward momentum, and the subsequent price correction will trigger deleveraging, with selling pressure being amplified by leverage, ultimately leading to a decline exceeding expectations. Historical data shows that the phase highs of AXW futures often coincide with the phase tops of the S&P 500.

What is even more worth noting is that Morgan Stanley's financial conditions index shows that from the outbreak of the Iran conflict to June 11, financial conditions have tighted equivalent to an interest rate hike of 31 basis points, mainly driven by rising yields on 10-year U.S. Treasury bonds and the appreciation of the dollar. However, as stock market indices continue to rise, most investors remain oblivious to this tightening – the stock market's rise itself contributed an easing effect of about -21 basis points on financial conditions, somewhat masking the pressures brought by other factors.

Morgan Stanley's baseline forecast is that the Federal Reserve will cut rates by 25 basis points in March and June of 2027, ultimately bringing the target range for the policy rate to between 3.00% and 3.25%. But the bank warns that once deleveraging triggers a stock market decline, investors will be forced to reassess financial conditions, leading to a repricing of the Fed's policy path, where the previously weighted pricing of tail risks from interest rate hikes will disintegrate first.

Alexander Altmann wrote in a report to clients: "The technical forces that previously amplified upward momentum through leveraged expansion may begin to reverse."

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