The relative calm of financial markets at the beginning of 2026 has been shattered this week, triggered by tensions between the United States and Europe over Greenland and fears of widening budget deficits following the announcement of snap elections in Japan. US equities dropped sharply, wiping out year-to-date gains, and forty-year Japanese government bond yields rose above 4 percent. Meanwhile, instead of gaining value—as in previous episodes of market turmoil—the US dollar weakened and ten-year US Treasury yields climbed to 4.3 percent, reinforcing concerns that both assets may no longer serve as “safe havens.” Financial markets recovered on Wednesday when President Donald Trump said there was a framework for a deal with NATO over Greenland
The market volatility highlights growing fragility in the financial system—a development shaped in large part by a buildup of leverage across financial institutions and market activities, as well as their increasing linkages to the banking sector. This situation demands careful monitoring and stronger risk-management measures by financial authorities and market participants to reduce vulnerabilities and mitigate potential shocks.
From retail traders to hedge funds, leverage is rising
Leverage starts with retail investors using margin debt—borrowing from their brokerage firms to buy securities, using their existing investments as collateral. The amount of margin debt in the United States reached a record $1.2 trillion by late December 2025. At the same time, investors have added another $250 billion in leveraged exchange-traded funds (ETFs). While still a relatively small share of total ETF assets under management (AUM)—estimated at $13.4 trillion at the end of 2025—leveraged ETFs account for around 12 percent of daily ETF trading volume.
Leveraged ETFs reset their exposure daily to maintain their target leverage. In volatile markets, this practice causes the fund’s value to erode over time—making leveraged ETFs a risky instrument for investors with holding periods longer than a single day. In essence, the high degree of leverage embedded in these retail investments can multiply both gains and losses. The problem is that the latter can trigger margin calls from brokerage firms, forcing fire sales of securities and further amplifying market turmoil. More importantly, hedge funds—with $12.5 trillion in AUM—have significantly increased their leverage across a range of trading strategies to the highest levels since comprehensive data collection began in 2013. Specifically, their mean gross leverage ratio—defined as total market exposure, including long and short positions and derivatives, relative to net asset value (NAV)—has climbed to eight times NAV, up from around five times in 2016 (see chart).
In particular, the volume of Treasury basis trades—long positions in cash Treasuries combined with short positions in futures to exploit small pricing discrepancies—has risen markedly. Hedge funds’ long US Treasury exposure has reached a new record of $2.4 trillion, equivalent to around 10 percent of all US Treasuries held by the private sector. In recent years, hedge funds have also used the interest-rate swap market to implement these basis trades, with current exposures estimated at $631 billion.
When interest rates and securities prices move contrary to expectations, hedge funds incur losses, prompting them to unwind positions and generating stress in those markets. This dynamic was evident in April 2025, when hedge funds unwound their basis trades following adverse market movements following Trump’s announcement of reciprocal tariffs.
Notably, hedge funds—largely based in the United States—have expanded their basis-trade strategies to the larger and more liquid government bond markets of the euro area, particularly Germany, France, and Italy. Hedge funds face the same challenges in their euro area basis trades, including a potential lack of euro funding and adverse price movements, both of which could trigger fire sales of underlying bonds and cause stress in affected markets. Moreover, hedge funds themselves have become potential transmission channels, spreading stress from the US Treasury market to other sovereign bond markets if losses force them to raise liquidity by selling assets elsewhere.
Private credit introduces new vulnerabilities
Leverage has also risen in the rapidly growing private credit market, with the debt-to-earnings ratio of some borrowers reportedly reaching a historic high. According to the New York Fed, the private credit market has expanded from $500 billion in 2020 to $1.3 trillion by late 2025. Some observers even expect it to reach $5 trillion by 2029.
The private credit market has increasingly relied on covenant-lite loans, a worrisome development reminiscent of the practices that were widespread prior to the global financial crisis. Taken together, these trends raise the risk that private credit could become a source of financial instability if overall conditions deteriorate.
Beyond direct borrowing, private credit funds also invest in leveraged instruments such as collateralized loan obligations (CLOs) to enhance returns. This essentially amounts to a less transparent—or “hidden”—form of leverage. CLOs issue debt and equity tranches to investors and use the proceeds to purchase diversified portfolios of roughly two hundred loans or corporate bonds, structuring cash flows into tranches with varying risk-return profiles. The CLO market has grown to approximately $1.4 trillion, forming part of a broader $13.3 trillion structured credit-fixed income market, which also includes asset-backed and mortgage-backed securities.
Driven in part by their participation in the private credit market, life insurance companies have also increased leverage, with asset-to-equity ratios approaching the top quartile of their historical range—now nearly twelve times.
Nonbank–bank linkages heighten systemic risk
Commercial banks—while remaining profitable and well capitalized—have increasingly funded leveraged nonbank financial entities and activities. Bank lending to nonbank financial institutions—such as special purpose vehicles, CLOs, asset-backed securities, private equity funds, and business development companies—has grown at a robust pace, reaching $2.5 trillion.
In addition, banks themselves have originated $1.5 trillion in leveraged loans, reflecting an average annual growth rate of 12.2 percent since 1997. While such exposures account for roughly 14 percent of total bank assets, stress among these highly leveraged nonbank entities—or in the leveraged loan market—could generate losses and distress at individual institutions, if not across the entire banking system.
As a result, the Federal Reserve concluded in its November 2025 Financial Stability Report that “when taken together, the overall level of vulnerability due to financial sector leverage was notable.” This assessment underscores the importance of leverage as a key issue for regulators and risk managers when evaluating financial stability risks in 2026—and especially in responding to the current bout of market turbulence.
Elevated leverage increases the fragility of financial institutions and markets and amplifies the severity of potential market corrections. This reality calls on financial authorities to adopt measures commensurate with the risks identified in the November 2025 FSR—particularly steps aimed at reducing the vulnerability of the financial system. Meanwhile, private investors should exercise greater caution to limit exposure and mitigate the fallout from future market disruptions.
Hung Tran is a nonresident senior fellow at the Atlantic Council’s GeoEconomics Center, a senior fellow at the Policy Center for the New South, a former executive managing director at the Institute of International Finance, and a former deputy director at the International Monetary Fund.
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