Is Leverage in U.S. Stocks Stalling? Wall Street 'Has Exhausted Its Balance Sheet'

Behind this "balance sheet magic" lies a systemic risk driven by the substantial profits of prime brokerage, and the next Situational Awareness may already be on the way.

Written by: Zhao Ying, Wall Street Insights

When internal risk controls hit their limits, Wall Street's answer is not to hit the brakes, but to move the goalposts.

According to a recent Bloomberg report, Barclays Bank, after reaching the financing limit for hedge fund clients during the Asian AI stock trading boom earlier this year, borrowed part of the capital quota from its macro rates trading desk through an internal auction mechanism to maintain loan expansion for Asian hedge fund clients. Meanwhile, traders from several banks, including Goldman Sachs, began pressuring hedge fund clients to hold more short positions—this operation compressed the balance sheet usage on paper but did not actually reduce the overall market leverage level.

Goldman Sachs CFO Denis Coleman stated earlier this month that the demand for equity financing continues to exceed the industry’s available capacity, allowing Goldman to "selectively deploy resources." According to Goldman’s prime brokerage data, as of the week ending October 18, the net leverage ratio of U.S. long-short hedge funds fell by 3.2 percentage points to 43.7%, marking a five-year low—but this decline was almost entirely due to an increase in short positions rather than a reduction in long positions. Since July 31, long leverage has only decreased by 0.5 percentage points to 128.8%, while short leverage has increased by 8.0 percentage points to 85.1%, the highest level in five years, with an overall total leverage ratio of about 214%, which has actually risen compared to before.

Barclays 'Moving the Goalposts': Internal Auctions Bypassing Risk Control Limits

According to Bloomberg, Barclays executives earlier this year aimed to expand financing for Asian hedge fund clients to seize the opportunity presented by the rapid rise of AI stocks in Asia. However, the bank had reached its internal financing limits. The solution was for the macro rates trading desk to transfer part of its capital quota to the prime brokerage business through an internal auction mechanism—operated by the global markets division led by Adeel Khan.

Barclays officially stated that the bank "dynamically deploys investment banking balance sheet while maintaining strict control over risk and return in seizing client opportunities." However, according to information from insiders cited by Bloomberg, this "strict control" only truly came into play after the limits were reached, and the response was to redefine the limits themselves.

It is noteworthy that the British bank began reviewing this market area in July when cracks appeared in AI trading and explicitly focused on the financing business of London prime brokers for Asian stocks in September.

Ironic Scene: Rejecting 'AI Stock God' Yet Still Using Limits to the Extreme

The most ironic detail in this event is that Barclays previously refused to accept hedge fund Situational Awareness as a client on the grounds of concentration risk in the AI sector—this decision has since proven to be correct.

Situational Awareness, founded by Leopold Aschenbrenner, operates with about 4 times leverage through total return swap instruments, mainly establishing positions in AI infrastructure and short software stocks via Goldman Sachs. In July, when the AI sector corrected, margin calls followed, forcing the fund to sell all its public holdings at about a 10% discount to Citadel, owned by Ken Griffin, with the fund size plummeting from about $45 billion to about $10 billion within days.

However, although Barclays successfully avoided this year's most conspicuous liquidation event, it still pushed the financing limits for Asian hedge funds to the extreme, even having to borrow capital from other business desks. This indicates that the collapse of Situational Awareness was merely the most visible symptom of a systemic issue where a few trading firms' balance sheets collectively bet on the same AI theme, rather than the root cause.

Industry Under Pressure: Goldman Sachs and UBS Acknowledge Financing Saturation

Barclays is not alone. According to Bloomberg, Goldman CFO Denis Coleman stated earlier this month that the demand for equity financing continues to exceed the industry’s available capacity; he had previously stated in July that there was "demand far exceeding the scale we are willing to undertake" in the prime brokerage and fixed income financing sectors. UBS CFO Todd Tuckner also mentioned in July that the bank's equity balance sheet usage in prime brokerage was becoming "more restrained."

Bloomberg strategist Simon White had already issued a warning in June, pointing out that futures financing rates had surged sharply due to a spike in demand for total return swaps, with the leverage exposure provided to the market by dealers reaching record levels, and stock inventories rising to a high of $223 billion, indicating that "dealer balance sheets may face supply bottlenecks due to regulatory constraints." Barclays' subsequent actions are a direct confirmation of this "supply bottleneck."

The Trick of 'Adding Short Positions': Total Leverage Rises Instead of Falls

When balance sheet space runs out, Wall Street's "solution" is to have clients add to their short positions. According to Bloomberg, traders from banks like Barclays and Goldman Sachs collaborated with hedge fund clients to encourage them to hold more short positions to reduce the balance sheet usage on the prime brokerage's books—funds from short positions could be internally used to finance long positions.

However, Goldman’s prime brokerage data reveals the essence of this operation. Goldman’s Lee Coppersmith noted in the weekly report on October 18 that the decline in net leverage since the end of July "has almost entirely come from an increase in shorts rather than a decrease in longs." Long leverage has only slightly decreased by 0.5 percentage points to 128.8%, while short leverage has surged by 8.0 percentage points to 85.1%, at the 100th percentile over the past five years, with an overall total leverage ratio of about 214%, which has risen since the collapse of Situational Awareness.

UBS trader Torsten Sippel also pointed out in the weekly report on October 18 that last week's market movements "looked like a position reset rather than a full stock liquidation, very similar to the deleveraging triggered by Situational Awareness months ago," and warned that with hedge funds' net exposure having dropped to the 30th percentile over the past five years and total leverage remaining above the 90th percentile, "if profit and loss pressures persist, the portfolio faces further deleveraging vulnerabilities."

Coppersmith also admitted that if performance pressures continue, "there is indeed room for further deleveraging through selling longs and covering shorts." A total leverage of 214% means that if longs and shorts move in opposite directions simultaneously—just as happened when AI infrastructure stocks fell and software stocks rebounded in July—the so-called "hedge" will quickly fail.

Substantial Returns Drive Risk: Prime Brokerage Becomes Revenue Engine

Why go to such lengths to break through limits? The answer lies in profits. According to Bloomberg's forecast, Barclays' equity business is expected to announce about £865 million (approximately $1.2 billion) in third-quarter revenue this Thursday, which would be the bank's strongest third-quarter performance since 2009—the year after the acquisition of Lehman Brothers' North American business.

Prime brokerage has been the core driver of Wall Street's equity revenue this year, and the market volatility that has driven trading revenue surges is largely generated by the leverage provided by prime brokers. This creates a self-reinforcing loop: banks lend to funds, funds push up AI stock prices, AI volatility brings trading revenue, and revenue provides more balance sheet space for prime brokerage—until this cycle reverses.

Currently, the British bank is reviewing the Asian stock books of London prime brokers, and UBS has characterized last week's deleveraging trend as a replay of the Situational Awareness collapse, while overall total leverage remains close to historical highs.