Institutions have traditionally been at the center of the financial storm. In 1998, hedge fund Long-Term Capital Management triggered a global crisis. Bear Stearns and Lehman Brothers were two large firms contributing to the crisis that accelerated throughout 2008.
In these cases, excessive leverage was to blame. Individual investors are now using leverage, and they might not understand the impact their trades will have on their wealth.
Leveraged exchange-traded funds have become popular and by some estimates contain at least $50 billion in assets. These funds are often viewed as a form of portfolio insurance by individuals who buy inverse funds to profit from a market decline.
Inverse leveraged funds are designed to deliver two or three times the gain of their underlying index on days when the index falls. These funds rebalance daily, and that rebalancing could precipitate the next major market crisis.
If stocks fall 3 percent in a day, leveraged inverse funds should have gains of 6 to 9 percent. In the moments before the market closes, they will need to rebalance, and they will be placing large orders at the market prices to close profitable positions and open new trades.
Futures markets are very liquid, but the total dollar volume of S&P futures contracts traded on the Chicago Mercantile Exchange totals about $7 billion. There is more than $50 billion in leveraged funds.
When the funds need to rebalance, there might not be enough liquidity in the market to allow for trades at reasonable prices.
Other traders know the funds will be required to rebalance and should be ready for the orders. This compounds the problem, since they will be in a position to demand steep price concessions in order to take the other side of the trade. As individuals see leveraged funds are not tracking the indexes as closely as expected, they might rush to sell and fuel more market volatility.
Excessive volatility can set off an unpredictable series of events in the markets and an end-of-day leveraged-fund rebalancing window could be the start of the next market crisis.
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