BIS: Hedge fund leverage could amplify market shocks

The Bank for International Settlements, based in Basel, has warned that rising leverage at hedge funds could magnify market shocks, citing a near-collapse in July of the AI-focused fund Situational Awareness.

In its quarterly review, the BIS said Situational Awareness came under severe pressure after a sharp deterioration in its AI-related investments led banks to demand more collateral. To meet margin calls and ease liquidity strains, the fund sold most of its public equity holdings to Citadel.

Situational Awareness was founded by Leopold Aschenbrenner and concentrated on public equity tied to artificial intelligence. The July sell-down followed margin calls from lenders after the fund’s positions weakened.

The BIS described the transmission mechanism: when market liquidity declines, highly leveraged funds may be forced to sell assets while prices are falling. That forced selling can push prices lower, increasing losses and prompting further collateral demands from lenders, which can amplify market moves.

The institution highlighted the interaction of leverage, liquidity and broader market conditions as the main concern. The BIS has repeatedly flagged rapid growth in AI-focused investments this year as a potential source of vulnerabilities if valuations fall or financing becomes less available.

So far, global markets have remained relatively resilient. The BIS noted, however, that rising government bond yields could tighten financial conditions and put additional pressure on investors that rely on short-term borrowing.

Gaston Gelos, head of financial stability policy at the BIS, described hedge funds as ‘at the core of the core markets’ and characterised the situation as ‘fragile.’ The quarterly review used the Situational Awareness episode to illustrate how problems at a single, highly leveraged fund can affect other market participants and complicate central banks’ management of financial stability.