U.S. stock leverage can't increase anymore? Wall Street has "exhausted its balance sheet" and can only urge hedge funds to "add short positions"

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

According to the latest report from Bloomberg, earlier this year, Barclays reached its lending limit to hedge fund clients amid the Asian AI stock trading frenzy. Through an internal auction mechanism, part of the capital allocation from the macro rates trading desk was temporarily transferred to the prime brokerage division, allowing continued lending expansion to Asian hedge fund clients. At the same time, traders at several banks, including Goldman Sachs, began pressuring hedge fund clients to hold more short positions—a move that compresses balance sheet usage on paper, but doesn’t actually reduce the overall leverage level in the market.

Goldman Sachs CFO Denis Coleman said earlier this month that demand for equity financing continues to exceed industry available capacity, allowing the bank to "deploy resources selectively." Goldman’s prime brokerage data shows that for the week ended October 18, U.S. long-short hedge funds’ net leverage fell by 3.2 percentage points to 43.7%, a five-year low—almost entirely due to increased short positions, not reduction in longs. Since July 31, long leverage dropped just 0.5 percentage points to 128.8%, while short leverage climbed 8.0 percentage points to 85.1%, the highest in five years. Overall total leverage remained around 214%, higher than before.

Barclays "Moves the Goalposts": Internal Auction Skirts Risk Control Limits

According to Bloomberg, earlier this year, Barclays executives wanted to expand lending to Asian hedge fund clients to capture the rapid rise in Asian AI stocks. However, the bank had already hit its internal financing limit. The solution was: the macro rates desk used an internal auction mechanism to transfer part of its capital allocation to the prime brokerage division—operated by the global markets division under Adeel Khan.

Barclays officially stated that the bank "dynamically deploys the investment bank’s balance sheet, maintaining strict control of risk and returns while seizing client opportunities." However, according to Bloomberg sources, such “strict control” actually only became effective after reaching the upper limit, with the main response being a reset of the limit itself.

Notably, UK banks began reviewing this market segment as cracks appeared in AI trading this July, and in September shifted their focus to London prime brokers’ financing of Asian equities.

Irony: Rejected the "AI Stock Star" but Still Used All Available Capacity

The most ironic detail of the event is: Barclays previously rejected hedge fund Situational Awareness as a client due to risks associated with concentrated positions in the AI sector—an ultimately correct decision in hindsight.

Situational Awareness, founded by Leopold Aschenbrenner, operated with about 4x leverage through total return swap tools, mainly building long positions in AI infrastructure and short positions in software stocks through Goldman Sachs. When AI stocks corrected in July, margin calls ensued, and the fund was forced to cash out all its public holdings at roughly a 10% discount to Citadel, owned by Ken Griffin. The fund’s size plummeted from about $45 billion to $10 billion within days.

Nevertheless, while Barclays successfully sidestepped the year’s most high-profile blow-up, it still pushed lending limits to Asian hedge funds to the edge, even borrowing capital from other business units. This indicates that the collapse of Situational Awareness was only the most conspicuous symptom of a systemic issue—a handful of dealers collectively risking their balance sheets on the same AI theme—not the root cause itself.

Industry-Wide Pressure: Goldman and UBS Admit Financing Approaching Saturation

Barclays is not alone. According to Bloomberg, Goldman Sachs CFO Denis Coleman said earlier this month that equity financing demand continues to exceed industry capacity; in July, he stated that there is "demand far above what we are willing to take on" in prime brokerage and fixed income financing. UBS CFO Todd Tuckner said in July that the bank’s usage of its equity balance sheet for prime brokerage is becoming "more disciplined."

Bloomberg strategist Simon White issued a warning back in June, noting futures financing rates were spiking due to surging demand for total return swaps. Dealers’ leverage exposure supplied via futures and total return swaps had hit record levels, with equity inventory rising to $223 billion. "Dealer balance sheets could face supply bottlenecks due to regulatory constraints." Barclays’ later maneuver directly confirms this “supply bottleneck.”

The Short Position Ruse: Total Leverage Rises Instead of Falling

When balance sheet room runs out, Wall Street’s "solution" is: urge clients to increase short exposure. According to Bloomberg, traders at Barclays, Goldman Sachs, and others collaborated with hedge fund clients to lower prime brokerage balance sheet usage by encouraging them to hold more shorts—the funds from short selling can be internally used to finance longs.

However, Goldman Sachs prime brokerage data reveals what’s really happening. Lee Coppersmith noted in the October 18 weekly report that, since late July, the drop in net leverage "came almost solely from increased shorts, not reduced longs." Long leverage dipped only 0.5 percentage points to 128.8%, while short leverage jumped 8.0 points to 85.1%, the 100th percentile in five years. Overall total leverage hovered at 214%, rising even after the blow-up at Situational Awareness.

UBS trading desk’s Torsten Sippel also commented in the October 18 weekly report that last week’s market action "looked like position reshuffling rather than massive equity liquidation, much like the de-leveraging triggered months ago by Situational Awareness," warning that with hedge fund net exposure at the 30th percentile in five years and total leverage at the 90th percentile or above, "if P&L pressure continues, portfolios face further vulnerability to de-leveraging."

Coppersmith also admitted that if performance pressures remain, "there is indeed room for additional de-leveraging by selling longs and covering shorts." With leverage at 214%, if both long and short positions move adversely at the same time—as occurred when AI infrastructure stocks dropped and software stocks rallied in July—the so-called 'hedge' will quickly fail.

Profits Drive Risk-Taking: Prime Brokerage as Revenue Engine

Why go to all the trouble to break through limits? The answer is profit. Bloomberg forecasts Barclays’ equities business will announce about GBP 865 million ($1.2 billion) in Q3 revenue this Thursday—its strongest third-quarter result since 2009, the year after acquiring Lehman Brothers’ North American business.

Prime brokerage has been the main source of equity revenue for Wall Street this year, and the surge in trading revenue has largely been generated by the leverage provided by prime brokers themselves. This forms a self-reinforcing loop: banks lend to funds, funds push up AI stock prices, AI volatility boosts trading revenues, and revenues free up more balance sheet space for prime brokerage—until the cycle reverses.

Currently, UK banks have started to review London prime brokers’ Asian equity books. UBS described last week’s de-leveraging as a replay of the Situational Awareness blow-up, while total leverage overall remains near record highs.