Published on July 24, 2025 9:02 PM GMT
Recently, I stumbled upon a paper that is not well known outside economic policy circles that brings to light a variable often overlooked when talking about financial crises: The amount of leverage.
In the paper, Mr. Geanakoplos argues that in good times, lenders become optimistic. They loosen standards, demanding less cash down (a lower "margin" or "haircut") for a loan. This allows the "natural buyers" (investors who are more optimistic or risk-tolerant) to borrow heavily and bid up asset prices, creating a bubble. When bad news hits, the cycle violently reverses. Lenders get nervous and demand more cash down for the same loans. This forces the leveraged optimists to sell assets to raise cash, which pushes prices down further, which causes more forced selling. The system de-leverages in a painful, cascading spiral, and in the resulting crash, the asset price can fall more than any single agent in the economy believes is justified by the news.
Geanakoplos concludes that central banks should consider monitoring and regulating leverage as a primary policy tool. To prevent a crash, policymakers should curtail leverage during boom times. To reverse a crash, they should work to restore leverage to reasonable levels, for instance, by having the central bank lend directly at more generous collateral terms than the private market is willing to offer.
The paper was well received in the aftermath of the 2008 financial crisis, and echoes of its theories are seen in legislation such as the Dodd-Frank Act and Basel III. This new regulation has led to prudence in lending and margin standards by financial institutions post-2008, which, until the COVID crisis, has likely contributed to a long period of relative stability.
After reading and analyzing the paper, I’ve come to the conclusion that we are likely in the beginning stages of a new leverage cycle. There have been several developments that, while good in many respects, might contribute to a cycle that could lead to a bubble.
These are developments I believe are contributing to the new leverage cycle:
1. The democratization of public securities investing. In 2020, we saw the rise of self-directed brokerages such as Robinhood, which allow people to seamlessly access capital markets. While I welcome this development and believe it should continue, it also gives unsophisticated participants access to leverage in the form of both options trading and margin lending. These platforms are in a constant battle to expand their lending capabilities to more clients, effectively creating a new, large class of the "natural buyers" Geanakoplos identified as the drivers of the cycle.
2. The popularization of leveraged ETFs. Leveraged ETFs have been around since 2006, but with the democratization of public securities investing, these products have exploded in popularity. On any given day, a significant number of the top 10 most actively traded exchange-traded products (ETPs) are leveraged or inverse funds. These instruments offer a form of frictionless, "pre-packaged" leverage that accelerates the boom phase of the cycle Geanakoplos described.
3. The institutionalization of crypto in the United States. The United States has been moving forward to legalize the investing and trading of these financial products. As the asset class gets liberalized, institutions will be lining up to provide leverage using crypto as collateral. This speaks directly to the paper's core theme: the rules around what is acceptable as collateral are paramount to financial stability. When JP Morgan is already exploring this type of lending, it is almost a given that we will start seeing institutional lending backed by crypto.
4. The rise of treasury public firms. There is a novel financial product being offered to the masses that has gained meteoric traction in 2025: the treasury company. In simple terms, these are public companies whose sole role is to use their balance sheet to buy another asset. Right now, Bitcoin and Ethereum are the most popular assets, but we are starting to see public companies buy stock in other companies to attract investors. These new public companies are using financial engineering to leverage their exposure to their treasury holdings via issuing debt, preferred shares, or some brand new debt-type product. This is a perfect modern example of the "double leverage cycle" Geanakoplos warned of, where one asset (the firm's stock) is a claim on another leveraged asset (the crypto held in treasury), creating a dangerous feedback loop.
The developments above all contribute to the rise of leverage in the system. Some of this leverage is being collateralized by cryptocurrency like Bitcoin, others by high-beta equities. The US government is on a de-regulatory push that, while potentially good in some areas, might contribute to this leverage cycle.
If you trade or invest with leverage, be mindful that when it gets easy to borrow or collateralize an asset, many participants will take advantage of it. This, coupled with the rate-easing cycle we are currently in, might lead to dangerous levels of leverage in the system.
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