With two recent high profile incidents of hedge funds becoming irresponsibly overleveraged in the market (Melvin Capital and Archegos) and causing market wide effects, it seems worth exploring the national security implications of continued poor oversight of institutional leverage in equities markets, and the potential economic effects.
With numerous countries with adversarial relationships to the US and NATO powers having a much more managed approach to their citizens business ventures and economic output, it is not far fetched to consider that overleveraging can become a tactic of economic warfare, and a way of winning or setting advantageous conditions for wars without firing a shot.
China is the classic and most probable candidate for this, so we’ll start with them as an example. Consider their practice of internment and reeducation for Chinese leaders of businesses who become problematic for the state, such as Jack Ma with Alibaba. Consider also their fairly commonly known practice of leveraging western students and workers of Chinese descent in order to commit industrial espionage. From these two points, we can consider a hypothetical scenario where the CCP could engineer a domino crash through planned use of leveraging and defaults, either through a single action (apply pressure to an economic agent to both become overleveraged and then insolvent) or multistep (apply pressure to one or several agents to become over-leveraged, and then act seperately to cause a disruption in that area and subsequent defaults).
The utility of this sort of attack is twofold. It can be used to provide a distraction on demand, where unwanted attention on international affairs could be diverted by engineering a domestic economic crisis, compounded with social media campaigns. It could also be used as a prelude to military action, in order to attack a country’s defense contracting and solvency for defense spending indirectly, while at the same time sowing internal strife to reduce the capability for a decisive and coherent response to provocation.
This type of attack would be difficult to predict and mitigate the effects of as either a retail or institutional investor, as it could be triggered with little to no warning from traditional indicators. Hedging against it would be tricky as well, but would most likely be found with plays on defense contractors such as $OSK, $BA, $LMT, ect. if the situation escalated to armed conflict. In this case, the saying “an ounce of prevention is worth a pound of cure” holds very true, as the best course of action would be addressing the use of leverage by institutional investors before a state actor uses it as an instrument of war.
TLDR; Institutional leverage can and will be exploited at some point as a form of economic warfare by state actors, causing pre-planned recessions or economic crashes.