2016 continues to be “The Year of Living Dangerously” for stock market investors. And we’re only a little more than three weeks into the New Year!

So far, China has featured in most of the headlines when it comes to market risk, followed by oil prices. But there’s another risk – lurking right here in the United States – that threatens to add even more risk to an already volatile mix.

We already caught a preview of this in 2015 – the very real potential risk caused by ETFs.

History Lesson

Before I delve into the current risks, I want to remind investors about a time when untested financial innovations added to a financial crisis.

Many – including economist John Kenneth Galbraith – say one key factor in the crash of 1929 was the new innovative financial instrument called the investment trust, formulated by Goldman Sachs. Yes, the “vampire squid” was around then too.

Investment trusts were the precursor to today’s mutual funds and ETFs, holding a basket of stocks. But they used a unique form of leverage.

For example, say Company A invested in companies B and C; Company B invested in companies C and D; Company C invested in companies D and E, etc. And along the way, bonds and preferred stocks of these firms were also sold in the marketplace.

It looked like a perpetual cash machine to the public. Until it all crashed. But thankfully, Goldman escaped unpunished (ha!).

Lack of Liquidity

Modern-day innovative instruments include both leveraged and inverse ETFs. These funds use leverage in a different way – through derivatives – which Warren Buffett has called “financial weapons of mass destruction.”

The Securities and Exchange Commission (SEC) is clearly worried, because by the middle of last year, these ETFs had a record $63 billion in assets. And that number is climbing rapidly.

On December 11, the SEC considered a proposal to limit the amount of derivatives – and therefore leverage – these ETFs can use. Fresh in the SEC’s mind, no doubt, is how credit derivatives nearly brought down the financial system in 2008.