Yen Carry Trade’s Impact on the Crypto Market Explained

Crypto experienced one of its worst days in years on August 5, a downturn that few anticipated but was primed by months of leveraged trading. The Japanese yen’s abrupt uptrend ultimately struck the match that led to this significant crash. However, the positive note is that the market disruption may burn out as quickly as it ignited.

The Perfect Storm: Leveraged Trading and the Yen Carry Trade

Leveraged trading has long been a double-edged sword for the crypto market. Institutional traders frequently use leverage, or borrowed funds, to amplify their returns — often in staggering amounts. By August 5, open interest, a measure of net borrowing, stood at almost $40 billion. Leveraged trades paid off handsomely during crypto’s bull market, thanks to nearly free yen-denominated financing.

Bargain-bin Borrowing and the Crypto Surge

Interest rates on United States Treasury bills rose above zero in 2022 for the first time in years, while Japanese rates remained rock-bottom. Trading firms exploited the opportunity, securing significant yen-denominated loans to fund trades in other markets. The yen carry trade essentially subsidized a flurry of leveraged crypto investments, pushing the market to new heights. By 2024, yen loans to foreign borrowers reached approximately $2 trillion, up over 50% from two years prior, according to ING Bank.

Japanese Policy Shift and the Market Fallout

The landscape shifted dramatically on July 31 when the Bank of Japan raised rates on short-term government bonds from 0% to 0.25%, following an increase in March from -0.1%. This policy change pushed the yen’s value higher, making yen-denominated loans significantly more expensive almost overnight. From July 31, the USD/JPY exchange rate plummeted from around 153 yen per dollar to 145.

Faced with expensive loan repayments, traders scrambled to liquidate positions, leading to a sell-off that saw Bitcoin (BTC) and Ethereum (ETH) prices plunge around 18% and 26% respectively. Even traditional markets weren’t spared; the S&P 500 dropped more than 5% on the same day.

Domino Effect: How the Crash Unfolded

The sudden yen appreciation set off a cascade of liquidations which ultimately led to the significant crypto downturn. Notably, Jump Trading sold over $370 million in ETH between July 24 and August 4, adding fuel to the fire. By August 5, more than $1 billion in leveraged trading positions across thousands of trades had been liquidated, according to CoinGlass data.

Short-term Pain, Long-term Gain?

The liquidation frenzy may serve as a market correction, shaking out high-risk leveraged positions and reducing exposure to yen-denominated debt. Open interest in the crypto market now stands at $27 billion, down almost $13 billion from before the crash.

Additionally, the USD/JPY exchange rate may not have much room left to fall, according to ING’s analysis. If Japan’s central bank intervenes—prompted by a substantial 12% drop in its stock market on August 5—borrowers could find some relief. David Aspell, a senior portfolio manager at Mount Lucas Management, suggested, “If there was a shot at intervention working — this is the time.”

Economic Indicators and Potential Market Rebounds

The recent rise in U.S. unemployment as reported in July could prompt the Federal Reserve to cut rates more aggressively than previously anticipated, offering more liquidity and possibly setting the stage for a late-summer rebound in the crypto markets. As such, while crypto markets are notoriously unpredictable, there’s optimism for a recovery.

Lessons for Future Investors

The key takeaway from this event is the inherent volatility and risk in highly leveraged crypto trading. Future traders must exercise more prudence to avoid falling victim to similar market corrections. As the saying goes, “think twice before aping into another leveraged trade.”

Further Reading

For additional insights, consider visiting the Cointelegraph article on how the yen carry trade wiped out crypto here. To understand the background of the yen carry trade, see this (IHG Bank analysis)[https://www.ing.com/Newsroom/All-news/Japan-Scales-Carry-Trade-Risks.htm] and how Japan’s interest rate hikes are influencing global markets, check out this (detailed explanation)[https://www.marketwatch.com/story/why-japans-interest-rate-hike-has-global-ramifications-2024].

The views and opinions expressed in this article are those of Alex O’Donnell and do not necessarily reflect the stance of Cointelegraph. The content is for informational purposes only and should not be considered as financial or legal advice.