Crypto suffered one of its worst days in years on August 5. Few saw it coming, but traders’ addiction to leverage had been quietly adding to the risk profile of the entire market for months. If leveraged trading was the trigger, the sudden surge in the Japanese yen was the spark. Fortunately, the fire died out as quickly as it had started.
The high cost of yen loans caused the crash. Now, markets are preparing for a healthy recovery as traders finally reduce their leverage and yen exposure. If the broader markets stabilize — and they likely will — crypto could soon be back.
Bargain-bin borrowing
It’s no secret that crypto doesn’t trade on fundamentals. Prices are largely driven by short-term institutional traders who profit from crypto’s volatility. To increase profits, traders double down on positions using leverage, or borrowing capital – often in huge amounts. Just before the crash, open interest (OI), a measure of net borrowing, stood at nearly $40 billion.
All that borrowed money has to come from somewhere. Lately, that place has been Japan. In 2022, yields on US Treasury bonds rose above zero for the first time in years and have continued to rise. Interest rates in Japan remain extremely low. Trading houses have taken advantage of this by borrowing money from Japan to buy higher-yielding assets in international markets.
It seemed like a good time. By 2023, the crypto bull market was in full swing. Leveraged trades—which can magnify profits or losses by 2x or more—were profitable. Meanwhile, borrowing in yen was virtually free.
This is the essence of the so-called yen carry trade, and it’s not just crypto. By 2024, yen loans to foreign borrowers will reach around $2 trillion, up more than 50% from two years ago, according to a report from ING Bank.
*Bargain-bin borrowing refers to borrowing money at extremely low interest rates, like buying discounted items from a “bargain bin”. In the context of finance and investing, the term is often used to describe borrowing funds at low cost to invest in other assets with the potential to yield higher returns. This is especially common when interest rates in a country are low, as in the case of Japanese yen loans with near-zero interest rates.
End of 17-year policy in Japan
Everything changed on July 31, when the Bank of Japan raised the interest rate on short-term government bonds from 0% to 0.25%. (This followed a hike in March, when the bank raised rates for the first time in 17 years from -0.1%.) This seemingly innocuous move set off a chain of events that eventually led to Bitcoin (BTC) and Ethereum (ETH) prices falling by about 18% and 26%, respectively.
Even traditional markets were hit hard, with the S&P 500 – an index of US stocks – falling more than 5% on the day.
The trigger wasn’t the Japanese interest rate hike, but what happened next: the rise in the value of the yen in foreign exchange markets. (Currencies typically appreciate when domestic interest rates rise.) Since July 31, the USD/JPY exchange rate has fallen from around 153 yen to the dollar to 145. Suddenly, those yen loans have become significantly more expensive.
Whether due to margin calls from lenders or general caution, traders began unloading billions of dollars in positions. Jump Trading’s unstaking of over $370 million in ETH between July 24 and August 4 caused a stir, but they were not the initiators of the decline. At best, Jump was just an accelerant to an already historic sell-off.
In fact, more than $1 billion in leveraged trading positions – representing hundreds of thousands of trades – were liquidated between August 4-5, according to CoinGlass.
Come back stronger?
Traders have exited high-risk leveraged positions and are finally reducing their large yen loans. In crypto, total open interest now stands at $27 billion – nearly $13 billion less than before the crash.
Meanwhile, USD/JPY may not have much room to fall.
If all else fails, there is always the possibility of a rate cut. Japan’s stock market also fell about 12% on August 5 – its worst one-day drop since 1987. That could force the Bank of Japan to intervene, softening the blow for borrowers. US interest rates could also be on the verge of a cut, following a July report showing a sharp rise in unemployment.
In Japan, “If there was an opportunity to intervene – now is the time,” David Aspell, a senior portfolio manager at Mount Lucas Management, told Cointelegraph. “Based on recent data from the US, it looks like the Fed will cut rates more than they expected a few months ago.”
If that scenario plays out, crypto could be set for a late summer rally. Of course, crypto markets are unpredictable. If there’s one lesson from all this, it’s to think twice before engaging in another leveraged trade.
Explaining the liberation of the Japanese Yen carry trade
Unlike most other countries with high interest rates, Japan has maintained zero or negative interest rates for the past 17 years, and negative rates for the last 8 years. However, things changed in March 2024 when the Bank of Japan ended this policy and raised interest rates for the first time in 17 years.
Maintaining low interest rates is intended to stimulate the economy, but prolonging this policy for a long time has caused the following consequences:
Weak Yen: The value of the Yen hit a more than 30-year low against the USD as of July 2024.
Exports benefit, imports suffer: Weak yen boosts exports but hurts imports.
Japanese government bonds less attractive: Low interest rates make Japanese government bonds less attractive to investors, leading to the Bank of Japan owning 53% of all government bonds (as of March 2024).
Easy Loans: Low interest rates make borrowing money very attractive.
The Bank of Japan raised interest rates for the first time in March and again in July 2024. It also announced that it would reduce its purchases of Japanese government bonds to about 3 trillion yen ($19.64 billion) per month from the first quarter of 2026.
Initially, no one questioned the Bank of Japan’s decision as it seemed reasonable to save the yen, control inflation, and make their bonds more attractive. However, upon closer examination, people began to worry about the risks of “unleashing the yen carry trade.”
The yen carry trade is a financial strategy in which an investor borrows money in Japanese Yen at a low interest rate and invests it in assets with higher interest rates, typically assets denominated in USD or Euro. Low interest rates in Japan make borrowing money in Yen cheap.
Investors borrow money in Yen, then convert this money into other currencies (like USD) and invest it in higher-yielding assets. These assets can be bonds, stocks, or other financial instruments in countries with higher interest rates or returns.
The profit from this strategy comes from the difference between the low interest rate paid on the Yen loan and the higher return on the investment assets. For example, if an investor borrows Yen at 0.5% and earns 5% on US bonds, the difference of 4.5% is the profit.
As the Bank of Japan starts to raise interest rates, the profits from the carry trade shrink, and some investors will unwind these trades. “Unwinding” here means selling assets (such as stocks and other assets denominated in USD) and then converting them into Yen to pay off the debt. This causes:
Strong Yen: The Japanese government may want this, but it hurts exports, and Japan is a big exporter, which makes Japanese stocks fall.
Falling Asset Values: Selling off these assets reduces their value.
In short, the carry trade is a strategy of taking advantage of low borrowing costs in Japan to invest in higher yielding assets elsewhere. As yields shrink due to the Bank of Japan raising interest rates, a unwinding occurs, affecting asset values. The extent of this impact is currently unclear, but it is a topic of interest.
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