The crisis was triggered by the rising prices of loans denominated in yen.
Investors borrowed heavily from Japan to fund their international deals at a discount.
Aug. 5 was one of the worst days for cryptocurrency in recent memory. Traders’ dependence on leverage has been subtly increasing market-wide dangers for months, and few anticipated this. Leveraged trading may have been the spark, but the sudden surge of the Japanese yen was the fuel. Hopefully, the effect will go out just as fast as it came.
The crisis was triggered by the rising prices of loans denominated in yen. Institutional traders that focus on short-term gains from crypto’s volatility are the primary drivers of price movements. Traders often use enormous sums of borrowed money, or leverage, to increase their profits on investment. Open interest, a proxy for net borrowing, was about $40 billion just before the catastrophe.
Someone needs to pay back all that borrowed money. Japan has been that spot as of late. For the first time in years, interest rates on US Treasury notes climbed over zero in 2022 and continued to grow. Rates in Japan remained very low. Profiteering trading businesses borrowed heavily from Japan to fund their international deals at a discount. The funding for dealers, denominated in yen, was almost free.
Although not exclusive to cryptocurrency, this was the crux of the so-called yen carry trade. A research from ING Bank states that by 2024, the amount of loans denominated in yen to foreign borrowers had increased by more than 50% compared to the previous two years, reaching almost $2 trillion.
Robust Comeback Anticipated
Rate hikes on short-term government bonds by the Bank of Japan from zero to 0.25 percent on July 31 turned the tide. After that apparently harmless action kicked off a chain reaction, the values of Ethereum and Bitcoin fell by around 18% and 26%, respectively. The S&P 500, an indicator of US equities, fell more than 5% on the day, indicating that even established markets were severely jolted.
Indeed, according to CoinGlass, hundreds of thousands of deals totaling over $1 billion were liquidated between Aug. 4-5. Recent US data suggests the Fed will be decreasing rates more aggressively than first anticipated. Crypto may be in for a late-summer bounce if that scenario comes to fruition.
The markets are poised for a positive recovery now that traders are reducing their exposure to the yen and leverage. Crypto may soon stage a robust return if wider markets stabilise, which they will likely do. Bitcoin has made a strong comeback with the price climbing back over $60,000 after falling below $50,000 during the crash.
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