Summary
- The Bank of Japan raised interest rates, increasing the value of the yen.
- Traders using yen loans for leveraged trades faced higher costs.
- This led to massive sell-offs and a crash in the crypto market.
- Bitcoin and Ethereum prices dropped significantly.
- Traditional markets, including the S&P 500, were also affected.
- Reduction in leverage may stabilize the crypto market.
- Potential rate cuts could provide relief to borrowers and support a market rebound.
How the Bank of Japan Wrecked the Yen Carry Trade and Crypto Markets
Introduction
On August 5th, the crypto market experienced one of its worst days in years, losing 15% of its value over the weekend. This sudden crash left many wondering what happened. The answer lies with the Bank of Japan and its recent decisions.
The Role of the Bank of Japan
The Bank of Japan plays a key role in the global financial system. On July 31, it raised interest rates on short-term government bonds from 0% to 0.25%. This move came after a hike in March, where rates were raised from -0.1% for the first time in 17 years. The rate hike seemed small, but it had big consequences.
What is the Yen Carry Trade?
To understand the impact, we need to know about the yen carry trade. The yen carry trade is when traders borrow money in yen at low-interest rates and invest it in other markets where returns are higher. This strategy was very popular because Japan’s interest rates were rock-bottom while other countries had higher rates. Traders used these yen loans to fund leveraged positions in various markets, including crypto.
Leveraged Trading in Crypto
Leveraged trading means borrowing money to increase the size of a trade. It can amplify gains or losses by two times or more. Before the crash, open interest in crypto, which measures net borrowing, was almost $40 billion. This shows how much traders were relying on borrowed money to boost their returns.
How the Yen’s Value Affected Crypto
When the Bank of Japan raised interest rates, the value of the yen increased in foreign exchange markets. From July 31, the USD/JPY exchange rate dropped from around 153 yen per dollar to 145. This made yen-denominated loans more expensive. Traders who had borrowed yen now faced higher costs, and many started to sell their positions to cover these new expenses.
The Impact on Crypto Markets
This mass selling caused a major crash in the crypto market. Bitcoin and Ethereum prices dropped around 18% and 26%, respectively. More than $1 billion in leveraged trading positions were liquidated between August 4-5, according to CoinGlass. This means hundreds of thousands of trades were closed out because traders couldn’t meet their margin calls.
Broader Market Effects
The impact wasn’t limited to crypto. Traditional markets were also shaken. The S&P 500, an index of US stocks, dropped more than 5% on the same day. In Japan, the stock market fell about 12%, its worst one-day drop since 1987. This widespread effect shows how interconnected global markets are.
Bargain-Bin Borrowing
For a long time, traders benefited from cheap borrowing in Japan. In 2022, interest rates on US Treasury bills rose above zero for the first time in years and kept climbing. However, Japan kept its rates very low. Trading firms took advantage of this by borrowing huge amounts of yen to finance trades in other markets. This strategy seemed smart as the crypto bull market was in full swing in 2023.
An End to the Strategy
By 2024, yen-denominated loans to foreign borrowers reached around $2 trillion, up more than 50% from two years earlier, according to a report from ING Bank. Everything changed when the Bank of Japan raised rates. The surge in the yen’s value made these loans much more expensive, leading to the crash in the crypto market.
After the Crash
After the crash, the market is set for a healthy rebound. Traders have started to reduce leverage and exposure to the yen. Open interest in crypto now stands at $27 billion, almost $13 billion less than before the crash. This reduction in leverage may help stabilize the market.
Future Outlook for Crypto Markets
The future of the crypto market depends on several factors. If broader markets stabilize, crypto might recover soon. The USD/JPY exchange rate may not have much room left to fall, according to ING. This means the costs of yen-denominated loans might not increase further.
Potential Rate Cuts
There is also a possibility of rate cuts. Japan’s stock market drop may force the central bank to intervene and soften the blow for borrowers. The US may also be in for some relief, as recent unemployment data suggests the Federal Reserve might cut rates more aggressively than previously thought.
Conclusion
The recent crash in the crypto market shows how global events can have far-reaching impacts. The Bank of Japan’s rate hike and the resulting surge in the yen’s value triggered a cascade of events that led to massive sell-offs in the crypto market. However, the reduction in leverage and potential stabilization of broader markets offer hope for a rebound. As always, traders should be cautious with leveraged positions and stay informed about global economic trends.
