How the Bank of Japan Disrupted the Yen Carry Trade and Impacted Crypto Markets

On August 5, 2024, the crypto market experienced one of its toughest days in years. The sharp increase in costs for the Japanese yen-denominated loans acted as the spark that ignited the fire of volatility in the wider financial markets and crypto too. This drop caught many off guard, although traders’ heavy use of leverage had been quietly building up risks for months. 

Crypto prices are often driven by short-term institutional traders who thrive on market volatility. They use strategies like high-frequency trading and arbitrage, which can create price swings. To boost their profits, they frequently leverage their positions with borrowed funds, sometimes to a staggering extent.

For example, controlling $100,000 worth of cryptocurrency with just $10,000 of your own money using 10x leverage. This can lead to huge gains if the trade goes well, but also dramatic losses if it doesn’t. Just before the crypto market crash, the total borrowed funds, known as open interest, hit nearly $40 billion.

Lately, Japan has become a key source of this borrowed capital. In 2022, interest rates on U.S. Treasury bills rose above zero for the first time in years and continued to climb, while Japan kept its rates very low. The Bank of Japan’s policy of ultra-low interest rates made borrowing in Japan significantly cheaper than in other major economies. Trading firms jumped at this opportunity, taking out large loans in Japan to finance trades in other markets at a lower cost.

This strategy seemed perfect. In 2023, the crypto bull market was in full swing, and leveraged trades, which can magnify gains or losses by a factor of 2X or more, were highly profitable. Traders enjoyed the benefits of almost free yen-denominated loans. 

This practice, known as the yen carry trade, wasn’t just confined to the crypto market. By 2024, yen-denominated loans to foreign borrowers had risen to about $2 trillion, marking a more than 50% increase from two years earlier.

Japan’s Rate Hike Ripple Effect on the Crypto Market

On July 31, 2024, the Bank of Japan (BoJ) made headlines after it increased the rates on short-term government bonds from 0% to 0.25%. This move followed a March hike, the first in 17 years, where the rate was raised from -0.1%. Although this adjustment seemed minor, it set off a chain reaction that sent Bitcoin (at the time, $55,514) and Ethereum ($2,500) prices plummeting by roughly 18% and 26%, respectively, within the next seven days.

The BoJ’s decision was intended to curb inflation and stabilize the economy, but it had far-reaching effects. Traditional markets were also hit hard, with the S&P 500, a major U.S. stock index, dropping over 5% on August 5, reflecting widespread investor concern and market instability.

The real catalyst behind these drastic changes was the yen’s surge in value in foreign exchange markets due to attractive foreign investments following the rate hike. From July 31, the USD/JPY exchange rate fell from around 153 yen per dollar to 145, making yen-denominated loans significantly more expensive for borrowers.

This sudden rise in borrowing costs led to widespread selling in the crypto markets. Traders who had leveraged their positions using yen-denominated loans were suddenly facing higher costs and potential margin calls. To avoid substantial losses, many began selling off their positions, contributing to the steep drop in crypto prices.

Jump Trading’s sale of over $370 million in ETH between July 24 and August 4 caught significant attention, intensifying an already inevitable major selloff. CoinGlass reported between August 4-5 that over $1 billion in leveraged trading positions, from hundreds of thousands of trades, were liquidated.

Meanwhile, some investors are already taking advantage of the current market dip, buying up assets as JPMorgan suggested.  Eleonor Genova, head of communications at Nexo, reminded her X followers in recent post that big drops can be the best times to buy crypto. She pointed out three times in the last decade when buying after a big drop paid off, stating, “Are we really worried about these drops? I’m not. Fear holds us back. The long-term trend has always been up.”

Bitcoin has maintained its support level around $54,000 and has bounced back more than 10% from its lows earlier in the month. After the significant drop on August 5, there has been a noticeable recovery. Bitcoin’s price has risen above $57,000 on August 7, and altcoins have also surged with gains of 5% to 10%, indicating a positive shift in market sentiment and renewed investor interest.

A Path to Recovery for the Crypto Market?

Just like a fever can sometimes help the body heal, the recent turbulence in the crypto markets might be setting the stage for a recovery. The recent market chaos has pushed traders to scale back on risky investments, leading to a significant cut in yen-denominated debts. Now, the net open interest in crypto has dropped to $27 billion, down nearly $13 billion from before the crash.

According to Arthur Hayes, the co-founder of BitMEX, “The yen is a key player in the global economy.” Hayes reportedly said this before the market drop, expressing belief that changes in the yen’s value will impact tech stock prices and US debt. 

If the economic situation worsens, rate cuts could be implemented. Japan’s stock market saw a dramatic 12% drop on August 5, its worst single-day decline since 1987. This might prompt Japan’s central bank to step in to help borrowers.In the US, the recent Jobs report showed a rise in unemployment and this could lead the Federal Reserve to cut rates more aggressively. 

If both scenarios occur, it might lead to a recovery in the crypto market later this summer. However, the crypto world is highly unpredictable, so investors should be cautious with leveraged trades.

Disclaimer: This article is intended solely for informational purposes and should not be considered trading or investment advice. Nothing herein should be construed as financial, legal, or tax advice. Trading or investing in cryptocurrencies carries a considerable risk of financial loss. Always conduct due diligence. 

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