Crypto experienced a severe downturn on August 5, marking one of its worst days in recent years. While it caught many off guard, the groundwork for this market upheaval had been laid over months of increased leverage trading. If leveraged trading was the kindling, the recent sharp rise in the Japanese yen was the match. Fortunately, this market volatility might be short-lived. The increased costs of yen-denominated loans triggered the crash, but now there are signs that markets could enjoy a healthy rebound as traders reduce their leverage and exposure to the yen. Should broader markets stabilize, crypto could be poised for a comeback.
The Allure of Cheap Borrowing
It’s well-known that cryptocurrency prices are driven more by short-term trading behavior than by fundamentals. Institutional traders, in particular, capitalize on the volatility of crypto assets to maximize returns. To further amplify gains, these traders often resort to leverage, using borrowed funds to take larger positions. Prior to the crash, the measure of net borrowing, known as open interest, was nearly $40 billion.
To sustain such high levels of borrowing, traders turned to Japan. In 2022, interest rates for U.S. Treasury bills began to rise above zero for the first time in years, continuing their upward trend. Meanwhile, rates in Japan remained extremely low. Trading firms took advantage of this by securing large loans in yen to finance trades cheaply in other markets. This practice, known as the yen carry trade, wasn’t confined to the crypto market. By 2024, yen-denominated loans to foreign borrowers had surged to approximately $2 trillion, a 50% increase from two years earlier, according to an ING Bank report.
A Seismic Shift in Japanese Policy
The landscape changed dramatically on July 31, when the Bank of Japan raised rates on short-term government bonds from 0% to 0.25%. This followed a previous hike in March, when the rate was increased from -0.1% for the first time in 17 years. While the rate hike itself may have seemed minor, its effects were significant. Bitcoin and Ethereum prices plummeted by 18% and 26%, respectively. Even traditional markets were affected, with the S&P 500 dropping over 5% in a single day.
The real catalyst was not the rate hike but the subsequent surge in the yen’s value in foreign exchange markets. The USD/JPY exchange rate fell from around 153 yen per dollar to 145. This sudden appreciation of the yen made yen-denominated loans considerably more expensive. In response, traders began to liquidate positions worth billions of dollars, driven either by margin calls or general caution. For example, Jump Trading’s sale of more than $370 million in Ethereum between July 24 and August 4 may have intensified the downturn, but it was not the primary cause. According to CoinGlass, over $1 billion in leveraged positions were liquidated between the evenings of August 4 and 5, representing hundreds of thousands of trades.
The Path to Recovery
In financial markets, sometimes a fever is necessary to cure an ailment. The recent upheaval forced traders to exit high-risk leveraged positions and reduce their yen-denominated loan obligations. As a result, net open interest in crypto has fallen to $27 billion, a reduction of almost $13 billion from pre-crash levels.
There are also signs that the USD/JPY exchange rate may stabilize, offering some relief. ING suggests that the yen may not have much room left to appreciate. If necessary, Japan’s central bank might intervene to soften the impact on borrowers, especially after the Japanese stock market experienced a 12% drop on August 5, its worst one-day decline since 1987. Meanwhile, a recent U.S. report showing a sharp rise in unemployment could prompt the Federal Reserve to cut rates more aggressively than previously anticipated.
Should these scenarios play out, the crypto market could be set for a late-summer rebound. However, if there is one takeaway from this episode, it’s the importance of caution in leveraged trading.
Alex O’Donnell is a senior writer, previously founding DeFi developer Umami Labs and working as a financial journalist for Reuters, covering M&A and IPOs. He is also the crypto growth lead at startup accelerator Expert Dojo. This article is for informational purposes and should not be considered legal or investment advice. The views expressed are the author’s own and do not necessarily represent those of the publication.
