Crypto experienced one of its worst days in years on Aug. 5. Few saw it coming, but traders’ addiction to leverage has been quietly amplifying marketwide risks for months. If leveraged trading was the kindling, the Japanese yen’s abrupt uptrend was the match. Thankfully, the fire may burn out as quickly as it started. 

Surging costs on yen-denominated loans caused the crash. Now, markets are set for a healthy rebound as traders finally pare back leverage and exposure to the yen. If broader markets stabilize — and they probably will — crypto may soon make a comeback.

Bargain-bin borrowing

It’s no secret crypto doesn’t trade on fundamentals. Prices are mainly driven by short-term institutional traders, who profit off crypto’s volatility. To boost returns, traders double down on positions with leverage, or borrowed funds — often in staggering amounts. Shortly before the crash, open interest, a measure of net borrowing, stood at almost $40 billion.

All that borrowed money has to come from somewhere. Lately, that place has been Japan. In 2022, interest rates on United States Treasury bills rose above zero for the first time in years and kept climbing. In Japan, rates stayed rock-bottom. Trading firms cashed in — taking out huge Japanese loans to cheaply finance trades in other markets.

It seemed like good timing. By 2023, the crypto’s bull market was in full swing. Leveraged trades — which can amplify gains or losses by 2x or more — paid off handsomely. Meanwhile, traders’ yen-denominated financing was nearly free.