The Scoop: Crypto's crumble after carry trades collapse

This column was co-written by Frank Chaparro, director of special projects at The Block, and Laura Vidiella of MNNC Group. The views expressed in this column are their own and do not reflect the opinions of their employers.

This week has been turbulent for crypto. However, if you’ve been in this market for a while, you’re likely accustomed to these violent price drawdowns. Typically, they are triggered by a buildup of leverage on offshore platforms. As leverage accumulates, a catalyst can trigger a price drop, leading to cascading liquidations that drive the price down even further.

This week, it wasn't just crypto feeling the pain. August experienced significant turbulence as the popular yen carry trade unraveled. For those unfamiliar, this trade involves borrowing yen at low interest rates to invest in other currencies or assets with higher yields. When the Bank of Japan raised rates to their highest level in 15 years, the trade collapsed, causing bitcoin to drop from around $68,000 to the low $50,000s. Meanwhile, the S&P 500 declined by about 6% between July 31 and Aug. 5.

Frank couldn't help but recall a recent drive to Washington, D.C., during which his colleague George Calle listened to "The Rise of Carry: Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis."

In essence, nearly every financial meltdown can be traced back to the unwinding of this trade.

Calle recently wrote a blog post exploring the role of carry in the crypto meltdown of 2021/22, which we've often referred to in this column as the crypto credit crisis.

1. Terra/Luna collapse
2. GBTC premium flipping
3. DeFi yields narrowing
4. FTX collapse

The Terra/Luna crash was likely the most impactful event of 2022 given it kicked off the credit crunch that devoured the market. It conveyed elements of a carry trade given the Anchor protocol promised steady returns of 20% in a new and risky stablecoin, which eventually collapsed in a highly reflexive manner.

“Conversely, as a self-described “carry strategy”, the GBTC trade often involved leverage. In fact, a common theme across distressed lenders was their clients’ exposure to losses on this trade. Due to the nature of Grayscale as a close end fund, the GBTC trade had a few mechanical differences from a classic carry trades in that trading parties neither expected periodic payments, and thus were basically just participating in a delayed arbitrage without adequate risk controls.”

Highly recommend reading the full blog.

Summers are supposed to be relaxing, but the introduction of new funds tied to ether and macro and political uncertainty have made this spine-tingling volatile for crypto assets. The aggregate market capitalization of all cryptocurrency assets peaked at around $2.7 trillion in July and is currently sitting at around $2.2 trillion, according to CoinGecko. Can the devs do something?

Like similar drawdowns in bitcoin’s price, institutional investors came to save the day with JPMorgan analysts noting the rebound was driven primarily by institutional investors. Here’s reporting from my colleague Yogita Khatri: 

“JPMorgan's futures position indicator, which tracks cumulative open interest in CME bitcoin futures contracts, along with the positive slope of the futures curve, suggests a bullish outlook among these investors, JPMorgan analysts, led by managing director Nikolaos Panigirtzoglou, wrote in a report on Wednesday. A higher bitcoin futures price premium over spot indicates confidence from futures investors, they said.”

Selling pressure — while intense — exhausted “fairly quickly,” as per FalconX Research. 

“Sell pressure in the book has been accumulating in the orderbook to the point of reaching the yellow-flag level of 1.25x of buy orders, but during the sell-off this selling pressure was exhausted relatively quickly to the point that the orderbook now is skewed to the buy side.”

As for what's next, I believe the market will continue to grapple with political uncertainty. It's still unclear how supportive a President Harris Administration would be toward crypto. A recent meeting between cryptocurrency market participants and White House advisors did little to provide additional clarity. Here’s the relevant passage from Bloomberg: 

“Advisers to the Biden administration stopped short of making any promises to crypto industry executives who voiced policy concerns, according to a participant on a Zoom call held Thursday.  The White House advisers didn’t discuss any policy changes with the group, which included Coinbase Global Inc., Kraken and Ripple Lab officials.”