The crypto market crashed late Sunday and the worst may not be over.
The crypto market started to melt down at about 8 p.m. ET on Sunday and has yet to recover. As of 11:30 a.m. ET on Monday, Bitcoin (BTC -8.14%) is down 8.3% in the last 24 hours, Ethereum (ETH -13.89%) is down 14.7%, and Dogecoin (DOGE -6.33%) is off 9.1%. The two most popular crypto exchange-traded funds (ETFs) are also down. The iShares Bitcoin Trust is off 12.6% and the Grayscale Ethereum Trust down 19.2%. Both are compared to their closing price on Friday.
What drove the rapid sell-off was leverage. This time, it wasn’t just leverage in crypto, it was the yen carry trade that sparked the market.
The yen carry trade
Over the past day, a popular trade known as the yen carry trade has started to unwind. The trade involves borrowing yen, which has had an interest rate near zero since before the financial crisis in 2008, and converting it to a currency like the U.S. dollar to buy higher-yield assets.
This is essentially an interest rate arbitrage and there’s a good explainer here.
When the trade runs into problems is when the yield on yen debt rises or (worse yet) when the yen’s value goes up, making it more costly to convert money back to yen.
Both things have happened in just the last few days after the Bank of Japan increased interest rates from between 0% and 0.1% to a still modest 0.25%.
The biggest problem was a rise in the yen, or drop in the U.S. dollar to yen conversion rate, which you can see below. This quickly turns profits to losses.
US Dollar to Japanese Yen Exchange Rate data by YCharts
Unwinding the trade involves selling the assets acquired and converting funds back to yen. This can push underlying asset values lower and exacerbate the problem.
Leverage makes everything faster and worse.
Crypto’s leverage problem
This hit crypto first because crypto trades 24/7 and has a lot of leverage. And in the last 24 hours, the leverage has led to $1.22 billion in liquidations on crypto markets. Of those liquidations, $955 million were long positions by traders.
Liquidations can be a self-reinforcing loop for the market as declines lead to more liquidations, which leads to more declines.
It appears the downward spiral has stopped for now, but if other leveraged trades come under pressure the spiral could begin again.
Crypto isn’t a hedge
It’s been thought that cryptocurrencies were a hedge against currencies or the market, but it’s been clear time and time again that crypto trades in a correlated manner to growth stocks.
That’s why there’s been such a big decline in crypto when the stock market is also down. That’s a concern because stocks are still near all-time high valuations and investors are starting to get concerned about the economy. If the economy worsens and growth stocks drop, they may take crypto with them.
Leverage is a danger in the market and few markets are more leveraged than crypto, so buyer beware.
Travis Hoium has positions in Ethereum. The Motley Fool has positions in and recommends Bitcoin and Ethereum. The Motley Fool has a disclosure policy.