The "Carry Trade" Behind the Crypto Sell-Off

The "Carry Trade" Behind the Crypto Sell-OffEarlier this week, the cryptocurrency market witnessed a sharp downturn, with major cryptocurrencies plunging. Bitcoin dropped below $50,000 on Monday, its lowest point in six months, before rebounding to around $56,000 on Wednesday

The "Carry Trade" Behind the Crypto Sell-Off

Earlier this week, the cryptocurrency market witnessed a sharp downturn, with major cryptocurrencies plunging. Bitcoin dropped below $50,000 on Monday, its lowest point in six months, before rebounding to around $56,000 on Wednesday. Nevertheless, Bitcoin remains 24% lower than its all-time high of $73,798 reached in March.

This cryptocurrency sell-off wasn't solely driven by market sentiment fluctuations but was closely linked to unwindings of certain "carry trades" in financial markets. Rich Rosenblum, co-founder and co-CEO of GSR, highlighted these unwinding activities as a significant contributor to the recent decline in the crypto market. He predicted a substantial rebound for Bitcoin in the future, contingent upon when traders complete their exit from these carry trades.

Carry Trade: Borrowing at a Lower Rate, Investing at a Higher Rate

Carry trade is an investment strategy that aims to generate profits by holding or carrying an asset (e.g., currency or commodity) over a period of time. This strategy is most prevalent in the currency market, where traders borrow currency from low-interest-rate countries and invest in currencies from high-interest-rate countries, profiting from the interest rate differential.

Crypto Sell-Off: Unwinding Actions Trigger a Cascade

Rosenblum noted that the current cryptocurrency sell-off resembles the situation in March 2020 during the initial stages of the COVID-19 pandemic in the United States. At that time, some hedge funds using cryptocurrencies as a side hustle encountered margin calls in their other asset trades, meaning banks required them to provide more collateral. To raise cash and meet these obligations, these funds liquidated their cryptocurrency holdings, causing a sharp decline in the crypto market.

Rosenblum added, "We do believe, at some point, cryptocurrency prices will rise significantly, but first, we need to get the shorts to cover."

Traditional Market Unwinding: Japanese Yen Carry Trade and Volatility Trading

Currently, two popular carry trades in traditional asset markets are undergoing unwinding: the Japanese yen carry trade and short volatility trading.

• Japanese Yen Carry Trade: For years, traders have borrowed Japanese yen due to its historically low interest rates. They exchanged the borrowed yen for currencies from high-interest-rate countries, such as the US dollar, to earn the interest rate differential. However, with the Bank of Japan raising its key rate to around 0.25% last week, the attractiveness of this strategy has diminished. The yen subsequently rallied against the US dollar by over 7%, forcing many carry traders to meet margin calls. They were compelled to buy yen to cover their positions, further pushing up the yen's value and initiating additional margin calls. JPMorgan analysts stated that only half of the unwindings of the yen carry trade have been completed.

• Short Volatility Trading: This strategy involves betting on a decline in the short-term futures of the Cboe Volatility Index (VIX), also known as the "fear index." This strategy has yielded consistent returns for traders since 2020. However, the VIX index spiked to over 65 on Monday, taking those betting on a VIX decline by surprise. This rise in VIX exceeded 180%, representing its largest intraday surge ever. Ultimately, VIX settled at 38.57, its highest closing point since October 2020, marking a 64.9% daily increase. Subsequently, VIX retreated to approximately 24.40 on Tuesday.

Carry Trade Unwinding in the Crypto Space: Ethereum, Solana, and More

In the cryptocurrency space, carry trade unwinding has also contributed to price drops. Some traders were forced to unstake their Ethereum, Solana, and other major crypto tokens.

Staking involves investors locking their cryptocurrencies to secure the safety of certain blockchains and earn rewards. In the past week, Ethereum's performance has lagged behind some prominent meme coins like Dogecoin and Shiba Inu, which have been considered to lack practical applications. Rosenblum stated, "It's a sign of quality assets being forced out."

Crypto Market Outlook: Short-Term Volatility and Long-Term Potential

The cryptocurrency market is currently facing short-term fluctuations, but its long-term potential remains promising. As carry trade unwindings gradually subside, the crypto market is expected to rebound. However, investors should remain cautious, closely monitor market dynamics, and make investment decisions based on their risk tolerance.

Conclusion

The recent sell-off in the cryptocurrency market is not a random event. Unwinding activities in financial market carry trades, particularly the Japanese yen carry trade and short volatility trading, have significantly impacted the cryptocurrency market, leading to substantial declines in major cryptocurrency prices.

While the cryptocurrency market may experience further volatility in the short term, Rosenblum remains optimistic about the future. He believes that the crypto market will rebound as carry trade unwindings conclude. Investors need to stay vigilant, closely observe market shifts, and invest prudently according to their individual circumstances.