[TL；DR]:

Arbitrage refers to a trading strategy where investors buy low and sell high assets at two prices to secure low-risk returns.
Due to the low interest rate nature of the yen, yen arbitrage is widely utilized in the cryptocurrency realm, with investors leveraging the yen extensively for profit through leveraged operations. Following Japan’s interest rate hike on July 31st, the borrowing costs of the yen surged, significantly increasing the risks associated with yen arbitrage. To settle debts, yen arbitrageurs engaged in massive sell-offs of dollar assets, compounded by geopolitical risks, soft U.S. economic data, and other macro factors, resulting in a drastic drop in cryptocurrency prices on August 5th, leading to a substantial market crash.
The convergence of multiple bearish factors triggered this intense correction, yet the market was predominantly driven by emotional reactions. Presently, there are signs of a rebound, dispelling expectations of a bear market.

Introduction

On July 31st, the Bank of Japan announced a surprise increase in its policy target interest rate, raising it from around 0-0.1% to 0.25%, marking its second rate hike since abandoning negative rates in March. Following this unexpected rate hike, the yen appreciated, and the Japanese stock market experienced consecutive sharp declines. With a significant amount of yen loans present in the crypto market, the yen rate hike led to the potential liquidation of related assets. This, in turn, prompted a sharp downturn in a series of cryptocurrencies led by ETH. This article will delve into a detailed discussion of the impact mechanism of this event.

What is arbitrage？

Arbitrage is an investment strategy that typically involves buying at a lower price and selling at a higher price in the case where a tangible or financial asset has two prices in two or more markets, thereby generating low-risk returns. Individuals engaging in arbitrage trades are known as “arbitrageurs,” and various entities such as banks, brokerage firms, fund companies, and individuals can participate in arbitrage. Bonds, stocks, futures, and a variety of financial derivatives can serve as the underlying assets for arbitrage trading.

Source：LiteFinance
Arbitrage is a strategy with significantly lower risk compared to unilateral speculation. Arbitrageurs profit from market inconsistencies without bearing the risk of market fluctuations. In the financial markets, arbitrage can take on many forms, including stock price arbitrage, exchange rate arbitrage, commodity price arbitrage, and more.

Source：LiteFinance
Arbitrage not only exists in traditional financial markets but is also widely utilized in the realm of cryptocurrency markets. When there are price differences for the same asset across different trading platforms, arbitrageurs can engage in platform arbitrage by buying and selling the same asset. They can also conduct triangular arbitrage when prices of three different cryptocurrencies are mismatched, by swiftly executing trades among the three assets in a high-frequency manner.

The History and Current State of Yen Arbitrage

Since the early 1990s when the Japanese economic bubble burst, Japan has been mired in prolonged stagnation,during this period, economic growth was sluggish, and both corporate and individual investment sentiments were subdued, leading to persistent deflation. To address this economic malaise, the Bank of Japan began implementing low-interest-rate policies in the late 1990s, lowering the benchmark interest rates to levels near zero in an effort to stimulate economic activity by reducing borrowing costs. In 2012, former Japanese Prime Minister Shinzo Abe, during his second term in office, introduced a series of economic policies that further exacerbated the situation of low interest rates in Japan.

Against the backdrop of extremely low yen interest rates and with the yen being an internationally recognized currency with a relatively free foreign exchange market, yen arbitrage trading gradually gained popularity. Trading companies began borrowing substantial amounts of yen, providing financing for other trades at a low cost, and profiting from the interest rate differentials in the process.

How Japanese Yen Rate Hikes Impact the Crypto Sphere

In March of this year, the Bank of Japan ended an eight-year era of negative interest rates by raising its policy rate from -0.1% to 0%-0.1%. On July 31st, the Bank of Japan hiked rates again, raising the policy rate from 0%-0.1% to 0.25%, a 15 basis point increase. Additionally, starting from the fourth quarter of this year, they plan to decrease their purchases of Japanese government bonds by 0.4 trillion yen each quarter, initiating the”shrink the balance sheet” plan.

It is estimated that by 2024, the total amount of foreign loans denominated in yen will reach around $2 trillion. Before the collapse, the outstanding contracts in the cryptocurrency market amounted to approximately $40 billion, with a significant portion of funds originating from yen loans. The rate hike by the Bank of Japan has led to an increase in the cost of borrowing in yen, significantly raising the risks in yen arbitrage channels. Many yen arbitrageurs have started selling off US dollar assets to repay yen debts, reducing risks and causing a decrease in market liquidity. In the cryptocurrency market, this decrease in liquidity could lead to lower trading volumes, heightened price fluctuations, and potentially trigger panic selling.

Source：EastMoney
After Japan’s rate hike on July 31st, the yen surged in the foreign exchange market, causing the USD/JPY exchange rate to drop from 1 USD to 153 JPY to 145 JPY. With a significant increase in arbitrage risks and margin calls from lenders, some arbitrageurs began selling off large amounts of US dollar assets. Some analysts believe that these institutions may have foreseen the market downturn or received margin call notices, prompting them to swiftly convert risky assets into stablecoins.

Source：@EmberCN
Although the yen rate hike acted as the catalyst for the market decline, the fundamental reason lies in the market’s concerns over economic recession. If actual signals of an economic downturn emerge, the market could enter a prolonged bear market. The sharp pullback has already seen a rebound in US funds starting to bottom out, suggesting that this market slump is more of an emotional release rather than a bear market formation.