Bitcoin, Markets, and the Yen Carry Trade

After a choppy July in early August, Bitcoin experienced a significant drop in price from ~63,000 down all the way to ~$49,700. The entire cryptocurrency market faced substantial selling pressure, influenced by a ~10% drop in Japan’s Nikkei index on August 2 and compounded by a disappointing U.S. jobs report for July. The following illustrates how bad this "bull market" year of 2024 has been for some specific tokens.

tyd token 2024 — YTD returns for different crypto tokens in different sectors. Source

Despite this downturn, Bitcoin continues to trade within a broad range, making future price movements challenging to predict. Notably, Bitcoin "whales," or holders of large quantities of Bitcoin, remain optimistic. In July alone, addresses with over 1,000 Bitcoin accumulated an additional 84,000 Bitcoin. Simultaneously, exchanges witnessed a significant withdrawal of 64,000 Bitcoin, the largest since 2015, according to Glassnode.

Since July 30, Bitcoin's price has fallen by 21%, mirroring downturns in the U.S. stock market, which has been affected by rising unemployment claims, a decline in manufacturing, issues with the Japanese economy, and stress on a very popular FX trade called the Yen Carry Trade.

Mechanics of the Yen Carry Trade

The yen carry trade, a well-known financial strategy, has recently garnered significant attention due to its influence on market volatility. This approach, which involves borrowing in a low-yielding currency like the Japanese yen to invest in higher-yielding assets, has been a staple in traditional finance for years. However, its popularity has surged over the past two years, impacting various markets, including U.S. equities.

At its core, the yen carry trade exploits the interest rate differentials between countries. Investors borrow yen at low interest rates and convert it into higher-yielding currencies or assets, such as U.S. Treasuries or equities. This strategy not only benefits from the interest rate spread but also from potential gains in the invested assets. Over the past two years, a significant portion of the borrowed yen has flowed into U.S. equities, contributing to market rallies, particularly in big-cap tech stocks.

Recent Developments and Market Impact

The carry trade's impact on markets became evident with the recent volatility in the yen and its subsequent effects on global markets. A series of events, including a surprise rate increase by the Bank of Japan, heightened expectations of U.S. Federal Reserve rate cuts, and growing recession fears in the U.S., catalyzed a reversal in the yen's value. This reversal prompted interventions by Japan's Ministry of Finance to stabilize the yen, further exacerbating market turbulence.

The unwinding of the yen carry trade has led to significant asset sales as investors repay their yen-denominated loans or top up their margins due to rising margin calls. This process has created substantial volatility, particularly in Japanese equities, which experienced a 12% drop in a single day—a stark contrast to the more gradual movements typically observed in traditional markets.

Broader Implications

The relationship between speculative futures positioning in the yen and U.S. equities, particularly the NASDAQ 100, reveals a tight correlation. Continued unwinding of the yen carry trade could trigger further selling in U.S. equities and other foreign assets, compounding market volatility. This concern underscores the uncertainty facing investors, as it's challenging to predict the full extent and duration of this unwinding process.

Tether Keeps Setting Revenue Records

Tether, the preeminent stablecoin in the crypto space, has released its financial results for Q2, revealing an all-time high in US Treasury holdings. The quarterly attestation by auditor BDO disclosed that Tether’s US Treasury holdings, encompassing both direct and indirect exposure, surged to $97.5 billion. This milestone positions Tether as the 18th largest owner of US debt globally, surpassing countries like Germany, the UAE, and Australia.

According to Tether's press release, the firm ranked third in purchases of 3-month US Treasuries during the first half of 2024, trailing only the UK and the Cayman Islands. The company anticipates potentially leading this category by next year, driven by the continued adoption of its USDT stablecoin.

Key Highlights from Q2

Net Operating Profit: Tether reported a net operating profit of $1.3 billion in Q2, a decline from the previous quarter’s $4.5 billion, which was bolstered by substantial mark-to-market gains on Bitcoin positions. This quarter saw a $653 million loss.
US Treasury Holdings: Now constituting 68.3% of Tether's reserves, US Treasury holdings reached another record high.
USDT Issuance: Over $8.3 billion in USDT was issued in Q2, raising the total circulating supply to $112.7 billion.
Excess Reserves and Equity: Tether's excess reserves, which exceed its liabilities, stood at $5.3 billion, while the Tether Group's equity, including investments not part of reserves, reached $11.9 billion.
Bitcoin Holdings: Tether’s Bitcoin reserves were valued at $4.7 billion, a 12% quarter-over-quarter decline due to the falling Bitcoin price. The firm maintained its Bitcoin holdings at 75.3k BTC. CEO Paolo Ardoino asserted that the company continued its quarterly Bitcoin acquisitions via Tether’s investment arm.

Stablecoin capital inflow is a crucial barometer for the broader cryptocurrency market, reflecting investor confidence and technology adoption. Tether's addition of $8 billion in USDT during Q2 reinforces its market leadership in inflows and sustains its dominance at 70% of the global stablecoin market throughout 2024. However, Tether’s global dominance faces potential challenges with the implementation of the Markets in Crypto-Assets (MiCA) regulation in the EU. Unlike its competitor Circle, Tether has not secured a license from the European Banking Authority to operate in the region.

Looking forward, stakeholders are keenly awaiting further transparency from CEO Paolo Ardoino regarding Tether’s reserve composition, particularly the specifics of the alleged Bitcoin purchases. Since Tether committed to allocating up to 15% of its net operating profit to Bitcoin acquisitions starting Q3 2022, clarity on these transactions remains vital. Currently, Tether’s identified Bitcoin address ranks as the 8th largest holder, with a balance of 75.3k BTC, valued at nearly $5 billion.

Jump Exiting?

In the midst of ongoing market turbulence, Jump Crypto, the cryptocurrency arm of Jump Trading, is actively selling its assets. Blockchain data reveals significant movements of cryptocurrency, including ~$300 million of staked ETH, indicating a strategic reshuffle of their holdings, possibly in response to volatile market conditions and recent regulatory developments.

The timing of these asset movements coincides with the recent departure of Jump Crypto’s President, Kanav Kariya. This adds another layer of intrigue, suggesting potential internal changes or strategic shifts within the firm. Moreover, the increased regulatory scrutiny by the U.S. Commodity Futures Trading Commission (CFTC) could also be influencing these decisions, as companies frequently adjust their strategies in response to regulatory pressures.

The broader context of these strategic movements by Jump Crypto highlights the complexities and uncertainties in the current cryptocurrency market. As regulatory scrutiny intensifies and market conditions remain volatile, firms like Jump Crypto must navigate a challenging environment, making strategic decisions to safeguard their positions and adapt to evolving circumstances.

DeFi, DAOs, and Compound

Compound aims to provide a trustless money market for the cryptocurrency ecosystem, eliminating central points of failure and the reliance on centralized entities typical in traditional finance. Initially launched as a tokenless protocol in 2018, Compound was governed unilaterally by its founding team. This central control was deemed necessary for security and development during its early stages. However, in June 2020, Compound introduced its governance token, COMP, marking a pivotal shift towards decentralization.

Transition to Decentralized Governance

The launch of the COMP token empowered the Compound community to govern the protocol. COMP holders can propose and vote on protocol changes, fostering a decentralized decision-making process. For instance, in May 2021, COMP holders approved the addition of TUSD and LINK as supported markets, which have since grown to $100 million and approximately $160 million, respectively.

The initial centralization of Compound’s governance was an intentional but temporary measure. Robert Leshner, Compound's co-founder, emphasized that the initial unilateral control was meant to ensure security but would eventually be transferred to the user community. The Compound Whitepaper outlines specific powers transferred to COMP holders, including listing new cToken markets, updating interest rate models, and choosing new administrators through decentralized autonomous organizations (DAOs).

COMP Token and Governance Mechanism

The COMP token enables holders to propose and vote on protocol changes. Any user with 1% of COMP tokens delegated to their address can initiate a governance proposal. Voting on proposals lasts three days, and a consensus requires a minimum of 400,000 votes. This mechanism ensures that protocol changes reflect the community's consensus, akin to a corporate board's decisions.

The decentralized governance model aims to address the shortcomings of centralized exchanges like Bitfinex and Poloniex. Centralized exchanges require users to trust the exchange's integrity, limit participation to specific customer groups, and restrict the use of assets within the exchange's ecosystem. In contrast, Compound’s decentralized model allows for on-chain asset utilization, enhancing accessibility and transparency.

Governance Challenges and Strategic Exploitation

Despite its decentralized governance, Compound faces challenges typical in DeFi. A prominent example is the "governance attack" by a whale known as Humpy, who leveraged their holdings to influence protocol decisions. Humpy's strategy involved acquiring significant governance tokens to control reward distributions, first seen with Balancer during the DeFi Summer of 2022. Humpy's tactics highlighted vulnerabilities in governance models that allow strategic exploitation by large token holders.

Humpy’s actions underscore the need for DeFi protocols to reassess their governance structures to mitigate risks posed by influential market players. This includes implementing safeguards to prevent governance manipulation and ensuring that community interests are protected.

DAOs, as governance entities within DeFi, blend smart contracts with central intermediaries to manage risk. While this central governance model allows for expert oversight and responsive adjustments to market conditions, it also introduces operational, cyber, and political risks. DAOs must navigate these challenges to balance efficient management with the decentralized ethos of DeFi.

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