In the global financial markets, currency carry trade has long been favored by investors as an important speculative strategy. The Japanese yen, as one of the world's major low-interest-rate currencies, often serves as a core vehicle for carry trades. Meanwhile, with the rapid development of the cryptocurrency market, Bitcoin (BTC) has gradually been incorporated into mainstream investment products, particularly through exchange-traded funds (ETFs) and exchange-traded futures contracts, further strengthening its interaction with traditional financial markets. This article aims to analyze the intrinsic connection between the yen carry trade and arbitrage opportunities in the Chicago Mercantile Exchange (CME) Bitcoin futures market. By exploring the dynamic relationship between the two, we will reveal how global capital flows influence Bitcoin's price discovery mechanism through various financial instruments and examine the underlying arbitrage opportunities and risks.
Before analyzing the relationship between Carry Trade and Arbitrage, it is necessary to briefly introduce why the Japanese yen is used in carry trades, its historical background, and how the process works.
Historical Background of the Japanese Economy
Japan's long-term policy of low or even zero interest rates can be traced back to the bursting of the bubble economy in the early 1990s and the subsequent “lost decade”.
The Formation and Collapse of Japan's Economic Bubble (1980s–Early 1990s)
In the 1980s, Japan experienced rapid economic growth, and both the real estate and stock markets expanded quickly, creating a massive asset bubble. Companies and individuals took out large loans to invest, driving up asset prices. The banking system, encouraged by loose monetary policies, extended extensive credit, further fueling the bubble. This period, known as the "bubble economy," became one of the most prosperous eras in Japan's postwar economic history. Particularly after the signing of the Plaza Accord in 1985, the yen appreciated rapidly, prompting a significant inflow of capital back into the country. This led to a sharp expansion of both financial and real estate markets, with the government and banks promoting loose monetary policies, resulting in large amounts of capital flowing into the stock and real estate markets. Some even claimed that "selling Tokyo could buy the entire United States," illustrating Japan's economic boom at the time. By the late 1980s, the Nikkei Index at the Tokyo Stock Exchange surged from over 7,000 points in early 1980 to nearly 39,000 points by the end of 1989, with market capitalization multiplying several times over. In 1991, in an effort to curb the overheated economy, the Japanese government and the Bank of Japan implemented contractionary monetary policies, gradually raising interest rates to cool down the real estate and stock markets. This caused asset prices to plummet, and the bubble burst rapidly. Financial institutions and businesses faced deteriorating balance sheets, with a massive accumulation of bad debts. Japan then entered a prolonged period of economic stagnation, a phase known as the "Lost Decade."
The Lost Decade and BOJ's Monetary Easing (1990s–2000s)
After the bubble burst, Japan’s economy fell into a prolonged slump, with the balance sheets of both businesses and individuals severely damaged. This led to weak demand, reduced investment, and lower consumption. At the same time, deflationary pressures worsened, with prices continuing to fall, further stifling economic growth. Financial institutions accumulated a large amount of bad debt due to the burst bubble, and many banks faced severe capital shortages. To prevent a financial system collapse, the Japanese government had to repeatedly bail out banks, but the underlying fragility of the system was never fully resolved. During this period, Japan’s economic growth nearly stagnated, with GDP growth rates hovering around zero, and both corporate investment and consumer demand remained sluggish. In response to deflation and economic stagnation, the Bank of Japan began to gradually lower interest rates starting in the mid-1990s. By 1995, the BOJ had reduced the interest rate to 0.5%, the lowest in the world at that time. Rates were further lowered, leading to the implementation of a zero-interest rate policy in 1999, aimed at stimulating economic growth and inflation. In 2001, the BOJ introduced quantitative easing (QE), injecting liquidity into financial markets by purchasing large amounts of government bonds and other assets, further depressing long-term interest rates. The goal of this policy was to stimulate borrowing and investment, thereby driving inflation, but its effects were limited.
Zero-Interest and Negative Interest Rate Policies (Post-2000)
Japan's zero-interest and negative interest rate policies were key tools employed by the Bank of Japan (BOJ) to combat long-term economic stagnation, deflation, and low growth. The aim of these policies was to stimulate economic growth and raise inflation, pulling the economy out of the prolonged stagnation that followed the "Lost Decade." While zero-interest policies theoretically should promote economic recovery, Japan’s economic issues stemmed largely from structural problems such as population aging and corporate and personal deleveraging (reducing debt), thus limiting the effectiveness of these policies. Although the financial system avoided collapse, economic growth remained sluggish. Due to the limited impact of the zero-interest policy, the BOJ adopted an even more aggressive approach in 2016: negative interest rates. This made Japan one of the first major economies to implement negative rates. The BOJ imposed a negative interest rate (-0.1%) on a portion of the reserves that financial institutions held at the central bank, meaning that banks had to pay a fee to store excess funds at the BOJ. The goal was to encourage banks to lend money to the real economy and stimulate investment. In fact, Japan's zero-interest and negative interest rate policies laid the foundation for the yen becoming a major currency for global carry trade strategies. These policies made borrowing costs for the yen extremely low, making it an ideal currency for borrowing. Additionally, due to the BOJ’s loose monetary policy, the yen's exchange rate typically experienced minimal short-term volatility, making carry trade operations relatively safe.
What is Carry Trade and how does it work?
Carry Trade is a common financial trading strategy aimed at profiting from the interest rate differences between countries or markets. Specifically, investors borrow funds from countries or markets with low interest rates, then invest those funds in countries or assets with higher interest rates to earn the spread between the two.
How Carry Trade Works:
Borrowing Low-Interest Currency:Investors borrow currency from countries or regions with lower interest rates, typically those with loose monetary policies and near-zero or even negative benchmark rates, such as Japan or Eurozone countries.Example: Suppose Japan's interest rate is 0%, and an investor can borrow yen at a very low cost.
Converting to High-Interest Currency:The investor then converts the borrowed low-interest currency (e.g., yen) into a high-interest currency, such as the Australian dollar (AUD), Brazilian real (BRL), or Turkish lira (TRY). These countries often have higher benchmark interest rates to attract foreign capital or control inflation.Example: If Australia's interest rate is 4%, the investor converts yen into AUD and invests in the Australian market.
Investing in High-Yield Assets:The converted funds are typically invested in high-yield financial assets, such as bonds, bank deposits, or other fixed-income products in the high-interest country. The investor earns a return higher than the borrowing cost through the high interest rates.Example: The investor invests the converted AUD into the Australian bond market, earning 4% annual interest income.
Earning the Interest Rate Spread:The investor's profit mainly comes from two aspects: the interest rate spread and the exchange rate. The interest rate spread is the difference between the yield on high-interest assets and the borrowing cost of the low-interest currency. In this example, the borrowing cost of yen is 0%, while the return on Australian assets is 4%, resulting in a 4% interest rate spread. If exchange rates remain stable, the investor profits from this difference.
However, exchange rate risk is one of the most significant risks in Carry Trade. While investors can profit from the interest rate spread, exchange rate fluctuations may affect the final profit. For example, if the low-interest currency (e.g., yen) appreciates during the trade, the investor will need more funds to buy back yen when repaying the loan, offsetting the spread earnings or even causing a loss. According to incomplete estimates, the total volume of yen Carry Trade could exceed one trillion US dollars.
How to do risk-free arbitrage with BTC CME futures?
So, how can one conduct risk-free arbitrage using the current month futures contracts of BTC on CME? This involves cash and carry arbitrage, a strategy where arbitrageurs buy the spot asset and short the futures contract. The Chicago Mercantile Exchange (CME) generates the current month BTC futures contract (code: BTC1!) at the end of each month. At this point, the current month futures contract typically has a futures premium of around 1% compared to the spot price.
At the time of the futures contract's expiration, the price converges with the spot price, providing traders with an opportunity for risk-free arbitrage.
The futures premium on the Chicago Mercantile Exchange (CME) exhibits regular fluctuations during the monthly contract rollovers (i.e., the automatic shift to the next month's contract). The pattern of premium changes is similar to the premium of traditional exchange swap Delivery contracts, usually starting with a higher premium at the beginning of the contract and gradually converging toward balance as the contract approaches expiration.
Assume traders have $20 million. Without considering any leverage, they can use $10 million to buy BTC spot on an exchange and another $10 million to short BTC futures on CME for a risk-free arbitrage. During this period, regardless of price fluctuations, the short position is unlikely to be liquidated. Depending on the premium level, the monthly risk-free return is about 1%, resulting in an annualized risk-free rate of 12%. In this case, without considering compound interest, the $20 million could generate $1.2 million in risk-free returns for the trader. Based on CTFC report data, this explains why leveraged funds hold only a small number of long positions in CME but have large BTC futures short positions, as they are all engaging in risk-free arbitrage on CME futures. According to the data, the leverage ratios for these arbitrage funds range from 2 to 14 times, meaning the actual annualized returns are significantly higher than 12%.
As of September 28, 2024, according to CoinGlass data, CME currently holds 156,300 BTC in open interest, accounting for 28,4% of the total open interest in BTC futures (including perpetual contracts).
Following the approval of the BTC ETF, the open interest in CME's BTC futures surged from approximately $6.3 billion on January 12, 2024, to a peak of around $11.6 billion in April 2024.
At this point, we can speculate that a significant portion of the inflows into the ETF is also being used for arbitrage, specifically by buying ETF spot and shorting CME futures contracts to profit from the price difference. However, due to a lack of supporting data, we will not elaborate further on this speculation.
The relationship between JPY Carry Trade and CME BTC futures positions
On August 5, 2024, influenced by the news of the Bank of Japan's interest rate hike, the Nikkei 225 index experienced a maximum decline of over 12%, marking its largest one-day drop since the pandemic. On the same day, BTC also faced its largest sell-off since the pandemic, with a maximum decline of 12%. This rate hike to 0.25% was the first increase since the Bank of Japan exited its negative interest rate policy, raising the rate to 0.1%, signaling the beginning of a tightening of yen liquidity. Market speculation suggests that this was due to the unwinding of many carry trade positions that borrowed in yen, as traders anticipated that the Bank of Japan would continue to raise rates multiple times in the future, leading to a massive sell-off of various assets. According to CFTC data, the rate hike in Japan resulted in a significant unwinding of yen short positions, with yen futures short positions dropping from a high of $14.3 billion in early July to only $968 million by August 6. However, this does not fully reflect the overall scale of the yen carry trade, with estimates suggesting that the total size could reach trillions of dollars.So, why do Japan's policies impact global markets and have a significant connection to the cryptocurrency market?
（Source:Coinbase Institutional）
The chart clearly reflects the correlation between yen short positions and BTC futures positions on CME. As JPY short positions increase, the holdings of BTC futures contracts on CME also rise significantly. This suggests a possibility that a large portion of the BTC futures positions on CME is funded by liquidity provided through the yen carry trade or related derivatives trading. Traders are engaging in substantial arbitrage operations in the CME market by leveraging the low borrowing costs of JPY. Furthermore, the approval of the BTC ETF in January 2024 has provided institutions with considerable ease in capital flow compliance, allowing them to simply purchase BTC ETF spot in exchanges and short BTC futures contracts on CME to conduct arbitrage trading. In short, many professional investors have borrowed the inexpensive liquidity of JPY to engage in large-scale arbitrage trading on CME.
Overall, this article analyzes the profound connection between the yen carry trade and the arbitrage in CME Bitcoin futures. This connection is not merely a simple correlation; it results from a complex interplay of capital flows and market mechanisms. This cross-market arbitrage strategy presents both risks and opportunities. Changes in the monetary policy of the Bank of Japan directly impact global capital flows, subsequently affecting asset prices across various markets, including the cryptocurrency market.
In the future, as the cryptocurrency market continues to mature and regulations improve, along with further integration between traditional financial markets and the cryptocurrency market, this arbitrage strategy will evolve. Both its risks and returns will require deeper analysis and evaluation by investors. More refined risk management models and more effective arbitrage strategies will become focal points for investors. A keen insight into macroeconomic policies, market volatility, and regulatory changes will be an essential capability for investors in the future.
