The mastermind behind the "Black Monday" has not been eliminated yet, next time won't be so lucky!
Economists from the Bank for International Settlements (BIS) studied the turbulent events in the global financial markets on August 5th. They believe that although the market has performed well in the short term, the risks of future shocks remain high. The report points out that the weakening market volatility and the recovery of leveraged trading may lead to the next turmoil. The initial yen arbitrage trades, which were seen as the cause of the sell-off, are actually part of a broader market deleveraging strategy, indicating high risks in the financial markets
Some economists at the Bank for International Settlements (BIS), known as the "central bank of central banks," have decided to delve into what triggered the global financial market turmoil on August 5th. They found that despite the market performing quite well after the chaos, investors may not be so lucky next time. They are almost certain that turmoil will happen again.
The BIS team stated that with the decrease in volatility, traders opportunistically re-entered some leveraged bets that initially led to the sell-off. Ultimately, when the market crash ended, nothing really changed.
In a report released by the team on Tuesday, they stated, "The driving factors behind the surge in volatility and significant market fluctuations have not significantly changed. The financial market remains highly risky."
They added, "Only a small portion of trades based on low volatility and cheap yen financing seem to have been closed. Some more widespread trades financed in yen may involve more illiquid assets, which may be closed more slowly."
However, BIS economists still focused on analyzing how the events of August 5th unfolded.
They pointed out that, while the unwinding of yen carry trades was initially seen as the main reason driving the sell-off (which was reasonable), it was not the only popular strategy affected by the market deleveraging trend. Over-betting on stocks and options was also impacted.
They all have one thing in common: driven by long-term low volatility, traders increasingly used leverage to chase market momentum. And these trades quickly collapsed when volatility spiked at the end of July and early August.
Data from bank institutional brokerage departments showed that leverage played a significant role in this sell-off. The data indicated that hedge funds increased their use of borrowed funds before the turmoil occurred. As market volatility intensified on August 5th, clearinghouses required traders to inject more funds to cover risks, triggering a vicious cycle of additional margin calls.
The BIS team stated that the blow to the forex market carry trades was particularly severe. But as the Chicago Board Options Exchange (CBOE) Volatility Index (VIX) soared, a series of additional margin call notices also helped drive an unprecedented intraday surge in stock market implied volatility. Data from Dow Jones Market Data showed that the VIX index briefly surpassed 65 points in pre-market trading in US stocks.
After carefully considering all available data, the BIS team still could not determine the exact scale of yen carry trades before the sell-off. But they came up with a rough estimate: before the sell-off, a total of over $1 trillion may have been invested in yen interest rate differential trades.
This data is based on loan flows involving Japanese banks and foreign borrowers, as well as BIS estimates of hedge funds using foreign exchange forward transactions, including short interest in yen futures (which only accounts for a small portion of total positions), but does not cover all derivative products used by seasoned traders to short the yen.
The BIS team mentioned that outside the professional field, a large number of Japanese retail traders known as "Mrs. Watanabe" were also heavily shorting the yen The team also pointed out that the drop in Bitcoin prices on that day indicated that retail investors may also be affected by additional margin call notices, which may force them to liquidate other positions.
The BIS team stated that in hindsight, the trigger for the sell-off seemed relatively mild, further highlighting the role of leverage in amplifying crises.
In fact, the market faced a combination of punches: the Bank of Japan delivered a more hawkish message than expected when it raised interest rates on July 31. A few days later, data released by the US Department of Labor showed an increase in unemployment rates and a slowdown in the pace of job creation.
According to Dow Jones data, the S&P 500 index (SPX) fell by 3% at the close on August 5, marking the largest single-day decline since September 2022. The Japanese Nikkei 225 index dropped by over 12%, making it the worst day since October 20, 1987, also known as "Black Monday." Subsequently, global stock markets recovered most of the lost ground, with the S&P 500 index on Wednesday just one percent below its record closing high from mid-July