Markets bounced back quickly from early August crash – but investors may not be so lucky next time

By Joseph Adinolfi

A team of economists from the Bank for International Settlements took a closer look at what caused the August 5 market run. They found that nothing had really changed.

A team of economists from the Bank for International Settlements decided to investigate what triggered the global crisis that destroyed financial markets on August 5.

They found that despite the chaos, markets held up remarkably well. But investors may not be so lucky next time — and there almost certainly will be a next time. As volatility eases, traders have wasted no time rushing back into some of the same leveraged bets that contributed to the initial sell-off, the BIS team said. At the end of the day, nothing has really changed.

“The drivers behind the increase in volatility and large market moves have not changed significantly. Risk-taking in financial markets remains high,” the team said in a BIS Bulletin report published on Tuesday.

“Only some of the various trades based on low volatility and cheap funding in (Japanese) yen (USDJPY) appear to have been cancelled. Some larger transactions funded in yen, potentially involving more illiquid assets, could be written off more slowly,” BIS. the team said in the report.

But economists haven’t thought much about future risks. Instead, they focused their energies on analyzing exactly how things played out on August 5. The result is one of the more comprehensive accountings of what happened in global markets that day.

While the relaunch of Japanese yen trading initially received much of the blame – and rightfully so – for driving the sell-off, it was not the only crowded strategy affected by the sudden wave of deleveraging that rocked the markets. Long bets on stocks and options were also affected.

All had one thing in common: Traders used more and more leverage to chase the momentum, spurred by a prolonged period of low volatility. The first blow came as volatility spiked in late July and early August. Soon the entire edifice collapsed.

Data from the banks’ prime brokerages showed that leverage played an important role in the selloff. The data showed that hedge funds stepped up their use of borrowed money in the run-up to the event.

As volatility spiked on August 5, clearing houses required traders to put up more capital to cover their risk, triggering a vicious cycle of margin calls.

Carrying operations in the foreign exchange market were particularly hard hit, the BIS team said. But the cascading margin calls also contributed to an unprecedented rise in implied volatility in the stock market as the Cboe VIX volatility index rose.

The VIX, as the index is known, briefly rose north of 65 in premarket trading in the US, according to Dow Jones Market Data.

After scrutinizing all available data, the team was unable to determine the exact size of the yen trade prior to the sale. But they were able to come up with a rough, back-of-the-envelope estimate: In total, more than $1 trillion may have been deployed in yen trades before the sell-off.

That figure was based on credit flows involving Japanese banks and foreign borrowers, as well as a BIS estimate of hedge funds’ use of foreign exchange contracts.

The number also includes short positions in yen currency futures, although this is a small part of the overall figure. But it doesn’t surprise the full range of derivatives that sophisticated traders have used to bet against the yen.

Outside the professional sphere, Japan’s army of retail currency traders, known by the metonym “Ms Watanabe”, have shorted the yen heavily, the BIS team said.

A drop in bitcoin (BTCUSD) prices that day suggested the retail crowd was also likely hit by margin calls that may have forced it to liquidate other positions to cover.

The spark that set the selloff in motion looked fairly benign in retrospect, further underscoring the role leverage played in exaggerating the collapse, the BIS team said.

In fact, it was a one-two punch: The Bank of Japan sent a bigger message than expected when it raised interest rates on July 31. Then, a few days later, data released by the US Labor Department showed a rise in the unemployment rate, while the pace of job creation slowed.

The S&P 500 SPX ultimately fell 3% to close on Aug. 5, its biggest daily decline since September 2022, according to Dow Jones data. Japan’s Nikkei 225 JP:NIK fell more than 12% on its worst day since October 20, 1987 – better known as “Black Monday”.

The dollar (USDJPY) fell 2.8% to 142.54 yen. Stocks have since recouped most of their losses, with the S&P 500 trading within a percentage point of its record close since mid-July on Wednesday.

– Joseph Adinolfi

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08-29-24 0607ET

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