“Volatility Rise Made Carry Trades Less Attractive”: Should Japanese FX Brokers Worry?

Thursday, 26/10/2023 | 13:40 GMT by Arnab Shome
  • Margin FX trading volume in Japan touched a record in 2022.
  • A Bank of Japan report revealed that Japanese traders are moving away from carry trading strategies.
liquid, ftx

When it comes to margin forex trading, Japan dominates. The total annual FX trading volume in the country exceeded a record JPY 12 quadrillion (about $81.5 trillion) in 2022, growing 7.2 times in a decade. The USD/JPY pair, which accounted for only around 25 percent of the overall trading volume in 2012, jumped to 75 percent at the end of last year.

So, what factors gave the Japanese margin FX market such a boost? According to a market review paper by the Bank of Japan, titled “Retail Foreign Exchange Margin Trading in Japan: An Analysis from the Developments in 2022” market volatility and low transaction costs pushed the volume to a record level.

Tomitaka Ishimura, COO at GMO Financial Holdings
Tomitaka Ishimura, COO at GMO Financial Holdings

Tomitaka Ishimura, the COO at GMO Financial Holdings pointed out that an "increase in the supply of funds in each country [during the Coronavirus pandemic] led to an influx of funds into carry trades in high-interest currencies and transactions in the dollar-yen, which have high liquidity, leading to active trading."

He added: "Now that the coronavirus pandemic has ended, market volatility has increased with interest rate fluctuations due to monetary tightening policies in each country. Speculative traders have become active, and the trading volume of the Japanese FX market continues to set new record highs."

Volatility Shadows Carry Trading Opportunities

The Japanese yen is a low-yield currency, giving local traders perfect carry trading opportunities with other high-yield currencies like the Australian and New Zealand dollar. The rising US interest rates opened up these carry trading opportunities further.

"As Japan continues its low-interest rate policy, the difference in interest rates between Japan and other countries is widening," Ishimura said. "Carry trades in major currencies are also making a comeback, with foreign currencies being bought and the yen being sold."

"Exotic currencies have traditionally been popular in carry trades, but as US interest rates continue to rise, it appears that there is a growing preference for the dollar, which has excellent liquidity, interest rates, and safety."

However, Japanese traders moved away from carry trading toward short-term intraday trades.

“The monthly average of open positions on which swap points are accrued or charged – in other words, FX positions that have been created but have yet to be closed out with the opposite positions – doubled compared with ten years earlier. In comparison, the trading volume grew more than seven times, at a distinctly faster pace than the amount of open positions,” the paper stated.

FX trading volume in Japan

Huge Retail FX Margin Trading Market

The participation of retail traders in the Japanese market also jumped exponentially in the last decade to 10.54 million in 2022 from 4.5 million in 2012. The number of active accounts additionally leaped about 840,000, 1.4 times higher than a decade ago.

In Japan, retail FX trading spawned in 1998 and exploded after 2005, when it was brought under the Financial Futures Trading Law. The trading volume maintained the incremental trend despite the introduction of tiger regulations on margin requirements in 2010.

The FX trading activities in the country received a boost as the Japanese brokers do not usually charge commissions on trading and make money only from bid-ask spreads. With rising competition among brokers and growing demand, the bid-ask spread also narrowed significantly.

"We believe that the stabilization of Japan's FX market is largely due to the strengthening of investor protection through the development of regulations and rules," the COO at GMO told Finance Magnates.

"Under these circumstances, advertising activities that adhered to the rules became active. As a result, the domestic FX trading volume increased, and the media coverage around it created a cycle, resulting in a further increase in the number of trading participants."

Chantelle Lea, Regional Marketing Director at ThinkMarkets
Chantelle Lea, Regional Marketing Director at ThinkMarkets

Chantelle Lea, the Regional Director of Marketing at ThinkMarkets, commented: "Japanese forex brokers have taken a more assertive approach in their marketing efforts, spending considerably more on advertising and sponsorships. It has become common practice for brokers to have standing partnerships with celebrities, influencers, and sporting events."

The trading volume spike last year was primarily due to the global financial market, including the FX market. The volatility of USD/JPY remained high for almost the entire year. Although central

banks in major economies were moving to raise policy interest rates, the volume of carry trades remained sluggish, affected by the high volatility in the market.

“The rise in volatility made carry trades not as attractive as before,” the paper noted.

However, the GMO executive differs in opinion when he added: "It appears that the volume of carry trades is increasing as interest rate differentials are increasing, and day trading is also increasing as volatility is increasing due to interest rate differentials."

Trading volume and gross position per account in Japan

A Balanced Market

In retail FX margin trading, FX firms usually internally offset buy and sell orders from their customers. They then cover their positions mainly through trading with banks to hedge against FX fluctuations, known as cover deals.

According to the Bank of Japan's paper, the diversity of market participants in Japan balances out transaction directions, preventing too much widening of the bid-ask spreads that banks and other market makers offer, and maintaining and improving market liquidity. As such, the start and expansion of retail FX margin trading basically contribute to the improvement of liquidity in the interbank market.

“The impact of retail FX margin trading on market liquidity should be examined taking also into account the imbalances in transaction demands and the amount of activities, both of which fluctuate depending on market movements,” the paper added.

Challenges for Japanese Brokers

The demand for forex trading in Japan is high, but the market is well-regulated. As GMO's Ishimura pointed out, the regulations in the country are "neither too tight nor too lenient to protect traders well and facilitate fair and free competition." However, it is challenging for new brokers to enter the Japanese market and make a mark.

Lea from ThinkMarkets, which entered the Japanese market with a local acquisition in 2021, said: "Competition is very tight in the Japanese FX industry. Having a local office provides the organisation with valuable insights on how to dominate the Japanese FX market and mitigate the challenges that we face as one of the leading brokerage firms in the world."

When it comes to margin forex trading, Japan dominates. The total annual FX trading volume in the country exceeded a record JPY 12 quadrillion (about $81.5 trillion) in 2022, growing 7.2 times in a decade. The USD/JPY pair, which accounted for only around 25 percent of the overall trading volume in 2012, jumped to 75 percent at the end of last year.

So, what factors gave the Japanese margin FX market such a boost? According to a market review paper by the Bank of Japan, titled “Retail Foreign Exchange Margin Trading in Japan: An Analysis from the Developments in 2022” market volatility and low transaction costs pushed the volume to a record level.

Tomitaka Ishimura, COO at GMO Financial Holdings
Tomitaka Ishimura, COO at GMO Financial Holdings

Tomitaka Ishimura, the COO at GMO Financial Holdings pointed out that an "increase in the supply of funds in each country [during the Coronavirus pandemic] led to an influx of funds into carry trades in high-interest currencies and transactions in the dollar-yen, which have high liquidity, leading to active trading."

He added: "Now that the coronavirus pandemic has ended, market volatility has increased with interest rate fluctuations due to monetary tightening policies in each country. Speculative traders have become active, and the trading volume of the Japanese FX market continues to set new record highs."

Volatility Shadows Carry Trading Opportunities

The Japanese yen is a low-yield currency, giving local traders perfect carry trading opportunities with other high-yield currencies like the Australian and New Zealand dollar. The rising US interest rates opened up these carry trading opportunities further.

"As Japan continues its low-interest rate policy, the difference in interest rates between Japan and other countries is widening," Ishimura said. "Carry trades in major currencies are also making a comeback, with foreign currencies being bought and the yen being sold."

"Exotic currencies have traditionally been popular in carry trades, but as US interest rates continue to rise, it appears that there is a growing preference for the dollar, which has excellent liquidity, interest rates, and safety."

However, Japanese traders moved away from carry trading toward short-term intraday trades.

“The monthly average of open positions on which swap points are accrued or charged – in other words, FX positions that have been created but have yet to be closed out with the opposite positions – doubled compared with ten years earlier. In comparison, the trading volume grew more than seven times, at a distinctly faster pace than the amount of open positions,” the paper stated.

FX trading volume in Japan

Huge Retail FX Margin Trading Market

The participation of retail traders in the Japanese market also jumped exponentially in the last decade to 10.54 million in 2022 from 4.5 million in 2012. The number of active accounts additionally leaped about 840,000, 1.4 times higher than a decade ago.

In Japan, retail FX trading spawned in 1998 and exploded after 2005, when it was brought under the Financial Futures Trading Law. The trading volume maintained the incremental trend despite the introduction of tiger regulations on margin requirements in 2010.

The FX trading activities in the country received a boost as the Japanese brokers do not usually charge commissions on trading and make money only from bid-ask spreads. With rising competition among brokers and growing demand, the bid-ask spread also narrowed significantly.

"We believe that the stabilization of Japan's FX market is largely due to the strengthening of investor protection through the development of regulations and rules," the COO at GMO told Finance Magnates.

"Under these circumstances, advertising activities that adhered to the rules became active. As a result, the domestic FX trading volume increased, and the media coverage around it created a cycle, resulting in a further increase in the number of trading participants."

Chantelle Lea, Regional Marketing Director at ThinkMarkets
Chantelle Lea, Regional Marketing Director at ThinkMarkets

Chantelle Lea, the Regional Director of Marketing at ThinkMarkets, commented: "Japanese forex brokers have taken a more assertive approach in their marketing efforts, spending considerably more on advertising and sponsorships. It has become common practice for brokers to have standing partnerships with celebrities, influencers, and sporting events."

The trading volume spike last year was primarily due to the global financial market, including the FX market. The volatility of USD/JPY remained high for almost the entire year. Although central

banks in major economies were moving to raise policy interest rates, the volume of carry trades remained sluggish, affected by the high volatility in the market.

“The rise in volatility made carry trades not as attractive as before,” the paper noted.

However, the GMO executive differs in opinion when he added: "It appears that the volume of carry trades is increasing as interest rate differentials are increasing, and day trading is also increasing as volatility is increasing due to interest rate differentials."

Trading volume and gross position per account in Japan

A Balanced Market

In retail FX margin trading, FX firms usually internally offset buy and sell orders from their customers. They then cover their positions mainly through trading with banks to hedge against FX fluctuations, known as cover deals.

According to the Bank of Japan's paper, the diversity of market participants in Japan balances out transaction directions, preventing too much widening of the bid-ask spreads that banks and other market makers offer, and maintaining and improving market liquidity. As such, the start and expansion of retail FX margin trading basically contribute to the improvement of liquidity in the interbank market.

“The impact of retail FX margin trading on market liquidity should be examined taking also into account the imbalances in transaction demands and the amount of activities, both of which fluctuate depending on market movements,” the paper added.

Challenges for Japanese Brokers

The demand for forex trading in Japan is high, but the market is well-regulated. As GMO's Ishimura pointed out, the regulations in the country are "neither too tight nor too lenient to protect traders well and facilitate fair and free competition." However, it is challenging for new brokers to enter the Japanese market and make a mark.

Lea from ThinkMarkets, which entered the Japanese market with a local acquisition in 2021, said: "Competition is very tight in the Japanese FX industry. Having a local office provides the organisation with valuable insights on how to dominate the Japanese FX market and mitigate the challenges that we face as one of the leading brokerage firms in the world."

About the Author: Arnab Shome
Arnab Shome
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Arnab is an electronics engineer-turned-financial editor. He entered the industry covering the cryptocurrency market for Finance Magnates and later expanded his reach to forex as well. He is passionate about the changing regulatory landscape on financial markets and keenly follows the disruptions in the industry with new-age technologies.

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