The Swiss franc temporarily overtakes the yen, becoming the new favorite of arbitrage traders for financing.

According to Zhihui Finance APP, due to the threat of intervention and higher interest rates weakening the yen's appeal as a funding currency, arbitrage traders are turning their attention to the franc.

Latest data from the US Commodity Futures Trading Commission (CFTC) shows that, in the week ending August 11, hedge funds pushed net short positions in the franc to near a two-month high. Meanwhile, they have cut short positions in the yen for a second consecutive week.

Hedge funds shorting the franc

Funding Costs and Currency Intervention Become Key Considerations

Tobias Jungen, Head of FX Options for the Americas at Bank of America in New York, said: "The market has recently increased short positions in the franc, using it as funding for FX carry trades." He also noted that the volatility-to-yield ratio for emerging market trades funded with the franc makes options an effective way to gain exposure while limiting risk.

The franc's funding appeal stems from Switzerland's near-zero interest rates and the Swiss National Bank's willingness to curb sharp appreciation of the currency. In contrast, at the end of July, Japanese and US authorities joined forces to push up the yen exchange rate, causing yen volatility to spike and making investors wary of yen-funded trades. Last week, informed sources revealed that the Japanese government supports a recent rate hike by the central bank.

Higher yield differentials are increasing the franc's appeal as a funding currency. Data shows that, over the past month, a strategy of borrowing francs and investing in the high-yield Mexican peso generated a cumulative return of nearly 4%; the same strategy with yen funding yielded just 1.3%.

Put simply, arbitrage trading means investors borrow low-yield currencies and switch into high-yield currencies to capture interest rate differentials.

Stephen Jefferies, Head of FX and Emerging Markets at JPMorgan in London, said: "Large-scale intervention in 2024 severely hurt yen carry trades, and market participants are still cautious." He also mentioned that demand has recently picked up for alternative funding currencies such as the franc, euro, and even the New Taiwan dollar.

The Yen's "King of Funding" Status Difficult to Shake in the Short Term

However, the yen has long been the preferred funding currency for arbitrage trading and still enjoys the favor of some industry insiders.

The Bank of Japan's 1% policy rate is lower than most developed markets, and market concerns over Japan's long-term fiscal situation also weigh on the yen. The yen has now given back more than half of its post-intervention gains.

"The yen remains the world's main funding currency, and recent intervention hasn't changed this fundamental reality," said Markus Schmidt, Head of European Linear FX and Local Market Rates Trading at Crédit Agricole. As long as interest rate gaps between Japan and other economies exist, arbitrage traders will continue to short the yen.

Graham Smallshaw, Senior FX Spot Trader at Nomura Singapore Limited, said that as the yen recently corrected, his firm observed increased market interest in going long yen cross pairs (euro/yen, AUD/yen, and NZD/yen). These trades are mainly executed through European-style reverse knockout options (ERKO).

Some market participants believe that, at least at this stage, the franc remains the more favored funding choice. Steve Brice, Global Chief Investment Officer at Standard Chartered in Singapore, stated, "Franc-funded carry trades are more popular. We are seeing more carry trade funds coming from the franc."