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What Is a Funding Currency?

By Rutger Lokin · Updated

What is a funding currency? It is the currency traders borrow, or sell, to pay for a position in something that yields more. It is the cheap side of a carry trade. For most of the last decade that meant the Japanese yen and the Swiss franc, and for a while the euro.

Even if you never run a carry trade, you trade beside people who do. A funding currency’s price is set partly by other people’s positions, so it can fall on good domestic news and rise on bad global news. If you read it only through its own economy, it will keep surprising you.

How a carry trade earns and how it reaches your account through the swap is in the Carry Trade Guide: How It Works and Why It Unwinds. This page is about the currency on the borrowed side.

What it takes to be one

First, a rate near the bottom of the developed world. The Bank of Japan put a rate of −0.1 percent on part of the banks’ deposits from early 2016 (Bank of Japan, 29 January 2016) and only left negative rates in March 2024 (Bank of Japan, 19 March 2024). The SNB cut the rate on sight deposits to −0.75 percent in January 2015 (SNB press release). The ECB’s deposit rate was below zero from June 2014 (ECB, 5 June 2014) until July 2022 (ECB, 21 July 2022).

Second, the rate has to be expected to stay there. Nobody wants to borrow a currency whose central bank is about to raise rates, because the cost of the position would rise and the currency with it.

Third, a deep market. Carry positions are large, and the people holding them need to know they can get out in a hurry.

The gap that makes the borrowing worth it is on Interest rate differential by currency pair and, after inflation, on Real interest rates by currency. How the gap is worked out is in What Is an Interest Rate Differential?

The slow drift and the sudden snap

In calm markets every new carry trade sells the funding currency. That steady selling keeps it soft whatever its own data say, and it can drift lower for months.

Closing a carry trade means buying the funding currency back. When something frightens the market, many holders close at once, and months of drift can reverse in weeks.

Summer 2024 is the clearest recent case: between 10 July and 5 August the dollar lost about 11 percent against the yen (Fed H.10 rates on FRED), with a Bank of Japan rise to around 0.25 percent on 31 July in between (Bank of Japan statement). How the unwind ran, and how large it was, is in the Carry Trade Guide: How It Works and Why It Unwinds.

This buy-back is one reason the yen behaves as a safe haven currency. Part of the rally in a panic is fear, and part is simply people returning what they borrowed.

The three that have played the role

The role belongs to whoever has the lowest rates and the deepest market at the time. When those rates go up, the currency stops being cheap to borrow, and the role passes on.

Reading a funding currency

Don’t read the drift as a verdict on the economy. A yen that weakens for months while Japan reports decent data is usually telling you about carry positions, and that kind of weakness can reverse without a word of Japanese news.

Watch the right central bank. The funding currency’s own central bank matters most, because one rate rise narrows every carry trade built on it at once. July 2024 showed what that does.

July 2024 is the case everyone remembers, and it is not the usual one. Take the seven Bank of Japan rises since 2006 that have three months of prices after them. A month after each new rate took effect, the yen was higher against the dollar in three cases. Three months after, it was higher in only two. Seven is a small sample, but it does not show the yen reliably gaining after one. Even July 2024 is not one of the two: most of the yen’s jump came before the new rate took effect on 1 August, and three months later it was a little lower than on that day.

Each time, the Fed’s rate was still at least 2.6 points above Japan’s, so borrowing yen stayed cheap. A rise that leaves a wide gap narrows the trade without ending it. These are the policy rates the BIS lists (BIS), with moves measured from the day each new rate took effect on the Fed’s H.10 rates (FRED).

And before you sell a funding currency, check how many others already have. The leveraged funds’ line in the CFTC’s weekly Traders in Financial Futures report (CFTC) is the closest public view of them, though not every short in it is a carry trade. Which line to read, and why, is in COT Report Explained: Which of the Four CFTC Reports to Read.