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As G7 leaders prepare to meet in Canada, this year’s summit reflects a growing recognition that economic security and financial system resilience are deeply interconnected. The G7 Finance Ministers and Central Bank Governors’ Communiqué issued in Banff signals a shift toward a more comprehensive approach to risk. This is evident in the G7’s heightened focus on systemic vulnerabilities, including financial crime, the broadened role of the Financial Action Task Force, and increased attention to nonbank financial intermediaries, excessive leverage, liquidity mismatches, and the stability of cross-border payment systems.
Yet beneath this expanded agenda lies a stark and underappreciated reality: The very policies that stabilized markets after Covid-19 have quietly laid the foundation for a new systemic threat. A USD 24 trillion web of carry trade positions—built on cheap funding, hidden leverage, and the expectation of central bank rescue—has evolved into a structural vulnerability for the global financial system. The August 2024 unwind of yen-funded trades—wherein a sharp change in Japan’s monetary policy triggered a swift reversal of yen carry trades—was not a one-off anomaly. It was a warning of how fragile the system has become when decades of monetary accommodation collided with today’s highly leveraged financial markets.
Carry trades—borrowing in low-yielding currencies to invest in higher-yielding assets—have evolved from a niche arbitrage strategy into a cornerstone of global capital flows. What sets today’s environment apart is not just scale, but the degree of structural integration and opacity surrounding these trades.
The numbers tell the story. According to Bank for International Settlements data, yen-funded positions alone totaled approximately JPY 80 trillion (USD 500 billion) before the August unwind. When including Swiss franc and euro-funded positions, total global exposure likely exceeds USD 3.6 trillion—representing roughly 3.5 percent of global GDP concentrated in highly leveraged, correlated positions.
Risk is further amplified by concentration. When the few institutions managing these positions move in unison—as they did in August 2024—the resulting market dislocations can overwhelm conventional stabilization tools.
The appeal of the trade is clear: With 10-to-1 leverage, a 4.4 percent interest rate differential can generate 40 percent annualized returns. But this seemingly low-risk strategy depends on a critical assumption—that volatility will remain suppressed and central banks will intervene before losses become systemic. This assumption has been repeatedly validated by central bank actions since 1998, creating what economists call a “moral hazard on steroids.”
While floating exchange rates introduce risk, prolonged periods of low volatility and stable currency movements encourage a false sense of predictability. Over time, markets internalize the assumption of protection—fueling ever more capital inflows into trades that appear safe but rest on dangerous leverage. Carry trades are not the only form of hidden risk in the system, but they are among the most opaque, least regulated, and most vulnerable to sudden reversals.
Today’s carry trade vulnerability is not the result of speculative excess alone—it is the logical outcome of central bank policies designed to prevent past crises from recurring. Over the past 25 years, a pattern of aggressive interventions—from the rescue of Long-Term Capital Management in 1998 to the 2008 financial crisis and the Covid-19 market shock in 2020—has created what markets now view as an implicit “Fed put” on financial stability.
This shift has fundamentally altered how risk is calculated across the system. For corporations, easy money has fueled debt-funded share buybacks that boost executive compensation while increasing balance-sheet fragility. For investors, the dominant incentive is no longer rigorous analysis but the confidence that central banks will step in before losses become catastrophic.
This dynamic is reinforced when multiple central banks pursue ultra-loose policies simultaneously. Japan’s negative interest rates from 2016 to 2024 and Switzerland’s from 2015 to 2022 created massive global yield gaps, while the Federal Reserve’s interventions consistently dampened volatility. The result is a global environment where risk is systematically underpriced and carry trades are seen not only as profitable but implicitly protected.
But that protection is no longer assured. Persistent inflation has narrowed the room for maneuver, forcing central banks into what Chair of the Federal Reserve Jerome Powell has described competing imperatives—balancing inflation control with financial stability. The August 2024 episode showed how quickly those goals can come into conflict when leveraged trades begin to unwind, currencies shift, and central banks are caught between market panic and price stability mandates.
While carry trades rarely serve as the initial trigger for financial crises, historical analysis reveals their consistent role as accelerants that transform manageable market stress into systemic breakdown. The deeply procyclical structure of carry trade activity has played out repeatedly across recent financial history, each time following a similar pattern that culminates in policy intervention designed to prevent complete market collapse.
The pattern is predictable and dangerous: When volatility spikes beyond investor comfort levels, policymakers intervene to cap institutional losses while allowing gains to remain privatized during periods of market calm. This asymmetric policy response has created a structural backstop that incentivizes ever-larger carry trade positions built explicitly on the expectation that market corrections will be cushioned by official intervention before reaching systemically threatening levels.
The August 2024 episode illustrated this fragility with unprecedented clarity. The modest 25 basis-point rate increase by the Bank of Japan—a policy adjustment that should have been easily absorbed by well-functioning markets—triggered market reactions of a magnitude not seen since the 1987 stock market crash. Tokyo’s TOPIX and Nikkei indices plummeted over 12 percent in a single trading session, demonstrating how even minor policy adjustments can trigger massive position unwinding when leverage levels reach extremes.
Perhaps even more revealing was the market response in the weeks following the initial shock. Within just two weeks, the S&P 500 had recovered 95 percent of its losses, and the VIX volatility index fell back below 20 percent—levels associated with market complacency rather than systemic stress. Rather than signaling underlying market resilience, these rapid rebounds underscore the extent to which modern markets have become dependent on volatility suppression and implicit central bank intervention. The system did not heal itself; it was artificially stabilized through mechanisms that reinforce the very vulnerabilities that created the crisis in the first place.
Recent discussions in Washington further illustrate this dynamic. U.S. regulators are reportedly considering easing capital rules for Treasuries by adjusting the supplementary leverage ratio, a move aimed at increasing demand for government bonds. While this could improve liquidity and reduce funding strain, it also risks enabling greater leverage in Treasury-based carry trades by allowing banks to expand positions without holding additional capital. As with previous reforms, short-term market relief could come at the cost of amplifying the very mechanisms—hidden leverage and procyclical positioning—that make carry trade structures so destabilizing in times of stress.
As G7 leaders tackle broader risks—including financial crime and Ukraine’s reconstruction—the fragility posed by modern carry trades deserves urgent attention. The cross-border nature of carry trades renders unilateral regulatory approaches fundamentally inadequate and potentially counterproductive. A typical carry trade transaction might involve a Japanese investor borrowing yen in Tokyo, executing trades through London-based markets, and investing in U.S. dollar-denominated assets—touching multiple regulatory jurisdictions while remaining outside the comprehensive oversight of any single national authority. This regulatory arbitrage is not accidental; it is an inherent feature of a global financial architecture that has failed to adapt to the realities of modern cross-border capital flows.
Current international frameworks remain ill-equipped to address this challenge. The Financial Stability Board’s monitoring capabilities focus primarily on traditional banking institutions, while carry trade activity occurs through hedge funds, family offices, and other nonbank entities that operate beyond conventional regulatory perimeters. Similarly, the Basel III framework addresses bank leverage through capital requirements and liquidity standards, but it fails to capture the shadow banking sector, where carry trade concentration poses the greatest systemic risks.
The G7 is uniquely positioned to address these regulatory gaps through coordinated action that individual countries cannot achieve independently. The currencies of G7 nations serve simultaneously as funding sources (the Japanese yen, Swiss franc, and EU euro) and investment targets (the U.S. dollar and British pound) for the vast majority of global carry trades. This creates both shared vulnerability and shared responsibility that can only be addressed through multilateral cooperation rather than competing national approaches.
However, proposals for coordinated macroprudential regulation must grapple with several legitimate concerns. Efforts to regulate nonbank financial entities across borders risk overreach if they fail to distinguish between the risk profiles and structures of diverse institutions, such as hedge funds versus family offices. Some critics argue that imposing banking-style regulation on all nonbanks could stifle financial innovation and legitimate capital formation. Others warn that automated countercyclical tools—such as dynamic leverage or capital buffers—might become procyclical during market stress, exacerbating rather than containing volatility.
There are also meaningful implementation challenges. Real-time cross-border surveillance requires significant legal harmonization, infrastructure investment, and trusted data-sharing arrangements—none of which are easily achieved across sovereign jurisdictions with different privacy laws and political constraints. Furthermore, countries with large open capital markets—such as the United States—have historically been wary of ceding macroprudential autonomy to supranational frameworks.
Yet, the costs of inaction are rising. The August 2024 episode illustrated how modest shifts in Japanese monetary policy triggered a global unwinding of carry trade positions, unleashing volatility far beyond Japan’s borders. Without some form of coordinated surveillance and response mechanism, the next unwinding could be larger, faster, and less containable.
To strike the right balance, the G7 should pursue a phased and modular approach. Coordinated G7 action could begin with enhanced information-sharing protocols, voluntary adoption of standardized reporting thresholds, and pilot programs for joint stress testing of cross-border leverage exposures. These initiatives could evolve toward more formalized macroprudential tools as trust and technical capacity improve. The goal should not be to create a supranational regulator, but to close the most dangerous regulatory gaps while respecting the diversity of financial systems and national policy prerogatives.
The relative calm post–August 2024 may create dangerous policy complacency. Rapid market recovery has generated false confidence that obscures underlying vulnerabilities. This apparent strength reflects continued dependence on implicit central bank support, not fundamental improvements. Each successful intervention encourages additional risk-taking, making the eventual reckoning more severe.
Financial crises often emerge from long stretches of calm that obscure growing imbalances. Before 2008, years of low volatility masked the housing market’s fragility. Today, the structure of global curry shows similar warning signs: massive scale, extreme concentration, and systemic complacency.
G7 leaders face a shrinking window to act before these vulnerabilities outgrow the tools designed to manage them. Delay risks transforming a structural flaw into a full-blown crisis. The next unwind may be faster, larger, and less controllable.
This challenge demands G7 leadership precisely because G7 economies are both the architects and the custodians of the system. G7 currencies account for over 85 percent of global foreign exchange volume and dominate the USD 12.3 trillion in global currency reserves. More critically, they serve both as the funding base (the yen, franc, and euro) and the investment destination (the dollar and pound) for the world’s most systemically important carry trades.
The choice is stark. Act now—while markets are calm and coordination is possible—or wait until the next unwind spirals beyond the reach of conventional policy. By then, it won’t be about managing risk. It will be about containing contagion. The time for coordinated G7 action is not after the next shock. It is now.
Philip A. Luck is director of the Economics Program and Scholl Chair in International Business at the Center for Strategic and International Studies (CSIS) in Washington, D.C.Safae Irghis is a researcher with the Economics Program and Scholl Chair in International Business at CSIS.
