A break through the previous record of 79.75 triggered a cascade of stop-loss and algorithmic selling of the dollar, sending the yen surging in illiquid trade in the hours between the U.S. and Asian trading days.
Dollar/yen clawed back to near 77.50 on buying by Japanese importers and some retail margin traders, but the huge earlier drop to the record was seen prompting other investors to shed long positions in higher-yielding currencies, traders said.
The Japanese margin traders were cited as one of the main factors behind the plunge in the dollar as stop-loss orders were triggered in their leveraged bets in currencies like the Australian dollar.
Just the day before, Japanese margin traders had built up long positions in dollar/yen totaling $2.8 billion, according to data from the Tokyo Financial Exchange. Total long positions in major currencies including dollar/yen were a record $8.25 billion.
Traders also said that foreign investors were scrambling to get hold of yen to settle margin calls on bets on Japanese shares deeply in the red, forcing them to turn to spot currency at times as well as forwards and cross-currency swaps.
With a high risk of Japanese authorities intervening if the yen rises further from current levels, some market players were waiting for an intervention-sparked spike in dollar/yen before unloading positions, traders said.
A stronger currency risks compounding Japan's economic troubles at a time when it is struggling to contain a worsening nuclear crisis, convincing many market players it was only a matter of time before Japanese authorities intervened against further yen strength.
Junya Tanase, foreign exchange strategist at JPMorgan Chase in Tokyo, said there was a feeling in the market that the moves had gone too far in a short period of time and intervention was likely.
"There is a real possibility that authorities would intervene to calm the markets, though I don't think it will be heavy," Tanase said.
Japan's finance minister blamed speculation for the yen spike and said he was closely watching markets, a warning that the Bank of Japan may soon be given the signal to buy dollars.
Group of Seven nations will discuss possible steps to calm markets roiled by Japan's crisis at 7 a.m. Tokyo time on Friday.
FX analysts at Citigroup said there was an "extremely high" risk of intervention in the next 24 hours.
While the escalating nuclear crisis and subsequent rush for safety was the initial spur for the yen surge, the move higher was almost all about positioning.
All sorts of exotic option and structured products were stopped out, on top of the unwind of the leveraged long trades held by the margin traders.
During the surge, traders said the market was disorderly. Liquidity evaporated and bids were pulled, leaving huge gaps in the charts.
"It's mayhem out there," said one trader at an Australian bank in Sydney. "The yen's been moving a big figure a second on occasions. A lot of people are crying out for the central banks to step in."
The dollar's collapse cracked the previous record of 79.75 struck in 1995 in the months following the Kobe earthquake.
The yen also flew on the crosses, jumping around 6 big figures on the Aussie to as far as 74.50 yen, a six-month high, before clawing back to 78.05 yen.
The Aussie has shed over 7 percent against the yen so far this week as investors sell it as proxy for risk and global growth.
An unwind of yen-funded carry trades has driven the Japanese currency higher all week, with few signs yet of the Japanese investor repatriation of funds in foreign assets that many are expecting to help cover costs from the crisis.
The cost of hedging against a further yen rise jumped, with implied volatility on one-month dollar/yen and Aussie/yen options reaching near 20 percent.
Japanese officials played down the risks of such repatriation on Thursday, with Economics Minister Kaoru Yosano saying the yen was driven by speculative moves and not repatriation.
"I would assume that certainly the carry trade is being unwound," said Dan Fuss, vice chairman of Loomis Sayles, which oversees $150 billion in assets.
The Aussie was at $0.9802 and fell as far as $0.9705 on Thomson Reuters Matching, a three-month low and a huge reversal from $1.0143 at the end of last week.
The euro/dollar pair was a relative sideshow at $1.3920.
Japan's nuclear crisis reached a new danger level as a U.S. official said one of the pools containing highly radioactive spent fuel rods at the stricken plant had run dry.
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