Rehypothecation May Be Common in Traditional Finance, but It Will Never Work With Bitcoin

If there is one cause for consensus in crypto after a disastrous 2022 it’s that centralized crypto lending carries a particular cause for concern. The rehypothecation of customer assets allowed crypto firms to grow rapidly until they collapsed under the weight of these risks.

Rehypothecation is the technical terms used when financial platforms reinvest their depositors’ assets to further those platform’s access to credit. This practice is the norm in traditional finance – so deeply ingrained in the operating behavior of the legacy financial system that not doing so is dismissed out of hand as less efficient.

Applying this behavior onto bitcoin or crypto ignores the fundamental essence of these assets arising from a core bitcoin innovation. Scenarios like these will repeat into the future as long as the market is not effectively acknowledging and pricing the risk of rehypothecated collateral. The risk to a customer is fundamentally different when there is and when there is not rehypothecation of the customer’s collateral.

Hypothecation occurs when a person or entity takes a loan and receives an interest rate based on providing collateral, like when bitcoin is posted as collateral to a lender. The promise made by the lender is that when you pay off your loan, you will receive your collateral back.

However, lenders themselves often take leverage based on assets on their balance sheet and get credit on other platforms – providing themselves with additional credit for their own use using the customer’s originally posted collateral. This process is called rehypothecation. Deep in the fine print, that promise to return a borrower’s collateral is conditioned upon there being collateral available to return.

The very common use of rehypothecation in traditional finance created a sense of normal for how to treat assets – financial or otherwise. And as the bitcoin and crypto industry has grown, many from TradFi have brought those norms with them. Scratch the surface of many crypto firms and you’ll find them using customer deposits to further their business goals (often while stressing the importance of “sovereign” money like cryptocurrencies).

An inescapable reality of this practice in TradFi is that it functions fundamentally via the system of fractional reserve banking. Dollars are largely created through the system of central banking which is awash in cheap liquidity, and in the event of a crisis scenario, the government opens the liquidity pump further.

Fractional reserve banking necessarily incentivizes risk taking. When credit dries up, the stated goal for opening the spigot: to incentivize lenders to take risks and put capital to work via credit. In this way, the normal market forces to identify weakness are mitigated and the cycle perpetuates.

However, these fundamental differences between dollars and bitcoin are not often well enough understood and it is an error to proceed with bitcoin using the same rehypothecation approach.

To illustrate, the software industry has enjoyed the margins it does because of the inherent ease in replication of digital information: there’s essentially zero marginal cost to produce one additional unit of a digital product. Consequently, with music, movies and software, an entire digital rights management industry emerged with the internet to thwart free duplication of products.

Given that backdrop, a foundational innovation for Bitcoin was Satoshi’s solution for creating something that is provably digitally scarce – there can only ever be 21 million bitcoins – presenting us with something unusual for finance. There is a fundamentally different risk profile for collateral that is unique from that which is being continuously created or can be reproduced at will.

We must treat both bitcoin’s custody and the pricing of risk in bitcoin lending markets differently than an asset backed by a seemingly endless supply of dollars. The reason is simple: if someone loses your bitcoin, there is no way to make more of them to make you whole. They are truly, irrevocably gone.

Traditionally oriented lenders balk at the very idea of non-rehypothecated collateral for their loans. They would argue that a pure balance sheet loan – making a loan as an investment of your own capital risk – is less efficient than rehypothecation.

To be sure, a company’s potential returns would not be a juicy as those when leverage has been taken by rehypothecating a borrower’s collateral, getting more dollars and originating even more loans in a cycle that repeats itself for that specific lender. However, borrowers often lack the information needed to understand the risks they take when posting collateral to a lender who only offers this model, even though this currently represents nearly all centralized crypto lenders.

In the fallout of the failures in crypto and now in banking – where customer deposits above a certain threshold are treated as if the depositor was there with an investor’s hat on – it’s obvious that those depositors and borrowers did not intend to invest in the platform’s (or bank’s) business. Yet, in a failure depositors find themselves suddenly a creditor of the failed business.

For an everyday retail customer pursuing a personal loan and being asked to post bitcoin as collateral, it would seem sensible that they understand what is going to happen with their money and therefore have an understanding of what kind of overall risk they are taking when getting their loan.

$5 words like “rehypothecation” are rarely understood by borrowers today. Education for market participants is the most effective way to bridge the gap between the status quo in finance and the true benefits of a sustainable path forward in light of the emergence of Bitcoin and digital scarcity. One powerful way for market participants – borrowers in this case – to get a sense of the risk involved is simply to ask what will happen to their collateral before repayment of their loan.

Fortunately, the key learning for these customers is a simple truth: Non-rehypothecated lending is a superior and objectively lower risk way to take out a loan and would naturally be worth some premium for many customers. This could take the form of lower interest rates for higher risk loans or higher fees for safer, non-rehypothecated loans.

A more transparent market would offer both loan types and respective interest rates side by side. An informed borrower considering the risks and costs could choose the lower rate/higher risk loan, but they would do it from a place of informed consent and not unexpectedly find themselves to be a creditor in a platform’s bankruptcy proceeding, possibly having lost their bitcoin forever.

During the last bull cycle, we have seen risk taking with customer’s assets at a shocking level. Until we see more information in the market about how customers’ assets are used on platforms and a recognition that bitcoin and digital scarcity needs to be thought of fundamentally differently than in traditional finance, it appears likely that these highly leveraged scenarios and subsequent asset losses will repeat themselves in the future.

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