Hypothecation is a fifty cent word that you should probably be familiar with if you have a home mortgage or have a margin brokerage account in America… Rehypothecation is the next iteration in hypothecation.
And if you are an investor or considering investing in cryptocurrencies, you should definitely know about “crypto hypothecation” and the implications of the spread of “crypto rehypothecation”.
Hypothecation is what happens when you pledge an asset as collateral for a debt. In the case of a home mortgage, you are pledging your home as the collateral for the mortgage. The bank can foreclose on your home if you fail to pay your mortgage.
Rehypothecation is what happens when your bank then turns around and pledges the collateralized interest in your home as collateral for a subsequent debt that the bank takes on. The lender to the bank can then foreclose on your home if the bank fails to pay its debt.
This is what happened in the financial crisis of 2008. Hypothecation of subprime home mortgages led to rehypothecation of those same mortgages in the form of mortgage backed securities called “collateralized debt obligations” (CDOs).
But because the underlying mortgages were subprime and often worthless, the CDOs were also worthless…
The excessive rehypothecation led to a huge securitization bubble that was essentially backed by nothing.
What is Crypto Hypothecation?
Crypto hypothecation means using your cryptocurrency as collateral for a debt.
Example: You own some Bitcoin. You borrow money from someone and pledge the value of your Bitcoin as collateral for the debt. In this case, someone else has a claim on your Bitcoin until you repay the debt, plus interest, if any.
Your Bitcoin has been “hypothecated”.
What is Crypto Rehypothecation?
Using the prior example, crypto rehypothecation means the lender above uses the claim on your Bitcoin as collateral for another debt. Now their lender has claim to your Bitcoin.
Your Bitcoin has now been “rehypothecated”.
With rehypothecation, there are two (or more) borrowers, not one, with a claim to the original collateral.
Hypothetical Bitcoin Rehypothecation Example
Let’s say you have 10 Bitcoins worth $50,000 ($5,000 each) held in Coinbase. Coinbase lets you borrow against the $50,000 value of your Bitcoins to invest in other cryptos using a margin account.1
You borrow $50,000 against the value of your Bitcoin to buy $50,000 of Ethereum.
Once you do this, Coinbase has a claim to your $50,000 of Bitcoin… Your Bitcoin has been hypothecated.
Now, if established financial securities laws apply, such as the “Federal Reserve Board Regulation T” rule2, Coinbase could borrow money or cryptocurrency from another 3rd party lender (“Lender X”) and re-pledge the claim to your $50,000 of Bitcoin as collateral.
According to the law, Lender X now has claim to your Bitcoin…
But you have never heard of Lender X and have no idea of the terms of the loan that Coinbase agreed to with Lender X.
Now your Bitcoin has been rehypothecated.
If Satoshi Nakamoto is still around anywhere, he, she or they are probably shouting obscenities in the general direction of Wall Street.
Bitcoin Was Created to Solve the Problem of Rehypothecation
Whereas Bitcoin is immutable and cannot exist in more than one place at one time, rehypothecation means that derivatives of Bitcoin can be created, and copied, over and over.
When this happens, you can end up with a disaster like what happened in the 2008 financial crisis with instruments like collateralized debt obligations (CDOs).
What happened was that borrowers relied on borrowers relied on borrowers relied on borrowers… Like a massive game of “telephone“.
And, like in the actual “telephone” game, what started out supposedly as gold plated assets came out the other side as steaming piles of guano.
Bakkt and the InterContinental Exchange (ICE)
Rehypothecation of Bitcoin seems impossible, of course… Because Bitcoin and cryptos are supposed to be immutable assets on a blockchain.
However, this is already happening in the case of asset backed tokens. Asset backed tokens are a form of hypothecation using crypto.
Indeed, you can also easily trade cryptocurrency derivatives on exchanges such as Bitmex with leverage up to 100x.
This wasn’t always the case… But if crypto rehypothecation becomes a super common, mainstream thing, and if institutions run wild with it, I believe it could absolutely be a root cause of another financial meltdown because it means creating financial claims to digital assets that could be backed by nothing.
Where can you learn more about this…?
I first learned about the concept of crypto rehypothecation after listening to Episode 32 of Laura Shin’s “Unconfirmed” podcast with Caitlin Long. Caitlin Long is a Wall Street veteran who ran the pension solutions business at Morgan Stanley and then ran an enterprise blockchain company called Symbiont.
If you haven’t listened to the podcast, you can find it here.
This podcast episode is extremely timely because it answered questions I had about the Bakkt announcement by the InterContinental Exchange (ICE) to start a blockchain business and what the implications would be for Bitcoin and other cryptos.
The ICE announcement was salacious in that it included mention of a partnership with Starbucks. This is a quote from the press release:
“As the flagship retailer, Starbucks will play a pivotal role in developing practical, trusted and regulated applications for consumers to convert their digital assets into US dollars for use at Starbucks,” said Maria Smith, Vice President, Partnerships and Payments for Starbucks. “As a leader in Mobile Pay to our more than 15 million Starbucks Rewards members, Starbucks is committed to innovation for expanding payment options for our customers.”
WOW. When I read this, I thought… So… That’s good for crypto, right?
Caitlin’s take is that it is a double edged sword for the crypto world because she said that ICE would likely seek to financialize cryptocurrencies in the form of hypothecation and rehypothecation.
More worrisome potentially, for the buyers of rehypothecated assets, is the possibility of a hard fork of a blockchain. Such an event could leave off chain hodlers of digital assets with zero collateral.
How Can You Protect Yourself From Rehypothecation?
The Unconfirmed podcast mentioned above is great and Caitlin Long has a three part blog post series you can read on Forbes and it’s worth a read.
In terms of protection for crypto investors, it seems there are two ways to avoid being exposed to rehypothecation risk:
- Use a “Type 1” Account or “Cash Account”: If you are using a third party crypto brokerage, such as Coinbase, Circle, Robinhood or other, insist that you only use the equivalent of a “Type 1” account or a “cash account”. This is an account that is not marginable. Do not allow your broker to treat your account as a margin account… If the crypto broker you use adds margin capability automatically, ask them to turn it off or switch accounts.
- Private Cold Storage Wallet: Keep your cryptocurrency on chain at all times and store your private keys in an air gapped cold storage wallet of your own.
Of course, cryptocurrencies are not for the faint hearted anyway. Never buy any cryptocurrency unless you can afford to lose it all.
- I believe Coinbase Pro has margin accounts.
- According to this article in The Balance, the ownership of the collateral is passed down the chain again and again… This is made possible by something known as “Federal Reserve Board Regulation T”, or 12 CFR §220 – Code of Federal Regulations, Title 12, Chapter II, Subchapter A, Part 220 (Credit by Brokers and Dealers).