What Is Bitcoin Rehypothecation?

Bitcoin was created as an opt-out system for those who disagree with the preferential treatment of fiat currency and the financial trickery employed by specific sectors to manufacture profits without directly contributing to the real economy. Bitcoin’s intention was to de-risk the ability to hold your wealth over space and time and as an antagonistic network to the legacy financial system.

However, the dynamics of that relationship have changed in recent times as traditional finance looks to sink its teeth into bitcoin. Bitcoins NGU technology and access to international liquidity, as well as its mainstream popularity, have made it an attractive investment vehicle for traditional finance, which looks to be a rent-seeking entity on top of the value creation of the bitcoin network.

Legacy finances embrace of bitcoin comes with its own set of problems. Specifically, rehypothecation, which can enable investment firms to multiply their profits, could affect how bitcoin markets work while complicating its original intentions by adding additional risk to the system.

The current rehypothecation of bitcoin is seen by many bitcoin maxis as an attack on bitcoin? So let’s look at how it works and why bitcoiners have these concerns

What is a rehypothecated bitcoin?

Rehypothecation is when a custodian, such as a financial institution such as a bank or brokerage, loans out more assets or cash deposits than they have on their books with the sole intention of financial gain or to cover their obligations in the future. The practice could be seen as greed, but in some cases, market demand encourages risk-taking because the potential reward is so high.

It’s common practice for a prime brokerage to rehypothecate securities posted with them as collateral by a hedge fund for the brokerage transactions and trades.

Typically, a bank or broker has access to various collateral assets, including tangible assets and securities. In the case we’re considering; the asset would be bitcoin. Rehypothecation happens most often when a client leaves the bitcoin with a broker or, in some cases, the smart contract as a deposit in a margin account. The broker then posts the securities as collateral for the margin in the broker’s margin account or as backing for a loan.

The capital is then free to be placed in market trades to acquire an additional yield, pay the holder of the security a return, and pocket a healthy profit. 

Where does the rehypothecation of bitcoin happen?

Bitcoin held on-chain has no third party risk or exposure, but bitcoin that has been deposited onto an exchange, borrowed to a CEFI platform, or wrapped Bitcoin that is used to create representative tokens on altcoin chains or remora chains can all, in theory, be rehypothecated. 

If you are using any of these methods to hold your bitcoin or to earn a yield on your bitcoin, you may want to reconsider the market risk and custody risk you’re taking by having no direct control over those funds.

While you may see a percentage return in a pretty looking screen on an app, you have no idea where those funds are being placed and what risk the market marker or firm is taking, or who they’ve gone on and borrowed the funds to get a return.

Rehyphoticated bitcoin is often not subject to any insurance, and if there is a market failure, the likelihood of you being able to redeem the funds you lend it can be slim to none.

Why is the rehypothecation of bitcoin popular?

The issue of rehypothecation is directly associated with the centralised risk of bitcoin ownership; the more we allow third parties to hold bitcoin, the more we encourage this behaviour. You can wait for regulation to limit the exposure these entities can take on, or you can restrict them through market forces by taking custody of your coins. 

However, the chances of a total deleveraging of this risk are low because it would drastically reduce profits for centralised market markets. As long as they can generate profits and kick off yield to retail, you’ll find people willing to risk their bitcoin. 

Some will make it out with their returns, while others will end up caught in positions where they lose their bitcoin and have little to no recourse, having not considered their risks and position sizes.

Bitcoin’s manufactured scarcity makes it a pristine collateral asset for traditional finance to go out and play their financial games. Rehypothecation of bitcoin can allow financial services firms, such as to mint profits by building up a chain of loans using the same stash of bitcoin in its custody to represent a host of positions. 

Time to consider the risks

If you’re one of those bitcoiners who are chasing yield, do you ever consider where that bitcoin is, how many people have been promised that bitcoin for use, how many loans are backed by that bitcoin, and what protocols and trades that bitcoin finds itself in? That bitcoin could be funding all sorts of shitcoinery, Ponzi schemes, degen behavior, and leverage trading. 

If you’re comfortable with that risk, by all means, lend out your coins but know this, there is no CEFI platform that is too big to fail, there is no smart contract that is perfectly secure. In bitcoin, when you make a mistake, you’re punished for it, and nothing can be reversed; the timechain will immortalise your mistakes for all time.

The only way to discourage these practices and to keep yourself safe is through the simple yet powerful act of self custody. If you’re not holding your keys, you’re asking for risk, a risk that could never be seeing that bitcoin for years as you go through liquidation cases or worse, never seeing it at all.   

Do you believe in earning yield on your bitcoin? Are you actively lending out your bitcoin right now? Is it a large part of your stack? Let us know in the comments down below.