Introduction

Crypto lending has adopted many common practices from traditional finance. One such practice that has found its way into the crypto space is rehypothecation. This blog post aims to demystify rehypothecation, illustrating its role in the crypto lending space and how it impacts investors and the market.

An Illustrative Example

To appreciate the significance of this term in the context of digital assets, it is essential to first grasp the concepts of hypothecation and rehypothecation, and the applications in traditional finance.

Hypothecation refers to the process of using an asset as collateral to secure a loan, while retaining title, possession, and ownership rights. The promise made by the lender is that when the borrower pays off the loan, they will receive their collateral back. In traditional finance, this is a routine aspect of securing loans.

Further, lenders often use the borrowers's collateral to generate additional income or access additional credit for their own use, in a practice known as rehypothecation. Simply put, rehypothecation is the process where lenders use the borrower’s pledged assets for their own use (e.g., using it as collateral to access more credit in an effort to “put it to work”). The goal is to lower borrowing costs, increase liquidity in the market, and ultimately produce more revenue.

Given the potential uncertainty caused by rehypothecation, it is subject to strict regulatory oversight in traditional finance, with specific limits on how much client collateral can be rehypothecated.

Benefits of Rehypothecation

1. Lower Interest Rates: By leveraging assets for additional financing, platforms can potentially offer borrowers lower interest rates on loans.

2. Enhanced Liquidity: It allows lending platforms to maximize the utility of deposited assets, thereby increasing overall market liquidity.

Risks Associated with Rehypothecation

1. Counterparty Risk: The chain of borrowing and lending can create complex interdependencies, ultimately risking client assets.

2. Regulatory Uncertainty: The evolving regulatory landscape of cryptocurrencies means that practices like rehypothecation could face future scrutiny.

Rehypothecation in Crypto

Some crypto lending platforms rehypothecate client collateral. This allows these lenders to earn income from both the borrower's interest payments and the proceeds of lending out the borrower's collateral. However, this practice inevitably exposes a portion, if not all, of the borrower's collateral to risk.

The crypto lender crash of 2022 was in part caused by unsafe rehypothecation. Many crypto platforms were extensively reusing the crypto assets deposited by their clients as collateral for their own investments or loans. Celsius is an example of someone partaking in this practice. This significantly amplified risks, as it created a complex web of interdependencies among various financial players in the crypto market.

The collapse of Terra's UST, a stablecoin pegged to the dollar, and its associated token Luna marked the start of the 2022 crash. Crypto hedge fund 3AC was overexposed to Luna/UST and had to file for bankruptcy as the tokens plummeted. The contagion further spread as 3AC defaulted on its loans provided by crypto lenders BlockFi and Voyager.

In summary, the crypto asset price plunge led to a cascade of margin calls and liquidity crises. Lenders were unable to meet these calls, as the same assets were pledged multiple times across different lenders. This led to a domino effect, where the failure of one entity to meet its obligations triggered a chain reaction, affecting numerous other players in the market.

Arch’s Solution

When choosing a lending platform, it is important to consider the risks associated with rehypothecation. Borrowers choosing to use those platforms must accept the risk that either the lender or borrower of rehypothecated collateral may become insolvent, resulting in the permanent loss of the client's collateral.

At Arch, we recognize the responsibility that comes with managing your assets. That is why we never rehypothecate any collateral. Arch holds all customer assets on a one-to-one basis and does not lend them out to others. You can have peace of mind knowing that your assets will remain securely held in leading qualified custodians which protect your assets in the event of insolvency or bankruptcy.

If you want to learn more about crypto-backed loans through Arch, please book a call with our team here. If you’re ready to get started, sign up here.