If there’s one reason for the consensus in crypto after a disastrous 2022, it’s that centralized crypto debt is a particular cause for concern. The repossession of customer assets allowed crypto firms to grow rapidly until they collapsed under the weight of these risks.
Rehypothecation is the technical term used when financial platforms reinvest the assets of their depositors in order to further extend those platforms’ access to credit. This practice is the norm in traditional finance – so deeply embedded in the operational behavior of the legacy financial system that not doing so is dismissed as less efficient.
Christopher Callicott is the managing director of Trammell Venture Partnersis an Austin-based venture capital firm focused on seed- and early-stage startups.
Applying this behavior to bitcoin or crypto ignores the fundamental essence of these assets arising from core bitcoin innovation. Such scenarios will likely be repeated in the future until the market is effectively accepting and pricing in the risk of rehypothecated collateral. The risk to a customer is fundamentally different when the customer’s collateral is repossessed and not.
Hypothecation occurs when an individual or entity takes out a loan and receives an interest rate based on providing collateral, such as bitcoin posted as collateral for the lender. The promise made by the lender is that when you repay your loan, you will get your collateral back.
However, the lenders themselves often take advantage of the assets on their balance sheets and obtain credit on other platforms – providing themselves with additional credit for their own use by using the collateral the customer originally posted. . This process is called rehypothecation. Deep in the fine print, the borrower’s promise to return the collateral is conditional on collateral being available for return.
The very common use of rehypothecation in traditional finance made common sense for how the property should be treated – financial or otherwise. And as the bitcoin and crypto industry has grown, many of the people at Tradefi have brought those values with them. Scratch the surface of many crypto firms and you’ll find them using customer deposits to further their business goals (often stressing the importance of “sovereign” funds like cryptocurrencies).
An inescapable reality of this practice at TradeFi is that it basically operates through a fractional reserve banking system. Dollars are created largely through a system of central banking that is steeped in cheap liquidity, and in the event of a crisis, the government further opens the liquidity pump.
Fractional reserve banking essentially encourages risk-taking. The stated goal for opening the spigot when credit dries up: encourage lenders to take on risk and put capital to work through credit. In this way, the normal forces of the market are reduced to identify the weakness and the cycle is perpetuated.
However, these fundamental differences between the dollar and bitcoin are often not well understood and it is an error to use the same rehypothecation approach with bitcoin.
See also: Why bitcoin and rehypothecation don’t mix , Opinion
For example, the software industry has enjoyed margins due to the inherent ease of replication of digital information: there is essentially zero marginal cost to produce one additional unit of a digital product. As a result, an entire digital rights management industry emerged with the Internet to prevent the free duplication of products, including music, movies, and software.
Given that background, a fundamental innovation for bitcoin was Satoshi’s solution to making something that is digitally scarce – there can only be 21 million bitcoins – offering us something unusual for finance. Collateral has a fundamentally different risk profile that is unique from that which is being created continuously or can be reproduced at will.
We should treat the custody of bitcoin and the pricing of risk in the bitcoin lending markets differently than assets backed by a seemingly endless supply of dollars. The reason is simple: if someone loses your bitcoins, there’s no way to make more of them to make you whole. They are, in fact, irreversibly gone.
Traditionally oriented lenders balk at the idea of non-restricted collateral for their loans. They would argue that a pure balance sheet loan – making the loan as an investment of its own capital risk – is less efficient than a remortgage.
To be sure, a company’s potential returns won’t be a juicy one when leveraged by renegotiating a borrower’s collateral, getting more dollars and generating even more loans for that specific lender in a cycle that repeats itself. goes. However, borrowers often lack the necessary information to understand the risks they take on when posting collateral to a lender that only offers this model, even though it is currently common to almost all centralized crypto lenders. represents.
In the aftermath of failures in crypto and now banking – where customer deposits above a certain threshold are treated as if the depositor were an investor with a cap – it is clear that those depositors and borrowers have no intention of investing in the platform. was (or the bank’s) business. Yet, in a failure the depositors suddenly find themselves creditors of the failed business.
For everyday retail customers taking out personal loans and being asked to post bitcoin as collateral, it would seem sensible that they understand what is going to happen to their money and therefore understand what they are paying for. What kind of overall risk they are taking on the loan.
$5 terms like “remortgage” 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 real benefits of bitcoin and a sustainable path in light of digital scarcity. A powerful way for market participants – in this case borrowers – to get a sense of the risk involved is simply to ask what will happen to their collateral before their loan is repaid.
Fortunately, the key learning for these customers is a simple truth: non-recourse loans are a better and objectively less risky way to borrow and will naturally be worth some premium to many customers. This can take the form of lower interest rates for high-risk loans or higher fees for secured, non-recourse loans.
A more transparent market would offer both loan types and associated interest rates side by side. An informed borrower considering the risks and costs may choose a lower rate/higher risk loan, but they will do so from a place of informed consent and will not unexpectedly find themselves a creditor in a forum’s bankruptcy proceedings, potentially keeping their bitcoin forever. will lose for ,
During the last bull cycle, we have seen alarming levels of risk taking with clients’ assets. Until we see more information in the market about how customers’ assets are used on the platform and a recognition that bitcoin and digital scarcity need to be thought of in a fundamentally different way than traditional finance, it appears that It is expected that this would be a highly leveraged scenario and subsequent loss of assets. Don’t repeat yourself in the future.
The views and opinions expressed here are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.