Rehypothecation: The Financial World’s 15 letter, Four Letter word
Rehypothecation is a term that has a bad reputation. This post is about the difference between rehypothecation and rehypothecation. I’m sure you saw what I did there. I want to highlight the difference between the same word. Which seems very odd. My goal is to get you to understand the word has two meanings. Getting it right is extremely important for the future of crypto finance.
You have a choice in extending credit, so choose wisely. Regardless of what anyone makes it out to be, an unsecured loan involves the most credit risk. The alternative to unsecured lending is, unsurprisingly, secured or collateralized loans. In this case, one lends out something of value but in return, also receives something of value. For those familiar with the History channel this is something like a pawn shop situation. This is a low risk case. Now the third case is more interesting. Someone hands over a pile of stuff to you to keep an eye on for security and so that you can make it easy (or possible) for them to move it around to different places. You charge them for that and, in addition, get the privilege of using their stuff as collateral on loans for whatever you feel like. If you’d like to make up a name for such a business, try out “prime brokerage”.
It turns out that both the second case, a collateralized, low-risk loan, and the third case, a “multi-party claim on a single-asset” situation, despite being vastly different, are both called rehypothecation. In a collateralized loan, even if someone borrows and then re-lends it out, everything is dealt with 1:1 and therefore it stays a very safe transaction. On the other hand, things get very dicey when a prime broker goes out of business. That’s what occurred in 2008 when Lehman went bankrupt. The problem was not a chain of collateral gone wrong per se. It was that more than one person (trading firm) was showing up to claim the same bag at the airport (collateral). Hilarity did not ensue.
Collateral re-use is fine so long as there is a clear claim to collateral by one party at each stage. When more than one party can claim the collateral, the not-so-technical term for that begins with cluster and rhymes with “truck”
Consider an unsecured loan. Firm A borrows 10 BTC from firm B. Perhaps the term was for 6 months and the rate was 3%. Meanwhile one week BTC lending is trading 6% so A lends those 10 BTC out to another firm, C. What happens if C defaults and does not return the 10 BTC to A? This is an unsecured loan and A incurs a loss. In some way, A will need to obtain 10 BTC to get the 10 BTC back to B. If A is leveraged, then A will likely default causing B to default.
Unsecured Loan Initiation:
Unsecured Loan Default:
Now consider how things work at a prime broker. Note that not all brokers, prime or otherwise, require customers to allow the broker to access the collateral as “rehypothecation”. In some cases, there is an opt-in choice which usually enables some sort of a rebate or otherwise cheaper service. Regardless, this is what it looks like:
The broker uses the 10 BTC in Firm B’s account as collateral to get $100K in USD. One does not even need for A to re-use the 10 BTC in another transaction for this to get ugly. Should the broker get into financial trouble and default with Firm A, Firm A, as is its right, takes possession of the 10 BTC and presumably sells it in the market to get its $100K back. This is at the heart of the problem. To whom does the 10 BTC belong? Firm A or Firm B? The technical term for this is a real four letter word. It begins with cluster and rhymes with “truck”. Instead, let’s call this version of rehypothecation multi-party collateral claim transactions.
On the other hand, collateral re-use is absolutely fine so long as the legal claim to the collateral is clear. Consider firms A, B, C. B lends 10 BTC fully collateralized to A. And A turns around and lends the 10 BTC to C also on a fully collateralized basis. For the purpose of this example, consider that BTC is priced at $10,000. It looks like:
Collateral Re-Use Initiation:
Suppose C defaults:
The combination of full collateralization and the clear claim of A over the $10,000 means that the default is isolated to Firm C. Firm A sustains no loss and Firm B is not even aware that Firm C even exists.
By the way, in case you were wondering if the BTC that Firm B lent out is the same that came back to it, there is no such thing as the “same” BTC. There are no CUSIPs or serial numbers for BTC. That’s not how value is transferred in a distributed ledger. Firm B’s wallet/account for BTC does not indicate certain BTC. It is just a running summation of all the deposits and withdrawals for that particular wallet number. A distributed ledger is the electronic equivalent of hash marks.
What is now quite transparent is that reusing collateral under fully collateralized conditions is safe so long as the value of the collateral matches. At Digital Gamma we work to ensure that is the case by securing additional collateral in escrow so that should the value of BTC climb, A would have more than just the $10,000 to use to repurchase the 10 BTC.
What is not so transparent is that “rehypothecation” has two different meanings and the two meanings are very different for those participating in the lending markets. Simply reusing collateral to engage in trades is stable and safe. Enabling and engaging in situations where multiple parties can lay claim to the same collateral is clearly problematic when things go wrong. The main reason that these situations occur is that the customers of firms that engage in this practice either are not aware of it or don’t have a realistic alternative.
There are those in the crypto world that are going to take advantage of the ambiguity of the word rehypothecation. A “multi-party collateral claim” situation is unequivocally bad. On the other hand, collateral re-use works just fine. The beauty of the crypto community is that we are focused on thinking for ourselves and trusting in the process, not the players. The process for collateral re-use works.
