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Rehypothecation and commingling are two legal practices that enable investment firms and/or financial institutions to multiply their profits. However, their use in cryptocurrency investing and custodianship is controversial at best and criminal at worst (think FTX, whose executives did both while committing outright fraud).
Here’s a brief discussion about the risks that cryptocurrency rehypothecation and commingling add to the already risky cryptocurrency markets and actions that might be taken to lessen the risks to investors.
Key Takeaways
- Rehypothecation and commingling are two legal practices that enable investment firms and/or financial institutions to multiply their profits.
- Cryptocurrency can be rehypothecated and commingled as long as the custodians have permission from their depositors.
- Cryptocurrency risks increase the risks of rehypothecation and commingling, so the practices should be used with caution by custodians.
What Are Commingling and Rehypothecation?
Typically, banks and financial services companies segregate collateral from individual parties based on different parameters, such as owner and loan type. This practice ensures clean accounting and enables them to return the collateral when it is due.
As its name suggests, commingling involves combining collateral from multiple parties into a single “omnibus” account. This is standard practice on Wall Street and is popular for obscuring account balances and alleviating concerns regarding custodial counterparties’ (CCPs) inability to meet their financial obligations.
Rehypothecation is the bank and brokerage practice of using deposited assets as collateral. Put simply, rehypothecation allows CCPs to use a Bitcoin deposit as collateral for a loan to another, who could use it as collateral for a loan to another, and so on. Rehypothecation compounds both gains and losses, making it very risky when doing it with an asset as volatile as Bitcoin.
The Affects on Bitcoin
What commingling means for Bitcoin investors is that the practice makes it difficult to distinguish between assets and liabilities in a CCP’s balance sheet because they are not required to disclose individual amounts. As a result, there is no way to know whether they have enough assets to cover their liabilities. Commingling also centralizes cryptocurrency holdings to a single account, thereby making the account an attractive target for thieves and hackers. For example, a CCP may hold cryptocurrencies in a single “omnibus” wallet instead of distributing them across multiple online wallets. In turn, these wallets become repositories for hackers to target.
Rehypothecation means that there would likely be a chain of uncollateralized loans that can be traced back to the same cryptocurrency. A loan default by a single party within that chain or a successful custodian hack could bring the entire setup tumbling down.
Further complications related to rehypothecations arise from the fact that the same asset will be accounted for on the balance sheets of multiple firms or institutions, obfuscating the true value held by each entity in the chain of loans.
As the cryptocurrency ecosystem grows, a crash could result in severe damage to unrelated assets, in much the same way that the Great Financial Crisis affected different and unrelated parts of the world economy.
Can These Risks Be Mitigated?
Bitcoin’s manufactured scarcity makes it an especially valuable asset for Wall Street. Rehypothecation of Bitcoin could allow financial services firms, such as Goldman Sachs, to mint profits by building up a chain of loans using the same stash of Bitcoin in its custody.
Following the collapse of once-trusted crypto exchange FTX in 2022, its bankruptcy proceedings, and the highly publicized trial of its CEO Sam Bankman-Fried, it is likely that the public and regulators are more aware of the practices and the consequences they can have. FTX and its executives lent users’ cryptocurrency to its investment branch, Alameda Research, without consent, which used them to make trades. When the exchange collapsed, billions of dollars in customer funds were lost.
Thus, when even trusted custodians can get away with misusing common practices, mitigating the risks of rehypothecation and commingling misuse can only come from awareness, legislation, and enforcement. Cryptocurrency custodians and exchanges can legally use the techniques to make more money or obscure their balance sheets, but they need permission from their depositors. People seeking to make cryptocurrency deposits as collateral or who prefer to custody their crypto at a custodial provider should understand whether their deposits are subject to commingling or rehypothecation. If they are uncomfortable with it, they should not deposit funds at the institution.
Additionally, legislators should revisit the two practices, developing measures that allow for more transparency, especially within private companies that have custody of customers’ crypto. Private companies involved in finances need to be held just as accountable as publicly traded firms before a crisis occurs, not only after.
What Are Some of the Risks That Come With Owning Bitcoin?
Loss of principle (market risk), theft, no federal insurance coverage, and counterparty risk (using third parties like exchanges or service providers) are a few of the external risks you’re exposed to when you own Bitcoin. If you custody your private keys yourself, you risk losing or forgetting them and theft; if you store them in cold storage, you run the risk of them being stolen or losing the devices.
What Is the Collateral Behind Bitcoin?
It is interesting that a virtual asset like Bitcoin has nothing backing it up. The only things that prop up its market value are sentiment and demand; otherwise, it is worthless.
What Is the Correlation Between Bitcoin and Other Assets?
Bitcoin is generally treated the same as other investments. All investors and traders read the same books, take the same courses, and are taught the same techniques. So, they all use many of the same strategies when buying and selling. Thus, the correlation is not that Bitcoin or other assets rise and fall in response to each other; it is that many assets are traded by investors in the same way, which makes them appear to be correlated.
The Bottom Line
Cryptocurrency commingling and rehypothecation are controversial practices but are not illegal. However, financial institutions, brokerages, and custodians should use them very carefully because the traditional risks of each are amplified when using cryptocurrency.