There is no denying that the world of cryptocurrency has seen its fair share of ups and downs in recent years, with 2022 proving to be a particularly tumultuous time for the industry. One major issue that has arisen is the centralization of crypto lending and the rehypothecation of customer assets, which has led to rapid growth for some firms but has also resulted in devastating collapses.
Rehypothecation is a practice widely used in traditional finance, where deposited assets are reinvested by financial platforms to improve their access to credit. While this may be the norm for conventional banking systems, applying it to cryptocurrencies, like Bitcoin, ignores their core innovation, decentralized and scarce nature.
Lenders in the traditional finance sector often take leverage based on their balance sheet assets and receive credit on other platforms. The problem arises when this same practice is applied to cryptocurrencies, as the risk to a customer is fundamentally different when their collateral is rehypothecated. In the event of a crisis, central banks can supply liquidity to the market. However, this is not the case with cryptocurrencies like Bitcoin, which have a limited supply and cannot be created at will.
This fundamental difference between traditional financial assets and cryptocurrencies must be reflected in the way we treat their custody, as well as the pricing of risk in lending markets. If someone were to lose your Bitcoin, there would be no way to create more to compensate for the loss, making them truly irreplaceable.
Despite the risks, many established lenders are hesitant to move away from rehypothecation when dealing with digital assets. They argue that relying solely on one’s balance sheet for loans is less efficient than the rehypothecation model. Unfortunately, borrowers are often ill-informed of the risks they take when putting up their collateral with a lender who only offers rehypothecation.
The key to a more sustainable future in cryptocurrency lending may lie in educating market participants about the true benefits and potential pitfalls of this emerging industry. By understanding the implications of rehypothecation, borrowers can make informed decisions about the type of loan they’re taking out and the risks they’re willing to assume.
One solution for navigating this new landscape would be offering both traditional rehypothecation-based loans and alternative, safer non-rehypothecation loans side by side, with varying interest rates and fees. This would allow borrowers to choose between lower-rate, higher-risk loans, and safer options with potentially higher fees, all while being well-informed about the potential consequences.
As we move forward in the world of digital currencies, it is crucial to adapt our lending practices and ensure that the unique characteristics of these assets are acknowledged and appropriately managed. If not, we may continue to see the same devastating impacts of rehypothecation on the cryptocurrency market, jeopardizing both borrowers and the industry as a whole.
Source: Coindesk
