Rehypothecation: Playing Roulette With Your Crypto

Why are centralized exchanges imploding? Why does the same financial feedback loop keep happening? We know history repeats itself, but there must be a theme for this repeated failure.

As suspected, leverage is the culprit. Humans will always try to distort equilibriums to get short-term benefits, whether it be with drugs and the body, or with borrowed money and our net worth. Eventually, life always reverts to the mean; it’s simply a canon of complex adaptive systems. Everything you borrow must be returned (with interest), and often things over-correct in the opposite direction in the process.

However financial leverage manifests itself in different ways. What FTX did was a breach of trust and quite possibly fraud, but the activity is actually fairly common-place behavior amongst banks and financial institutions. You probably have other brokerage accounts who are doing some form of it to your money right now.

First we must introduce two terms: hypothecation, and rehypothecation.

Hypothecation: when an asset is pledged as collateral for a loan. The owner usually does not give up possession or ownership. If the loan is not returned, the lender can seize the asset. Essentially it’s a collateralized loan.

Rehypothecation: where banks or brokers use assets provided by clients for their own investment purposes. For example: a customer leaves securities with a broker and the broker then uses those securities to collateralize its own borrowing. The broker then has two debts: one by way of owing the client his assets back whenever he calls them, and another debt on the loan he received where he pledged someone else’s assets to back his loan.

Rehypothecation is not uncommon in the financial world. That doesn’t mean it shouldn’t be understood as reckless risk taking and a core component of why these implosions keep happening (this practice was largely responsible for Lehman’s demise).

Imagine if you lent me your car and I gave you a loan for it, keeping the car in my garage as collateral (hypothecation). And then, I went and lent your car out again, and got a loan for myself with it (rehypothecation).

Now imagine I did that without you knowing about it. Now doubly imagine what happens if I lose the money the other guy gave me for lending out your car. Guess who keeps the car? It’s not you, dear retail user.

This isn’t overly reductionist. It’s a straightforward example without any financial mental gymnastics, and illustrates what these exchanges are doing with your crypto on “your” account.

In TradFi, brokers have in their Terms of Service that they can do this with margin accounts. Select brokers will not lend out fully-paid-for securities without your explicit consent, and if you agree to it they’ll cut you in on the income they generate from it (shout out to Interactive Brokers here). But most don’t do this, if you have a margin account with a broker for stock trading, odds are you have been rehypothecated. If you use a CEX to hold your crypto, you’ve probably been rehypothecated. It’s okay to feel a little violated about it.

What makes the FTX situation so odious and likely fraudulent is they specified in their terms that crypto in customer accounts would not be loaned out for trading, and would not be used for outside trading purposes.

It was just a lie. And now you’re seeing the cascading effects of that foolhardy leverage wash itself out of the system. And deceit aside, is this something you want to have done to your assets even if it is codified in your broker’s terms? Why continue to accept this as a norm, letting someone risk your capital for their gain?

This is a TradFi anachronism. We don’t have to tolerate this. This is why we DeFi. DEXs fix this.

BlockFi, Genesis, 3AC, FTX, Celsius, Gemini, Coinbase, every CEX, are NOT DeFi or crypto. They operate IN crypto. They are TradFi corporations LARPing as crypto. Just because the assets they trade and borrow are tokens does not mean they embody any of the core features of what make DeFi, DeFi.

This kind of opaque, shadowy use of your crypto could never happen with a DEX. If it did, we’d all be able to see it onchain, rather than secretly on some Bahamas corporation balance sheet that no one has access to. A core feature of DeFi is complete transparency about where your assets are, how they’re used, and your ability to custody them; all of these things are antithetical to the CEX.

We’re not writing this to advocate for our own DEX; rather, we made a DEX because we advocate for this. We all passionately believe in the DeFi ethos and implore you to get your coins off exchanges and live freely and transparently onchain with us. End this cycle and stop letting other people gamble with your money.

Follow at @BackTheBunny

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