Finance and investing can be overwhelming, confusing and sometimes just mind-blowing.
One such concept recently on-trend was Rehypothecation.
So last week I spent some time learning about what it is, how it works and also some of the risks it imposes.
🧵 👇
0/44
One such concept recently on-trend was Rehypothecation.
So last week I spent some time learning about what it is, how it works and also some of the risks it imposes.
🧵 👇
0/44
1/
The goal of this thread is to highlight and simplify the concept of rehypothecation.
In comparison to other threads I've written, I found this one especially challenging due to its complexity, but learned a huge amount while researching which is always an amazing feeling.
The goal of this thread is to highlight and simplify the concept of rehypothecation.
In comparison to other threads I've written, I found this one especially challenging due to its complexity, but learned a huge amount while researching which is always an amazing feeling.
2/
A brief rundown of what we'll cover;
🔘 The concept of 'hypothecation'
🔘 Rehypothecation in TradFi
🔘 Rehypothecation in crypto
🔘 The risks and outlook
A brief rundown of what we'll cover;
🔘 The concept of 'hypothecation'
🔘 Rehypothecation in TradFi
🔘 Rehypothecation in crypto
🔘 The risks and outlook
3/ Hypothecation...
A legal term used in finance and loan agreements that refers to the pledging of an asset as collateral for a loan without giving up ownership of said asset.
A legal term used in finance and loan agreements that refers to the pledging of an asset as collateral for a loan without giving up ownership of said asset.
4/
Although this means that the borrower retains ownership, the lender has the right to take possession of the asset if the borrower defaults on (fails to pay) the loan.
Although this means that the borrower retains ownership, the lender has the right to take possession of the asset if the borrower defaults on (fails to pay) the loan.
5/
A simplified example of this is the hypothecation of mortgage agreements, as part of these contracts the borrower pledges the property as collateral for the loan provided by the lender.
A simplified example of this is the hypothecation of mortgage agreements, as part of these contracts the borrower pledges the property as collateral for the loan provided by the lender.
6/
The lender has a security interest in the property and can foreclose on the property if the borrower fails to make the required mortgage payments.
The lender has a security interest in the property and can foreclose on the property if the borrower fails to make the required mortgage payments.
7/
This means that the lender has the right to seize the property and sell it to recover the outstanding balance on the loan, working as a strong incentive for the mortgagor to fulfil their obligations.
This means that the lender has the right to seize the property and sell it to recover the outstanding balance on the loan, working as a strong incentive for the mortgagor to fulfil their obligations.
8/ Rehypothecation...
Collateral put down for a financial agreement is re-utilized as more collateral across more than one loan.
Collateral put down for a financial agreement is re-utilized as more collateral across more than one loan.
9/
You may have heard the term ‘fractional reserve banking’, which in a sense, is similar to the practice of rehypothecation in that both involve the creation of credit and the potential for leverage.
You may have heard the term ‘fractional reserve banking’, which in a sense, is similar to the practice of rehypothecation in that both involve the creation of credit and the potential for leverage.
10/
Fractional reserve banking is a system where banks keep a fraction of the deposits they receive from customers as reserves and lend out the remainder.
Fractional reserve banking is a system where banks keep a fraction of the deposits they receive from customers as reserves and lend out the remainder.
11/
This creates a multiplier effect where the initial deposit can be used to create more loans and deposits in the banking system.
This creates a multiplier effect where the initial deposit can be used to create more loans and deposits in the banking system.
12/
However, this also means that banks are creating credit that is not backed by an equivalent amount of reserves, which can lead to a potential for overleveraging and financial instability if not managed properly.
However, this also means that banks are creating credit that is not backed by an equivalent amount of reserves, which can lead to a potential for overleveraging and financial instability if not managed properly.
https://twitter.com/ChainLinkGod/status/1625988468928290816
13/
Rehypothecation is a concept which can be bucketed as a similar practice to fractional banking as it involves the utilization of assets, such as stocks or bonds (securities), as collateral for a loan.
Rehypothecation is a concept which can be bucketed as a similar practice to fractional banking as it involves the utilization of assets, such as stocks or bonds (securities), as collateral for a loan.
14/
The collateral is used by the borrower to secure the loan, but the lender still retains the ability to use it for its own purposes.
The collateral is used by the borrower to secure the loan, but the lender still retains the ability to use it for its own purposes.
15/
In other words, the lender has the right to re-use the collateral for other loans or investments, creating a daisy chain of synthetic interconnected financial relationships.
In other words, the lender has the right to re-use the collateral for other loans or investments, creating a daisy chain of synthetic interconnected financial relationships.
16/
Rehypothecation is a common practice in the financial industry, especially in the derivatives market.
Rehypothecation is a common practice in the financial industry, especially in the derivatives market.
https://twitter.com/hosekiapp/status/1625868785671446529
17/
Brokers and dealers can reuse the collateral pledged by their clients to secure their own financing needs.
Rehypothecation is especially popular in the derivatives market as it allows traders to increase their leverage.
Brokers and dealers can reuse the collateral pledged by their clients to secure their own financing needs.
Rehypothecation is especially popular in the derivatives market as it allows traders to increase their leverage.
18/
By using the same assets as collateral for multiple trades, traders can magnify their potential profits, but this comes with increased risks for trader and the clients whose funds they’re gambling with.
By using the same assets as collateral for multiple trades, traders can magnify their potential profits, but this comes with increased risks for trader and the clients whose funds they’re gambling with.
19/
In the event that the borrower is liquidated, and their collateral is seized by one of the lender parties, the chain is broken, meaning that that collateral placed down to secure the other loans now essentially doesn’t exist.
In the event that the borrower is liquidated, and their collateral is seized by one of the lender parties, the chain is broken, meaning that that collateral placed down to secure the other loans now essentially doesn’t exist.
20/
This is fine if the borrower(s) has enough liquidity (money or assets) to pay off the remaining loans, but if not, they will default on their loans and can face legal action from their creditors.
This is fine if the borrower(s) has enough liquidity (money or assets) to pay off the remaining loans, but if not, they will default on their loans and can face legal action from their creditors.
21/
This scenario may only affect a handful of parties, but as seen in 2008, it can quickly become a wider crisis if there are defaults on loans with rehypothecated assets. This is due to the interconnectedness and interdependency of the banking system.
This scenario may only affect a handful of parties, but as seen in 2008, it can quickly become a wider crisis if there are defaults on loans with rehypothecated assets. This is due to the interconnectedness and interdependency of the banking system.
22/
Is Rehypothecation possible with Crypto?
Yes, due to the opportunity that comes with speculating on its volatility, rehypothecation has bled over to the world of #crypto.
Is Rehypothecation possible with Crypto?
Yes, due to the opportunity that comes with speculating on its volatility, rehypothecation has bled over to the world of #crypto.
23/
It's important to note at this point, however, that there are different ways assets can be rehypothecated.
There are differences between how this is managed within #DeFi and #CeFi.
It's important to note at this point, however, that there are different ways assets can be rehypothecated.
There are differences between how this is managed within #DeFi and #CeFi.
24/
Although their are risks to both, through DeFi it is ordinarily through protocols that assets are rehypothecated.
A good example of this is through #yield farming.
Although their are risks to both, through DeFi it is ordinarily through protocols that assets are rehypothecated.
A good example of this is through #yield farming.
25/
In yield farming, assets are used as collateral to borrow other assets which are then used to generate yield.
The yield is generated through various strategies, such as lending to borrowers or providing liquidity for trading pairs.
In yield farming, assets are used as collateral to borrow other assets which are then used to generate yield.
The yield is generated through various strategies, such as lending to borrowers or providing liquidity for trading pairs.
https://twitter.com/Slappjakke/status/1629140698565058560
26/
These borrowed assets are #rehypothecated by the borrower, meaning they are pledged as collateral again to borrow more assets, to create more yield and so on.
Provided its a well known platform, you're likely to be able to see on-chain how this is distributed.
These borrowed assets are #rehypothecated by the borrower, meaning they are pledged as collateral again to borrow more assets, to create more yield and so on.
Provided its a well known platform, you're likely to be able to see on-chain how this is distributed.
27/
CeFi (centralized finance) represents custodians and exchanges which offer in similar in-house yield services with promises of certain returns.
CeFi (centralized finance) represents custodians and exchanges which offer in similar in-house yield services with promises of certain returns.
https://twitter.com/hhsahay/status/1627765742002229252
28/
The process of rehypothecation is similar, except less transparent as there's usually no way for the depositor to know if or how their funds are being utilized this way.
It's entirely possible for funds to be rehypothecated without the consent of the depositor.
The process of rehypothecation is similar, except less transparent as there's usually no way for the depositor to know if or how their funds are being utilized this way.
It's entirely possible for funds to be rehypothecated without the consent of the depositor.
29/
The 2022 s**tstorm with #FTX, Alameda and co, was fundamentally linked to the mismanagement of finances and overleveraged investments made with rehypothecated crypto assets; also likely just plain fraud.
The 2022 s**tstorm with #FTX, Alameda and co, was fundamentally linked to the mismanagement of finances and overleveraged investments made with rehypothecated crypto assets; also likely just plain fraud.
https://twitter.com/MarioNawfal/status/1591940438952402944
30/
User funds deposited into FTX were rehypothecated as collateral to enter its own risky investments. This was mainly managed through Alameda.
User funds deposited into FTX were rehypothecated as collateral to enter its own risky investments. This was mainly managed through Alameda.
31/
Alameda would use FTT as collateral on FTX to acquire other assets, such as USD stable-coins, from customer deposits.
FTX user funds could be directly withdrawn from FTX and utilized by Alameda to trade using their more sophisticated platform.
Alameda would use FTT as collateral on FTX to acquire other assets, such as USD stable-coins, from customer deposits.
FTX user funds could be directly withdrawn from FTX and utilized by Alameda to trade using their more sophisticated platform.
32/
This whole process works… until it doesn’t.
And in a volatile fledgling industry like crypto, a change in market direction is inevitable.
This whole process works… until it doesn’t.
And in a volatile fledgling industry like crypto, a change in market direction is inevitable.
33/
After the collapse of Terra’s $LUNA & $UST, the ripple effects were felt throughout the cryptoverse with very few entities or individuals being able to avoid the collateral damage.
Prices of cryptocurrencies dropped like a stone.
After the collapse of Terra’s $LUNA & $UST, the ripple effects were felt throughout the cryptoverse with very few entities or individuals being able to avoid the collateral damage.
Prices of cryptocurrencies dropped like a stone.
34/
By extension, this was one of the reasons which caused the issue with FTX and Alameda due to them being overleveraged.
By extension, this was one of the reasons which caused the issue with FTX and Alameda due to them being overleveraged.
35/
They might have been able to avoid a total collapse but were caught with their pants down when exposed by Twitter anons who sounded the alarm to a suspect looking balance sheet.
They might have been able to avoid a total collapse but were caught with their pants down when exposed by Twitter anons who sounded the alarm to a suspect looking balance sheet.
https://twitter.com/hodlKRYPTONITE/status/1588106234968043522
36/
This caused a run on FTX with concerned users looking to withdraw their assets.
Eventually FTX had to pause withdrawals because they didn’t have enough assets to meet the demands of the requests.
This caused a run on FTX with concerned users looking to withdraw their assets.
Eventually FTX had to pause withdrawals because they didn’t have enough assets to meet the demands of the requests.
37/
A lot of this was because of their pursuit of high risk investments through the rehypothecation of user funds.
A lot of this was because of their pursuit of high risk investments through the rehypothecation of user funds.
38/
Investing is incredibly risky in both the world of TradFi and Crypto.
Those in the traditional financial sector may argue that the latter is the riskier of the two due to its volatility.
Investing is incredibly risky in both the world of TradFi and Crypto.
Those in the traditional financial sector may argue that the latter is the riskier of the two due to its volatility.
39/
I agree that there is still a lot that the crypto world needs to learn - especially when it comes to tackling scammers and making the barrier to entry lower for non-natives.
I agree that there is still a lot that the crypto world needs to learn - especially when it comes to tackling scammers and making the barrier to entry lower for non-natives.
40/
I would argue however, that one of the biggest problems in the space is archaic, non-transparent and intermingled financial practices.
Rehypothecation is one problem at the top of the list.
I would argue however, that one of the biggest problems in the space is archaic, non-transparent and intermingled financial practices.
Rehypothecation is one problem at the top of the list.
41/
As we’ve seen, the rehypothecation of assets is risky because there is very little accountability or transparency with the process.
As we’ve seen, the rehypothecation of assets is risky because there is very little accountability or transparency with the process.
42/
Further, when there is a build-up of risk mismanagement and institutions gamble with user or customer funds, this can cause catastrophic results.
Further, when there is a build-up of risk mismanagement and institutions gamble with user or customer funds, this can cause catastrophic results.
43/
As a result of the FTX collapse, we’ve seen more exchanges, protocols and crypto companies commit to disclosing their proof-of-reserves to provide peace of mind that customer funds are backed 1:1.
As a result of the FTX collapse, we’ve seen more exchanges, protocols and crypto companies commit to disclosing their proof-of-reserves to provide peace of mind that customer funds are backed 1:1.
https://twitter.com/CoinDesk/status/1627579643787190273
44/
This is a good first step to take towards full transparency in the crypto space and unlike traditional investment banks, we can move away from fractional asset type practices.
This is a good first step to take towards full transparency in the crypto space and unlike traditional investment banks, we can move away from fractional asset type practices.
end/
Thank you for reading!
I hope you enjoyed this thread. It was a lot of fun to learn about and to write, a lot of this is still new to me so any feedback always appreciated.
Drop a follow, like or RT!
Find the link to my Substack - Crypto Contemplation - in my bio!
😄🌱
Thank you for reading!
I hope you enjoyed this thread. It was a lot of fun to learn about and to write, a lot of this is still new to me so any feedback always appreciated.
Drop a follow, like or RT!
Find the link to my Substack - Crypto Contemplation - in my bio!
😄🌱
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@Only1temmy
@N3tyan_
@DeFiMinty
@CryptoShiro_
@DamiDefi
@rektdiomedes
@rektfencer
@ViktorDefi
@diana_web3
@IamZeroIka
@Chinchillah_
@Slappjakke
@DefiIgnas
@cyrilXBT
@arndxt_xo
@CryptoKoryo
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@bubits_
@0xMughal
@jake_pahor
@eli5_defi
@Mizz0x_
@_Vinsmoked
@GrowCrypto__
@2lambro
@BucharaYT
@ArbiAlpha
@jpegrascal
@nftshark_
@ballanutsa
@cj_zZZz
@0xDinoEggs
@pedroo_nv
@bubits_
@0xMughal
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