Rehypothecation in Lending: What Is It and How Does It Work?

In this guide, you’ll find:

• What rehypothecation is and why it matters.
• How it works in the context of cryptocurrency.
• The advantages it can offer to participants.
• The risks associated with its use.
• Key factors to be aware of before engaging in rehypothecation.
• Unrestricted Rehypothecation: A Practice on Its Way Out?

Rehypothecation might not be a household term, but if you’ve ever borrowed or lent crypto, it’s worth understanding. Rehypothecation happens when a platform or institution takes collateral (your Bitcoin, for example) and lends it out again to earn extra income. It’s common in both traditional finance and crypto, and while it can lower borrowing costs and boost liquidity, it also introduces risks.

In 2022, crypto lenders like Celsius learned this the hard way, using customer assets to chase high yields until market conditions turned against them. The result was insolvency, frozen withdrawals, and billions lost. Even FTX, once a giant in the space, collapsed after mismanaging customer funds in a similar way.

So, is rehypothecation a tool for efficiency or a risk to be wary of? That depends on how it’s managed. In this guide, we’ll break down how rehypothecation works, the benefits it offers, the dangers it poses, and how you can protect yourself.

The Definition of Rehypothecation

Rehypothecation occurs when institutions lend out a borrower’s collateral, such as cash or crypto, to generate income. 

This practice helps lower borrowing costs and subsidize loan interest rates. 

Both crypto lending platforms and traditional banks use rehypothecation.

While rehypothecation boosts market liquidity by making more funds available for borrowing and trading, it also carries risks. 

The same collateral can be reused across multiple loans or transactions, creating a web of interconnected obligations. 

This interconnectedness increases uncertainty. 

If borrowers or counterparties default, lenders may struggle to reclaim their collateral. 

This can trigger a liquidity squeeze, making it harder for lenders to meet their own obligations.

Looking for a primer on the fundamentals of crypto lending? Check out our ultimate guide

How Rehypothecation Works

Rehypothecation refers to the lending out of collateral to earn additional income.

In traditional finance, when an individual or institution wants to borrow money, they may be required to provide collateral to secure the loan. 

This collateral can be in the form of securities, like stocks or bonds, or other assets with value.

Financial institutions, such as banks or brokerage firms, act as lenders. They receive the collateral from the borrower, then hold it as security for the loan.

The financial institution, which holds the borrower's collateral, may choose to lend out these securities to other parties, such as hedge funds or other investors, in exchange for interest or fees. This is rehypothecation.

By lending out collateral, the financial institution generates income from the interest paid by the borrowers who borrowed the securities. 

This income can be used to enhance the profitability of the lending institution.

While the lending institution is earning additional income through rehypothecation, they still need to manage certain risks. 

They must ensure they can recall the borrowed securities if the original borrower needs to sell or use them. 

They must also keep track of their exposure and risks associated with the borrowed assets.

Rehypothecation is subject to regulatory oversight in traditional finance, with specific limits on how much collateral can be rehypothecated and how it must be managed. 

These regulations aim to strike a balance between promoting financial liquidity and stability while preventing excessive risk-taking.

How Does Rehypothecation Work for Crypto?

Rehypothecation in crypto works similarly to traditional finance but with digital assets like Bitcoin or Ethereum as collateral. 

It adds liquidity to the market but also increases risks, as the same assets may be used across multiple loans or transactions. If a counterparty defaults, recovering the original collateral can become challenging.

Here's how it works:

Borrower Provides Collateral: A borrower deposits crypto assets with a lending platform to secure a loan.

Platform Reuses Collateral: The platform may lend out this collateral to other parties, such as institutional investors, to generate additional income through interest or fees.

Borrower Pays Interest: The borrower repays the loan with interest, while the platform profits from both the loan and the rehypothecated collateral.

Collateral Management: The platform is responsible for ensuring it can return the borrower’s assets when the loan is repaid.

Advantages of Rehypothecation

Lower Borrowing Costs

Rehypothecation allows crypto lending platforms to offer lower interest rates, so borrowers can potentially save on borrowing costs.

Subsidized Loan Interest Rate

The income generated through rehypothecation can be used to subsidize loan interest rates, benefiting borrowers further.

Disadvantages of Rehypothecation

In 2022, several cryptocurrency platforms, including Celsius and Voyager, collapsed partly due to rehypothecation. These platforms used customer assets to generate high yields by lending them out multiple times. When the market crashed, they faced liquidity crises and were unable to return assets to customers, leading to bankruptcies and significant customer losses.

The following year, FTX, a major crypto exchange, misused customer funds, reportedly leveraging them to back loans for its sister company, Alameda Research. This rehypothecation-like practice contributed to its liquidity shortfall when customers attempted to withdraw their funds, resulting in a sudden collapse.

Potential Risks for Traditional Investors

Systemic Risks During Stress

In volatile markets, rehypothecation can amplify risks. A drop in collateral value may trigger a chain reaction of margin calls and liquidations, leading to market instability.

Counterparty Risk

When collateral is reused across multiple loans, it becomes challenging to assess exposure and risk levels, creating uncertainty in times of financial stress.

Lack of Transparency

Some institutions may not clearly disclose how rehypothecation works or the extent of collateral reuse, making it harder for investors to gauge risks.

Risks for Cryptocurrency Investors

Market Volatility

Crypto prices are highly volatile. Sudden drops in value can trigger rapid margin calls or liquidations, especially for assets with high price swings.

Systemic Risks During Stress

Rehypothecation in crypto can worsen market instability during sell-offs. Falling collateral values may lead to widespread liquidations and cascading losses.

Limited Regulation

Unlike traditional markets, crypto rehypothecation lacks robust regulatory oversight, increasing the risk of fraud, market manipulation, or unsafe practices.

Counterparty Risk

The reuse of crypto collateral across multiple loans complicates risk assessments. A single default in the rehypothecation chain can have wide impacts.

Lack of Transparency

Many crypto platforms do not provide detailed information about rehypothecation practices, leaving investors unaware of how their assets are used.

How to Minimize Rehypothecation Risks

Rehypothecation risks can be reduced in a number of ways. Look for platforms that offer at least some of the following:

• Thorough risk assessment and due diligence on borrowers and counterparties.
• Clear and transparent contracts with defined rights and obligations.
• Limits on the amount of collateral that can be rehypothecated.
• Regular and accurate collateral valuations to monitor changes in value.
• Appropriate margin requirements.
• Regular stress tests to assess potential impact under adverse market conditions.
• Strong regulatory oversight and adherence to guidelines.
• Transparency in rehypothecation practices.
• Proper segregation of collateral assets to protect lenders and borrowers.

Related Content: The Risks of Crypto Lending - A Simple Guide 

Unrestricted Rehypothecation: A Practice on Its Way Out?

Insights from Mauricio Di Bartolomeo, Ledn Cofouder and CSO

The days of unrestricted rehypothecation, where companies can reuse your collateral freely, are numbered. Borrowers are increasingly demanding transparency and control over their assets, signalling a shift in expectations. While it’s still a prevalent practice, the industry is moving towards more borrower-friendly alternatives.

Borrowers Need More Control

Clients should no longer accept ambiguity around how their collateral is used. At the very least, they should demand clear disclosures and have options to choose solutions that don’t support rehypothecation. Transparency is becoming non-negotiable, and companies that fail to adapt may lose trust and market share.

Proof of Reserves: The New Standard

The future lies in proof of reserves, which provides transparency and accountability for client collateral. Borrowers want to know where their assets are, how they’re managed, and whether reserves back them. Soon, this will be the industry standard. Companies that cannot offer proof of reserves, whether through on-chain or accounting measures, will struggle to stay competitive.

What to Expect in the Coming Years

The shift is already underway. More Bitcoin and crypto companies are expected to roll out robust proof-of-reserves solutions. These will include a variety of approaches to verify both assets and liabilities. Borrowers will have greater visibility into how their collateral is handled, creating a more transparent and accountable ecosystem.

Ledn’s Role in Leading the Charge

As the industry evolves, Ledn is meeting these new demands head-on. By prioritising transparency and offering solutions that align with borrowers' expectations, we’re committed to shaping a more accountable future for crypto borrowing.

Follow Mauricio on X for more updates and insights.

How Ledn Manages Risk with Rehypothecation

Although Ledn offers the options of rehypothecation to subsidize clients’ borrowing rate, it  carefully manages risks and conducts thorough due diligence on all institutional lenders.  

It’s also fully transparent in how it uses platform assets via monthly Open Book Reports, Proof of Reserves and Client Dashboards.  

Unlike many other platforms, Ledn has never had to pause client withdrawals. 

Its proven track record, with nearly $600M of retail loan originations since 2018, shows that its risk management policies are industry-leading.

Conclusion

Rehypothecation increases liquidity and lowers borrowing costs but carries risks like counterparty defaults, systemic instability, and limited transparency. These risks are heightened in crypto due to volatility and weaker regulation, as seen in the collapses of Celsius, Voyager, and FTX.

Borrowers should prioritise platforms with strong risk management, proof of reserves, and clear rehypothecation policies. Transparency and due diligence will minimize risks and protect your assets.

Sponsored by 21 Technologies Inc. and its affiliates (“Ledn”). All reviews and opinions expressed are based on my personal views.