Rehypothecation in Crypto Lending: A Simple Guide

There is a lot of conflicting information out there on rehypothecation, a complicated-sounding term. However, it’s not difficult to understand. In this guide, we'll explain what rehypothecation is, how it works in the crypto context, its advantages, and the associated risks. 

What Is Rehypothecation?

Rehypothecation is a financial practice in which institutions lend out the collateral provided by borrowers to generate income. This collateral can be anything of value, such as cash or crypto. The aim is to lower borrowing costs and subsidize loan interest rates for borrowers. Both centralized crypto lending platforms and traditional lenders, like banks, engage in rehypothecation.

Rehypothecation creates a positive effect on market liquidity by providing more funds for borrowing, trading, and investing. Increased liquidity benefits market participants. It makes it easier for them to access credit, execute trades, and fulfill financial obligations.

However, while rehypothecation enhances liquidity, it also introduces uncertainty into the market. The process of lending out collateral creates interconnected obligations and exposure. The same collateral may be used by multiple parties as security for different loans or financial transactions.

This interconnectedness can lead to increased uncertainty and risk. If borrowers or counterparties default on their obligations, lenders may face difficulties in reclaiming their collateral. This can create a liquidity squeeze, where lenders struggle to meet their obligations due to the loss of collateral value or difficulty in recalling the assets.

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.

Let's break down how it works.

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?

In the crypto lending landscape, rehypothecation allows lending platforms to use cryptocurrency collateral to generate income. This income can be used to subsidize borrowing rates. By lending out collateral, these platforms can benefit from market gains while ensuring they can meet their lending obligations. 

Our guide ‘How to Borrow Against Crypto - Decoding Crypto Loans’ tells you everything you need to know about lending your Bitcoin and other crypto.

Rehypothecation vs. Hypothecation

It’s important to distinguish between rehypothecation and hypothecation. 

Rehypothecation involves lending out the collateral provided by borrowers to generate income.

Hypothecation is the practice of using collateral to secure a loan without necessarily lending it out to others.

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 even further.

Risks of Rehypothecation

Like any lending activity, rehypothecation comes with its share of risks, but they can be minimized. Ensure that the platform you choose has strong risk management and due diligence policies. 

Collateral Value Decline

If the value of the collateral significantly drops during the loan term, borrowers may face a margin call, requiring them to add additional collateral to maintain the required loan-to-value (LTV) ratio.

Collateral Liquidation

In extreme cases where the LTV reaches a certain threshold, the lending platform may liquidate the collateral to pay out the outstanding loan balance, potentially leading to loss of assets for the borrower.

Market Volatility

Cryptocurrency markets are highly volatile. Sudden price fluctuations can lead to a rapid decline in collateral value, triggering margin calls or liquidations.

In times of market stress or volatility, the uncertainty introduced by rehypothecation can amplify systemic risks. A sudden decline in the value of the lent collateral could trigger a series of margin calls and liquidations, causing further market instability.

Using more stable cryptocurrencies as loan collateral can reduce this risk.

Lack of Transparency

Some lending platforms may not provide sufficient transparency about their rehypothecation practices, making it challenging for borrowers to assess the risks adequately.

Lack of Regulation

The rehypothecation of cryptocurrency assets is less regulated compared to traditional financial markets, leading to potential risks of market manipulation, for fraudulent or risky practices.

Challenges in accurately assessing counterparty risk

Since the same collateral can be used by multiple parties, it becomes challenging to determine the true exposure and risk levels of each counterparty involved in the rehypothecation chain. 

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

How Ledn Manages Risk with Rehypothecation

Ledn engages in institutional lending in order to subsidize our clients’ borrowing rate. We carefully manage risks and conduct thorough due diligence on all our institutional lenders.  We’re also fully transparent in how we use platform assets via our monthly Open Book Report and Client Dashboard.  Finally, unlike competitive platforms, Ledn has never had to pause client withdrawals.  Ledn’s proven track record, with nearly $600M of retail loan originations since 2018, shows that Ledn risk management policies are best-in-class for the industry.

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

1. Thorough risk assessment and due diligence on borrowers and counterparties.
2. Clear and transparent contracts with defined rights and obligations.
3. Imposing prudent limits on the amount of collateral that can be rehypothecated.
4. Regular and accurate collateral valuations to monitor changes in value.
5. Establishing appropriate margin requirements.
6. Conducting stress tests to assess potential impact under adverse market conditions.
7. Strong regulatory oversight and adherence to guidelines.
8. Transparency in rehypothecation practices.
9. Proper segregation of collateral assets to protect lenders and borrowers.
10. Well-defined contingency plans for various scenarios.

Crypto Rehypothecation Example

Let's look at how crypto rehypothecation works in practice:

1. Initial Collateral Deposit: You are an individual investor. You need access to cash, but don’t want to sell your crypto holdings.   You decide to use a crypto lending platform to borrow funds against your Bitcoin holdings.
   
   
2. Loan Request and Collateral Lockup: You approach a crypto lending platform and request a loan of $20,000 USD. Based on your collateral (let’s assume, 1 Bitcoin worth $40,000) and the requested loan amount, the LTV ratio is 50% ($20K/$40K).
   
   
3. Lender Participation: CeFi crypto lending platforms operate as a centralized service, meaning the funds for the loan come from the platform itself or a pool of funds managed by the platform.
   
   
4. Rehypothecation Process: The lending platform takes your deposited Bitcoin collateral and pools it with other assets or funds within the platform. It then uses these pooled assets to offer loans to other borrowers, likely institutional investors.
   
   
5. Borrowing the Funds: After successfully obtaining the loan, you now have access to the $20,000 USD (or USDC/T equivalent)  you borrowed from the CeFi crypto lending platform. You can use these borrowed assets however you like.
   
   
6. Interest and Repayment: As part of the loan agreement, you agree to pay an interest rate on the borrowed USD. The interest rate should typically be lower than platforms like Unchained Capital due to the rehypothecation model, which allows the platform to subsidize the rates using income generated from lending out pooled assets.
   
   
7. Return of Collateral: Once you repay the borrowed USD along with the interest within the agreed-upon loan term, your collateral (1 Bitcoin) is returned to your account. If you fail to repay the loan, the platform may liquidate a portion of your collateral to cover the outstanding debt and interest.
   
   
8. Lender Earnings: Meanwhile, the CeFi crypto lending platform earns interest on the loans it provides. The rehypothecation process helps optimize the platform's capital utilization.

Conclusion

Rehypothecation might sound like a complex financial term, but it's a common practice in traditional and crypto lending. By lending out collateral to generate income, lending platforms can offer lower interest rates to borrowers and even subsidize their borrowing costs. 

However, it's important to be aware of the associated risks. If you're considering a crypto-backed loan, explore platforms like Ledn that carefully manage risks and conduct thorough due diligence on their institutional lenders. 

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