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.