Remortgaging may be common in traditional finance, but it will never work with Bitcoin

If there’s one reason for consensus in crypto after a disastrous 2022, it’s that centralized crypto lending presents a particular cause for concern. The rehypothecation of client assets allowed crypto firms to grow rapidly until they collapsed under the weight of these risks.

Rehypothecation is the technical term used when financial platforms reinvest depositors’ assets to promote these platforms’ access to credit. This practice is the norm in traditional finance – so deeply rooted in the operating behavior of the legacy financial system that not doing it is dismissed as less efficient.

Applying this behavior to bitcoin or crypto ignores the fundamental essence of these assets arising from a core bitcoin innovation. Scenarios like these will repeat themselves in the future as long as the market does not effectively recognize and price the risk of rehypothecated collateral. The risk for a customer is fundamentally different when there is and when there is no rehypothecation of the customer’s security.

Hypothecation occurs when a person or entity takes out a loan and receives an interest based on providing collateral, such as when bitcoin is provided as collateral to a lender. The promise from the lender is that when you pay off your loan, you will get your security back.

However, lenders themselves often take leverage based on assets on the balance sheet and obtain credit on other platforms – giving themselves additional credit for their own use by using the customer’s original collateral. This process is called remortgaging. Deep in the fine print, the promise to return a borrower’s security is conditional on there being available security to return.

The very common use of rehypothecation in traditional finance created a sense of normality for how to treat assets – financially or otherwise. And as the bitcoin and crypto industry has grown, many from TradFi have embraced these norms. Scratch the surface of many crypto firms and you’ll find that they use customer deposits to further their business goals (often while stressing the importance of “sovereign” money like cryptocurrencies).

An unavoidable reality of this practice in TradFi is that it functions fundamentally via the system of fractional reserve banking. Dollars are largely created through the central banking system which is flooded with cheap liquidity, and in the event of a crisis scenario, the government opens the liquidity pump further.

Fractional reserve banking necessarily encourages risk-taking. When credit dries up, the stated goal of opening the tip is: to encourage lenders to take risks and put capital to work via credit. In this way, the normal market forces are mitigated to identify weaknesses and the cycle continues.

However, these fundamental differences between the dollar and bitcoin are not often well enough understood, and it is a mistake to continue with bitcoin using the same remortgage method.

To illustrate, the software industry has enjoyed the margins it makes because of the inherent ease of replication of digital information: there is essentially zero marginal cost to produce an additional unit of a digital product. Consequently, with music, movies and software, an entire digital rights management industry emerged with the internet to prevent free duplication of products.

Given this backdrop, a fundamental innovation for Bitcoin was Satoshi’s solution to create something that is provably digitally scarce – there can only be 21 million bitcoins – and presents us with something unusual for finance. There is a fundamentally different risk profile for collateral that is unique from one that is continuously created or can be reproduced at will.

We need to treat both bitcoin’s custody and the pricing of risk in the bitcoin lending markets differently than an asset backed by a seemingly endless supply of dollars. The reason is simple: if someone loses your bitcoin, there is no way to earn more of them to make you whole. They are truly, irrevocably gone.

Traditionally oriented lenders reject the very idea of ​​non-rehypothecated collateral for their loans. They will argue that a pure balance sheet loan – providing a loan as an investment of own capital risk – is less efficient than remortgaging.

To be sure, a company’s potential returns would not be as juicy as those when leverage has been taken by rehypothecating a borrower’s collateral, getting more dollars and creating even more loans in a cycle that repeats itself for that specific lender. However, borrowers often lack the information needed to understand the risk they are taking when collateralizing a lender that only offers this model, even though it currently represents almost all centralized cryptolenders.

In the fallout from the failures in crypto and now in banking – where customer deposits above a certain threshold are treated as if the depositor were there with an investor hat on – it is obvious that these depositors and borrowers had no intention of investing in the platform’s (or the bank’s) business . Nevertheless, in a failure depositors suddenly find themselves a creditor of the failed business.

For a grocery customer seeking a personal loan and being asked to put up bitcoin as collateral, it would seem sensible that they understand what is going to happen to their money and therefore have an understanding of the overall risk they are taking when they get their borrow.

$5 words like “remortgage” are rarely understood by borrowers today. Education for market participants is the most effective way to bridge the gap between the status quo in finance and the true benefits of a sustainable path forward in light of the rise of Bitcoin and digital scarcity. An effective way for market participants – borrowers in this case – to get a sense of the risk involved is simply to ask what will happen to their collateral before repaying the loan.

Fortunately, the key learning for these customers is a simple truth: non-rehypothecated lending is a superior and objectively lower-risk way of borrowing, and will naturally be worth a premium for many customers. This can take the form of lower interest rates for higher-risk loans or higher fees for safer, non-rehypothecated loans.

A more transparent market would offer both loan types and respective interest rates side by side. An informed borrower who considers the risks and costs could choose a lower interest/high risk loan, but they would do so from a place of informed consent and not unexpectedly find themselves a creditor in a platform’s bankruptcy proceedings, possibly having lost their bitcoin forever.

During the last bull cycle, we have seen risk taking with client assets at a shocking level. Until we see more information in the market about how customers’ assets are used on platforms and a recognition that bitcoin and digital scarcity need to be thought of fundamentally differently than in traditional finance, it seems likely that these highly leveraged scenarios and subsequent asset losses will repeat themselves in the future .