Navigating Crypto as a Beginner #3: Wtf is Rehypothecation?!
A term which has been shared a lot recently in light of the backlash from the never ending crash last year... but what does it mean? We go over some of the basics in today's newsletter.
Intro:
There is a lot of terminology and jargon thrown about in the investing space, this is true for both the TradFi space and crypto (perhaps even more so). After a couple of years of investing I can just about fully grasp technical conversations had on YouTube videos and podcasts, and I’m buzzing that I’m able to say this.
One thing I’ve constantly struggled with, however, is the idea of ‘derivatives’. I think a big reason for this is that it’s baffling that many of the types of derivatives exist as legal financial instruments, hence why I’ve decided to write about it to hopefully educate myself in the process.
In this post I’ll look to break down the basics of derivatives, sharing some examples of how they work and touch on the risks when manipulated as a tool for investment. One of the key areas of focus to highlight is the process of ‘rehypothecation’ which refers to the repurposing and reutilization of investments and debt.
We’ll cover how this works in the TradFi sector but also how this instrument has bled over into the world of crypto too.
Diving into derivatives
A good place to begin is how we define derivatives and explain what they do.
Derivatives: Financial instruments that quite literally ‘derive’ their value from an underlying asset, such as stocks, bonds, commodities, or currencies.
They are binding contracts between two parties. One simplified example of this is a manufacturer and supplier agreeing to trade a certain amount of stock at an agreed price in the future to mitigate the risk of uncertain material costs. However, there is still a risk to either party that if the price of the materials fluctuates significantly, one party may take a financial hit. The manufacturer benefits if the cost of materials goes up and they paid a cheaper price earlier, but they would be out of pocket if the cost goes down. In this scenario, the contract is the derivative as it represents the future value of the stock (asset).
In the world of financial markets, this process pertains to investors who engage in speculation and betting on market movements, effectively allowing them to wager on the price of a security or asset at a specific point in time with certain confidence. This comes with its own set of risks as collateral can be offered by the investor to leverage into a trade to increase their proportional position when trading. In the event that an asset is volatile and quickly fluctuates in price, it can cause a margin call on the trader which means they either have to offer up more collateral or their initial collateral is forcibly liquidated to ensure they can adhere to their contractual agreements.
The use of investment derivatives has grown significantly over the past few decades, the global derivatives market is estimated to be valued up to a quadrillion dollars (yes, that’s a ‘q’). The truth is that nobody actually knows what it’s true value is due to the difficulty in accounting for derivative products and services across different international jurisdictions.
While they can be useful tools for investors to manage risk and hedging investments, they can also be mind-blowingly complex and, by extension, are inherently risky tools for investment.
The financial crisis of 2008 was in part caused by the misuse of derivatives, particularly in the form of mortgage-backed securities and credit default swaps (CDS) on subprime mortgages. These are a type of home loan given to people who have lower credit scores or less income than traditional borrowers, the loans often have higher interest rates and fees to compensate for the increased risk of lending money to people who may have a harder time paying it back. Even so, in the early 2000s, banks and mortgage lenders were giving out subprime mortgages to a lot of people, even those who couldn't afford the monthly payments. This led to a housing bubble and ultimately the crash when many of these loans defaulted - meaning the borrowers couldn't pay them back. It’s important to note here that the value of a mortgage is based on the value of the underlying property, but it is not considered a derivative because the mortgage itself is not a financial contract whose value is derived from the underlying asset.
It’s too easy to go down this rabbit hole so we’ll leave it this here for now.
Securing loans with collateral
Hypothecation is 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. 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.
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. 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. 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 requirements.
TL;DR: The ‘hypothesis’ is that the recipient of the loan will pay back the loan with any agreed interest, the home - although still owned by the borrower - is agreed to be put down as collateral so that in the event payments aren’t made, then the home can be obtained by the lender.
The magic of fractional reserve practices
Rehypothecation: Collateral put down for a financial agreement is re-utilized as more collateral across more than one loan.
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. Fractional reserve banking is a banking system where banks keep a fraction of the deposits they receive from customers as reserves and lend out the remainder. This creates a multiplier effect where the initial deposit can be used to create more loans and deposits in the banking system. 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.
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 loans.
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. 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.
Rehypothecation is a common practice in the financial industry, especially in the derivatives market. Brokers and dealers often reuse the collateral pledged by their clients to secure their own financing needs ← read that again and tell me it doesn’t blow your mind that they are able to do this.
One of the reasons that rehypothecation is popular in the derivatives market is that it allows traders to increase their leverage. 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.
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 doesn’t exist. 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 they will potentially face legal action from their creditors. This is particularly painful for the customers who had their collateral seized as it can take years for this to be paid back through lengthy lawsuits.
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. Not to mention the risk that banks continue practicing fractional reserve banking, enabling them to only require a reserve of 10% of customer deposits - making the event of a bank run even more harmful if there is a spike in requests for withdrawals and these cannot be met.
Is Rehypothecation possible with Crypto?
Yes, you probably guessed by now, Rehypothecation is also common to see in the crypto industry too… thanks for this one TradFi 👍🏼
The 2022 shitstorm which happened with 3AC, Voyager, FTX & Alameda Research was fundamentally linked to the mismanagement of finances and overleveraged investments made with rehypothecated crypto assets; also just plain fraud.
For the purposes of this post, I’ll just cover FTX and Alameda research. Some context on the two;
What is (was) FTX:
A cryptocurrency derivatives exchange platform that was used for trading crypto products and allowed for the use of significant leverage. This and the easy-to-use interface were a big factor for its explosion in popularity in 2021.
What is (was) Alameda Research:
Alameda Research was one of the largest liquidity providers in the cryptocurrency market and used sophisticated quantitative models and trading strategies to execute trades across multiple cryptocurrency exchanges. The company's trading algorithms analyze market data in real-time and make automated trades based on statistical analysis and predictive modeling.
FTX and Alameda Research had an extremely close relationship between one another to the point they were co-dependent.
Where did it all go wrong?
User funds deposited into FTX were rehypothecated as collateral to enter its own risky investments. This was mainly managed through Alameda. In the end there was actually very little distinction between the two entities.
The FTT token, the native token to FTX, was primarily utilized for exchange fee discounts, collateral for trades, governance and as rewards for liquidity farming. As the exchange skyrocketed in popularity over the course of 2021-22, as did the token.
FTX and Alameda Research were intermingling funds, which included those of the platform users, and the FTT token played a huge role in this. Simply put, Alameda would use FTT as collateral on FTX to acquire other assets, such as USD stable-coins, from the customer deposits of FTX. FTX user funds could be directly withdrawn from FTX and utilized by Alameda to trade using their more sophisticated platform.
This whole process works… until it doesn’t. And in a volatile fledgling industry like crypto, a change in market direction is inevitable.
After the collapse of Terra’s $Luna, the ripple effects were felt throughout the cryptoverse with very few entities or individuals being able to avoid being victim to the collateral damage.
Prices of cryptocurrencies dropped like a stone.
By extension, this was one of the reasons which caused the issue with FTX and Alameda due to them being overleveraged. They might have been able to avoid the collapse but were caught with their pants down when they were exposed by Twitter anon’s who sounded the alarm to a suspect looking balance sheet.
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 was mostly because of their pursuit of high risk investments through the rehypothecation of user funds.
Conclusion:
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 and also because there are a lot of scams.
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 and also safer for non-natives to the space to enter it. I would argue however, that one of the biggest problems in the space is archaic, non-transparent and intermingled financial practices and rehypothecation is a one problem at the top of the list.
As we’ve seen, the rehypothecation of assets is risky because there is very little accountability or transparency with the process. Further, when there is a build-up of risk mismanagement and institutions gamble with user or customer funds, this can cause catastrophic results.
As a result of the FTX collapse, we’ve seen more exchanges and crypto companies commit to disclosing their proof-of-reserves to provide peace of mind that customer funds are backed 1:1. 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.
And that’s the post!
I really hope you enjoyed this one. Up until now this was the most challenging article I’ve written and by a long way. It took quite a bit of time to be able to wrap my head around some of the financial concepts but hope it made sense.
Happy to receive any feedback or any advice for the future on anything I’ve missed.
Thank you for reading! See you next time.
f.
A non-exhaustive list of resources used for reference:
https://www.investopedia.com/terms/m/mbs.asp
https://www.investopedia.com/terms/c/creditdefaultswap.asp
https://www.thebalance.com/how-derivatives-helped-cause-the-financial-crisis-4169968
https://www.forbes.com/advisor/investing/what-are-derivatives/