What Is Rehypothecation and How Will it Affect Cryptocurrencies?

Cryptocurrencies have experienced their worst bear market since 2014 when prices fell by over 80 percent. Today, price declines are very similar to the sell-off experienced back then. In fact, several of the major cryptocurrencies have suffered losses in the neighborhood of 80 to 90 percent. While the signs of recovery seem to be appearing, one has to ask–what happened?

Of course, it’s impossible to pinpoint the exact reason. In fact, there are probably several factors influencing the sharp decline. And one of the major ones is rehypothecation.

What Is Rehypothecation?

At this point, you may be asking what is rehypothecation, and how did it find its way into the cryptocurrency landscape? Let’s discuss the details.

In regard to investment products sold on Wall Street (i.e. stocks, bonds, derivatives, currencies, and commodities), rehypothecation is a common occurrence. It’s been part of the Wall Street community for decades.

Traders and investors have simply learned how to deal with rehypothecation and accept the fact that it is permanently ingrained in these investment products. However, cryptocurrencies are certainly not part of traditional assets.

In fact, within the next three to five years, crypto could easily morph into its own asset class (probably under the umbrella of digital assets). This is why many traders and investors are slightly confused when they’re told that rehypothecation could become a problem with cryptocurrencies.

Rehypothecation Explained

In its simplest terms, rehypothecation is a practice by brokerage firms of using assets that have been posted as collateral by their clients and it’s quite common on Wall Street. Rehypothecation is used by all the large institutional banks and brokerage firms.

In order to gain a better understanding of rehypothecation, check out the following example:

Let’s assume John has 500 shares of Amazon stock in his account with XYZ Brokerage Firm. He decides to buy more shares of Amazon. However, instead of depositing funds in his account, John uses the original 500 shares of Amazon as collateral for his new purchase.

Essentially, John is borrowing funds to buy more shares of Amazon stock. Rehypothecation occurs when XYZ Brokerage Firm uses John’s 100 shares of Amazon stock to cover its own financial obligations.

Theoretically, John’s 100 shares of Amazon stock are being used as collateral on two separate transactions.

It may sound wrong to you, but rehypothecation is 100 percent legal. However, it does have the effect of suppressing prices and temporarily creating an artificial supply of the underlying security.

Was Rehypothecation Responsible for the Bitcoin High in December 2017?

Check out chart one below. Is it a coincidence that Bitcoin recorded its all-time high on the exact day that the CME launched its Bitcoin futures product? Probably not. Traditional futures exchanges are a perfect place to create rehypothecation because they offer custodial services and warehousing of physical commodities.

In regard to the CME, they offer both of these services, which provides the necessary ingredients to suppress prices through rehypothecation.

Some people will argue that bitcoin is a cash-settled futures product with the CME. Therefore, they claim that rehypothecation can’t occur because there is no warehousing of physical bitcoins. Unfortunately, rehypothecation can still occur synthetically through a cash-settled contract.

Of course, it would be foolish to place 100 percent of the blame on the CME for creating the all-time high of bitcoin in December 2017. There were several contributing factors which lead to bitcoin’s bull market top. However, it’s probably safe to say that the introduction of bitcoin futures played an important role.

Will Bakkt Bring Price Suppression to Cryptocurrencies?

The Intercontinental Exchange (ICE) will launch Bakkt on January 24, 2019. In addition to other products, Bakkt will introduce a one-day physically-delivered bitcoin futures contract. The futures contract will be traded on the ICE Exchange, which has been in existence since May 2000.

Without question, the ICE is considered an “old school” institutional firm, just like the CME. Consequently, any new product that’s unveiled through the ICE exchange will be met with a healthy amount of skepticism as it relates to price suppression and rehypothecation.

In fact, plenty of crypto traders gave a big “thumbs down” to Bakkt when it was introduced by the ICE on August 2.

Check out chart two below. It shows the date that ICE announced the formation of Bakkt.

As you can see, prices have been falling ever since Bakkt announced its intentions to become a major player in the world of cryptocurrencies. BTC was trading near the $8,300 level when the Bakkt news was released in early-August. Immediately, prices began to drift lower.

There has been a relentless decline in the price of BTC for the past five months until this week. Is it possible that beyond the Bitcoin Cash fiasco, the delayed ETFs, and the SEC clamping down on ICOs that Bakkt was the main catalyst?

In terms of its ability to suppress prices, Bakkt could certainly be placed in the same category as the CME. Bakkt will have a custodial relationship with its account holders along with providing warehousing services for its physically-delivered bitcoin futures contract. As we discussed earlier, these are the necessary ingredients for engaging in rehypothecation.

Digitex Will Play an Important Role in Preventing Rehypothecation

Digitex Futures offers several unique features not found in a traditional exchange. The first is the fact that Digitex offers its account holders a commission-free trading exchange, thus completely eliminating all financial intermediaries (i.e. brokers) from the equation.

These savings are passed directly to the customer in the form of a zero-fee trading experience. Additionally, Digitex has minted its own native cryptocurrency, DGTX. The token will be used by members of the crypto community who trade on the Digitex platform. All activity will be denominated in DGTX. This includes account balance, daily profit and loss, margin requirement, and tick value.   

It’s also important to discuss the things Digitex does not offer. For example, Digitex is not a custodian of customers’ accounts. In other words, Digitex has no control over customers’ account balances. Instead, they are held on the Ethereum blockchain within an independent decentralized smart contract. Digitex also does not provide warehousing services.

These factors alone are sending a strong message to the crypto industry. It has no intention of suppressing the price and creating an artificial supply. Arguably, the most important component of Bitcoin is the fact that Satoshi Nakamoto created a limited number of Bitcoins @ 21 million. Digitex will maintain the integrity of all cryptocurrencies by providing non-custodial services.

Maintaining True Price Discovery

One of the main reasons people were initially attracted to Bitcoin was because it provided an alternative to our current fiat system, which is notorious for creating money out of thin air. Under our current monetary system, money is simply printed into existence.

The cryptocurrency community will not support crypto exchanges and crypto businesses that attempt to manipulate the price through rehypothecation.

Digitex has an excellent opportunity to become an industry leader in providing traders and investors with non-custodial accounts. Those in the crypto community searching for a futures exchange with no “hidden agenda,” will surely select Digitex.

Personal Observations

It will be very interesting to see if these “old school” Wall Street financial institutions are successful in unleashing their “bag of tricks” on the cryptocurrency markets. It’s quite easy for these firms to suppress the price of stocks, bonds, and other traditional assets through rehypothecation because there is no finite supply of the underlying asset.

Unfortunately, for the Wall Street institutions, there is a pre-determined supply of most cryptocurrencies. As a result, it will not be easy for these firms to manipulate prices by creating an artificial supply.

Quite frankly, I would not be surprised if one of these institutions unleashed a major supply disruption while attempting to manipulate the price of Bitcoin on a physically-delivered futures contract.

In theory, rehypothecation works great as long as the exchange can supply the underlying physical commodity upon the request of the customer. However, what happens if the exchange is unable to locate an adequate amount of the commodity to meet the customer’s demand for the physical product? This would cause a dramatic price increase as the exchange scrambles to find enough of the physical commodity.  

As you know, Bitcoin is capped at 21 million bitcoins. If enough people in the crypto community store their bitcoins using an offline cold storage method, it could be very difficult for these Wall Street exchanges to meet the demand for physically delivered-contracts. This is an accident waiting to happen.    

Digitex Futures writers and/or guest authors may or may not have a vested interest in the Digitex Futures project and/or other businesses mentioned throughout the site. None of the content on Digitex Futures is investment advice nor is it a replacement for advice from a certified financial planner.