Two new words are making their way to the vernacular of any Bitcoin or cryptocurrency enthusiast. Wall Street brokers, investors, analysts have broken into bitcoin, like any conquerors they have brought their language with them. ‘Rehypothecation’ and ‘Commingling’ are pervasive Wall Street practices that enable the financial system to create more claims to an underlying asset than there are underlying assets. Yes, that is right! Both practices are synonymous to a bubble machine.
Rehypothecation and commingling, are as antithetical to how Bitcoin works as they are integral to how Wall Street works. This can offset Bitcoin’s algorithmically-enforced scarcity and, all else equal, suppress its price.
Rehypothecation and commingling are “inside baseball” terms about collateral practices. Both of these are popularly used and applied by a narrow group of people working all around the corners of Wall Street’s collateral and credit risk management departments. But, because of the entry of ICE (parent of the NYSE) into physically-settled bitcoin futures, these terms are now relevant to bitcoiners.
They will be as smoothly used as any other word within the industry. It best to familiarize yourself before the time comes. According to the Thomson Reuters legal dictionary ‘Rehypothecation’ refers to:
The right of a secured party to lend, pledge, sell, assign, invest, use, commingle or otherwise dispose of collateral, usually cash or securities, posted by a counterparty under a trading agreement.
Collateral rehypothecation is one of the primary motivations behind the offering of prime brokerage services by broker-dealers.
Pledgors who have their collateral rehypothecated are at risk of holding only a general unsecured claim for the value of their collateral should the secured party enter into bankruptcy or similar proceedings.
What this really means is that there might be no asset, only one when the system may show twenty. Whereas, Commingling refers to:
The act of mixing the funds belonging to one party with those of another party. Usually, spouses or business partners may commingle assets without a problem. However, in community property states, a spouse may run the risk of turning separate property into community property (transmutation).
Business partners may have to account to each other. Trustees, guardians, agents, and other fiduciaries must be careful not to commingle the funds that they are caring for with those of their own, since commingling is generally prohibited as a conflict of interest.
Commingling means that the CCP or custodian will hold client collateral (bitcoins, in this case) in a commingled, or “omnibus account,” rather than segregating them for each client in their own wallets.
Commingling means today’s obligations can be settled with collateral received yesterday, so it reduces the probability of a shortfall today. It also means that different types of collateral (bitcoins, cash, US Treasury securities, etc.) can substitute for each other because counterparties only post the net of all their balances, not the gross amount on each trade. This seems problematic on first look but it is not.
Yes, it is true that every time the private keys are exposed, hacking risk goes up. Bitcoin is designed to settle on-chain and gross, not netted, off-chain and delayed, also true. But, this still does not mean that the ability to commingle is not healthy for the system. This practice is a standard in Wall Street’s collateral agreements, and examples are to be found here and here. It will enable managements systems of Bitcoin and any settling currency to work smoother than before.
Rehypothecation is the process by which a lender receives an asset as collateral for a loan, and then pledges that collateral to cover its own exposure to a separate party, which then pledges that same collateral to a different party, and so on and so forth. There is no time limit and the chain could go on and on forever. However, the length of collateral chains can be several parties long, and there’s no means by which to track that length in real-time. This means there are no means by which to determine how many fractionally-reserved assets have been created within the financial system. Here’s how this works.
This could be insidious and subtle. Individual financial institutions appear solvent while they hold an asset against their debt. Double/triple/quadruple/quintuple counting of that same asset may occur. With really no score of how many times the business is solvent or indebted over the same asset.