Cryptocurrency lending websites are luring customers with high interest rates on deposited digital currencies. But what these investors do not realize is that there is a silent threat behind these returns rehypothecation. Such practice is prone to huge losses once collateral of users is mismanaged by the borrowers or platforms.
Understanding Rehypothecation in Crypto Lending
Rehypothecation occurs when an application reinvests the crypto collateral of the user to get additional yield. Under this, the lender can borrow the crypto to a third-party supply such as market makers. As much as this increases the efficiency of capital, it also gives the users more risks.
The crypto on platforms is frequently lent out on margin or deposited in DeFi protocols. In case such investments go wrong, they might not refund your coins. As such, even when you repay your original loan, your assets are at risk.
This is similar to centralized finance (CeFi) rehypothecation, with fewer protections. Conventional brokers possess rehypothecation limits and regulation. On the contrary, crypto platforms can be used without these restrictions.
CeFi vs. DeFi Exposure to Rehypothecation
CeFi applications, such as Celsius or Voyager are closed systems. Once the crypto is deposited on the platform, users are unable to trace it, which further complicates things. Consequently, users will not know of counterparty exposure or rehypothecation activity.
Smart contracts such as those used in DeFi protocols such as Aave or Compound are on-chain visible. Individuals are able to see the real-time location of their ETH or USDC. Nevertheless, smart contracts continue to have technical risks such as exploits and oracle failures.
Whereas DeFi is transparent, CeFi may conceal rehypothecation in terms of law. CeFi platforms usually demand the assignment of the ownership of the assets. It implies that in case the platform becomes insolvent, you have no legal rights to your coins.
Major Risks of Rehypothecation in Crypto
The greatest risk is that of counterparty insolvency. In case of default of a borrower such as a hedge fund, the platform will lose your BTC or altcoins. Then it will not give back your tokens even when you fulfil your repayment terms.
When bear markets occur, mass withdrawals cause liquidity crises. Users scramble to withdraw staked SOL, ETH, or BNB yet the site has rehypothecated them. It can also freeze withdrawals, as it did in the 2022 crypto crash.
Unsecured creditor status is also a problem to users. Should a CeFi site go bankrupt, your crypto cannot be secured in the same way as with a bank. By law, you rank last to repayment.
Real-World Examples from the Crypto Industry
Celsius Network collapsed in 2022 following a risky situation in which it staked user money in high-risk DeFi protocols. The platform was unable to salvage assets at a time when it was making a decline and withdrawal was frozen. Millions of BTC and ETH were lost by the users.
Voyager Digital was also a failure having lent more than 650 million USDC and crypto to Three Arrows Capital. Upon the default of 3AC, Voyager went into insolvency. Investors did not get the severe losses as their money was rehypothecated already.
These are some examples of how rehypothecation can ruin platforms in a single night. The crypto markets are evolving at a rapid pace, and platforms are unable to recollect liquidity at all times. It is the users who are the eventual victims when risks are not managed and concealed.
How Investors Can Protect Their Crypto
Non-custodial wallets, such as MetaMask or Ledger, should be used. You can rehypothecate your coins no matter who has possession of the coins because you are in control of the private keys. The greatest defense in DeFi is self-custody.
Terms of use Before using CeFi sites, review Terms of Service. Search such terms as transfer of title or right to pledge or re-pledge. These words imply that the platform is allowed to use staked crypto legally.
Do not use platforms that promise an abnormally high rate on stablecoins or altcoins. The high APY is usually accompanied by a high rehypothecation risk. When it sounds like it is too good to be, then it is.
Conclusion
However, rehypothecation is also a critical part of the crypto lending process, but there are hidden risks associated with rehypothecation. Despite the CeFi disasters or the risks associated with DeFi, the threat associated with your assets is still present.
