Rehypothecation Risks in Crypto Market

Introduction

Borrowing and lending are as old practices as money itself. When in financial hardships, you can go to a bank, pledge an asset of yours and get money to keep your financial circuit running. In the world of blockchain-based digital currencies, there are certain DeFi protocols that offer lending services. But getting a loan from a bank and a DeFi protocol are different matters as regulations regarding crypto market are still evolving. You are at risk in many ways in the matters of crypto lending. One of these is the rehypothecation risk.

What is Hypothecation and Rehypothecation?

Unless you are getting a loan from a close relative or a friend, you need to provide some collateral to the lender, which you have to forfeit in case you are not able to return the loan. Hypothecation is the process of pledging an asset of yours as a guarantee that you will pay back the loan, and if you don’t, the lender is entitled to get the ownership of the asset transferred. Suppose you need cash direly, and you don’t want to sell anything as you are sure that the shortage of cash is temporary. You go to a bank, pledge your gold and get money. If you fail to return the loan on time, the bank has got the right to seize your gold.

Rehypothecation is the practice of a lender to pledge the collateral of the borrower to get a loan or any other financial benefit from a third party. Going back to the example mentioned above, if the bank uses your gold to get a loan from another organization, it is rehypothecation.

Apparently, there is no harm in such practice as long as no party suffers. When you go back to the bank to return the loan and get your gold back, you don’t care where your gold has been if you are duly getting it back. However, if the third party makes some bad investments and is stuck, the bank will neither get the gold back nor be able to return it to you. The insolvency of the third party has brought loss to the two associated parties.

Rehypothecation in Crypto Market

Having understood the concept in banking, you can easily apply it to the crypto market. Suppose you have 100 $ETH, and you need stablecoins to trade, but you don’t want to sell your $ETH. You can pledge your assets to get stablecoins from centralized platforms as well as decentralized crypto lending protocols. Prominent examples of the first category are Nexo, YouHolder, CoinLoan, CoinRabbit, and Binance Loans. On the other hand, Aave, Morpho and Compound Finance are notable decentralized lending protocols.

Rehypothecation Risk in Crypto

Whether you are using a centralized lending platform or a decentralized lending protocol, your collateral is a trust that your lender is bound to return immediately when you pay back your loan. Nevertheless, lenders frequently rehypothecate the borrowers’ collateral to maximize their gains. If a lender is getting 5% interest from your, they can earn some extra money by either lending your collateral or staking it somewhere. Your lender will not be able to return your collateral if it is stuck on another platform. Rehypothecation risk is more serious in crypto market than in banking system due to lack of regulation at the moment.

For example, Securities Investor Protection Corporation is a non-profit organization in the US to provide protection to investors in case of rehypothecation losses through banks. Moreover, the lender is legally bound not to rehypothecate above the limit of 140% of the lent amount. Contrarily, crypto lending platforms make you sign agreements that immediately transfer the ownership of the collateral to them. The agreement gives the lenders more freedom as compared to traditional financial lenders, but also fetters the borrower excessively.

Amplified Rehypothecation Risk on Centralized Exchanges

Generally, one might think that centralized exchanges (CeXs) are safer than the decentralized exchanges (DeXs), but this is not always the case. When it comes to loans, CeXs are less transparent than DeXs because the borrower cannot see where their collateral is. The exchange might use it anywhere without any accountability. However, by no means does it imply that you can trust DeXs blindly. They have only this much edge that you can monitor your funds on chain. If anything goes wrong, ways to pursue the protocol are still limited.

Mass Withdrawal Risk

Apart from the insolvency risk of the third party, a sudden rush from borrowers to withdraw their funds may put pressure on the lender platforms and protocols, and creates liquidity issues. Again, it is just like a bank that may struggle to accommodate too many customers coming to withdraw money at once. This risk is especially substantial when the market is hit by some bad news. Regardless of whether the lenders’ rehypothecated collateral is liquid or not, an onrush of withdrawal requests is always difficult to fulfill.

How to be Safe from Crypto Hypothecation Risk

Use a Non-custodial Wallet

The best way to save yourself from the hypothecation risks is to use non-custodial wallets. This ensures that your assets cannot be rehypothecated by the lender. You might wonder how a lender can take assets locked in a non-custodial crypto wallet as collateral. Smart contracts on the DeFi lending protocols have this capability to lock your private-wallet funds and keep them as collateral. Your funds are unlocked when your return the loan but your are liquidated if you default.

Perusal of Terms and Conditions

Before using a centralized lender, read the Terms of Service carefully as they are provided in fine print, too tiny to read easily. Look for clauses regarding “transfer of title” or the platform’s right to “pledge, re-pledge, or hypothecate” your assets.

Beware of High Yields

Bridle your greed and avoid the protocols that offer unusually high yield for staking your funds. This is a clear indication that the protocol is involved in risky hypothecation practices.

Conclusion

Rehypothecation remains one of the most overlooked yet serious risks in the crypto lending market. While it can improve capital efficiency for platforms, it exposes borrowers to liquidity shocks, insolvency risks, and delayed or failed collateral recovery. With limited regulatory safeguards compared to traditional finance, the responsibility is on users to stay vigilant. Using non-custodial solutions, carefully reviewing lending terms, and avoiding unsustainably high yields can reduce exposure. In a rapidly evolving crypto ecosystem, protecting your collateral should always take priority over chasing short-term returns.