Bitcoin has had a tumultuous relationship with Wall Street since its inception during the financial crisis. However, the dynamics of that connection seem to have shifted recently. The qualities of cryptocurrencies, as well as its general acceptance, have made it an appealing investment tool for the same group of individuals.
Wall Street’s acceptance of bitcoin is fraught with complications. Commingling and rehypothecation, two processes that allow investment companies to increase their profits, might modify how bitcoin functions and undermine its initial aims.
Caitlin Long, a Forbes writer and Wall Street veteran, has published a full explanation of this issue in a piece. Long believes that rehypothecation and commingling will shift bitcoin and cryptocurrency risks to exchanges, clearinghouses, and central derivatives counterparties. Because hackers would have a single point of attack to damage the bitcoin ecosystem, centralized risk translates to heightened vulnerability. 1
What Are Commingling and Rehypothecation?
Banks and financial services firms often separate collateral from individual parties depending on several characteristics such as owner and loan type. This technique ensures accurate accounting and allows them to repay the collateral when it is due.
Commingling, as the term implies, is the combining of collateral from several parties into a single “omnibus” account. Commingling is common practice on Wall Street and has grown in popularity as a way to minimize or lessen the likelihood of custodial counterparties (or CCPs) failing to keep their half of the contract.
Mixing has two potentially negative implications. First, since CCPs are not allowed to disclose specific amounts, it is impossible to discern between assets and liabilities in their balance sheets. As a consequence, it is impossible to determine if they have sufficient assets to fulfill their responsibilities. Commingling also consolidates bitcoin assets into a single account, making it an appealing target for thieves and hackers. For example, instead of spreading bitcoins over several online wallets, a CCP may keep them in a single “omnibus” wallet. As a result, if hackers want to destroy the Bitcoin ecosystem, they may attack these wallets.
Rehypothecation affects bitcoin’s identification even further. Simply enough, rehypothecation lets CCPs to utilize the same bitcoin as collateral multiple times. Long defines it as “the process by which a lender accepts an asset as collateral for a loan and then pledges that collateral to cover its own risk to a third party, which then pledges the same collateral to a different part.”
This implies that a series of loans may be traced back to the same asset. A single loan default inside the chain, or a successful custodial hack, might bring the whole arrangement crashing down. Further complexities come from rehypothecations since the same asset will be accounted for on many balance sheets, obscuring its origins.
As the bitcoin ecosystem expands, the ripple effects of a catastrophe might cause serious harm to other assets, similar to how the mortgage crisis damaged many and unconnected sections of the global economy.
Can These Risks Be Mitigated?
Long believes that by prohibiting rehypothecation and commingling for bitcoin, the difficulties associated with centralized risk may be minimized. However, the likelihood of such a happening is limited since it would significantly diminish CCP revenues. Bitcoin’s artificial scarcity makes it a particularly desirable asset for Wall Street. The rehypothecation of bitcoin might enable financial services businesses like Goldman Sachs to benefit by constructing a chain of loans utilizing the same hoard of bitcoin in its possession. According to Long, Intercontinental Exchange (ICE) declared its entry into bitcoin due to rehypothecation and commingling. 1
Investing in cryptocurrencies and other Initial Coin Offerings (“ICOs”) is very dangerous and speculative, and this article is not a suggestion by Investopedia or the author to do so. Because every person’s circumstance is different, a knowledgeable specialist should always be contacted before making any financial choices. Investopedia makes no guarantees or warranties about the accuracy or timeliness of the information provided on this site.
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