What platforms can do with your funds - Rehypothecation risk

In the world of decentralized finance, the rapidly growing number of investors is seeking ways to earn from their cryptocurrency assets. Lending platforms offer users the opportunity to deposit funds and earn returns, sometimes even 5% to 8% annually. However, behind these attractive interest rates lies a complex process called rehypothecation—a practice used by platforms to generate profits but which can lead to the loss of funds. It is important for every investor to understand how this practice works and what risks it entails.

How Rehypothecation Actually Works

Rehypothecation is the process by which a platform holding your assets as collateral reuses those assets for its own purposes. Instead of your bitcoin or other assets sitting inactive in a cold wallet, the platform loans them out to a third party—often an institutional borrower such as a risk management fund or a market maker—at a higher interest rate.

A practical example: If you lend 1 BTC to a platform and earn a 5% annual return, the platform might then lend that BTC to an institutional borrower at an 8% return. The 3% difference becomes the platform’s profit. From the service provider’s perspective, this is a profitable business model that allows them to offer competitive interest rates. However, from your perspective, your assets are no longer stored securely—they are in the hands of another entity that may or may not be able to return the funds.

The Chain of Risks—When Funds Can Disappear

Rehypothecation creates a “chain of financial dependency.” If the chain is broken anywhere, all parties involved can suffer losses.

Institution insolvency: Suppose a risk management fund (which has borrowed your assets from the platform) makes a poor investment and loses the BTC. That fund can no longer return the assets to the platform. The platform then faces a shortfall and can no longer return your funds.

Liquidity problems: During market downturns, thousands of users may try to withdraw their funds simultaneously. If the platform has rehypothecated most assets into long-term loans or illiquid investments, it may not have enough liquid assets to meet all withdrawal requests. This often leads to withdrawal freezes and bankruptcy.

Unsecured creditor status: While rehypothecation in traditional banking is regulated (usually up to 140% of the loan amount) and secured through institutions like SIPC, the crypto world still lacks a clear regulatory framework. Most platform terms of use state that after deposit, ownership of the assets is transferred. In case of bankruptcy, depositors are often classified as unsecured creditors—meaning they are last in line for repayment.

Real Examples: How Platforms Failed in 2022

The risks of rehypothecation became evident during the crypto market downturn in 2022, when several major platforms collapsed:

Celsius Network: This platform aggressively rehypothecated user assets into high-risk DeFi protocols. When the market turned downward, Celsius couldn’t quickly restore liquidity to meet user withdrawal demands. The platform filed for bankruptcy, and billions of dollars of user funds were locked up.

Voyager Digital: Voyager loaned hundreds of millions of dollars of user funds to the hedge fund Three Arrows Capital (3AC). When 3AC suffered catastrophic losses and couldn’t repay the loan, Voyager became insolvent. Users lost access to their funds.

These cases clearly demonstrate how a chain of dependency can break. All depositors were exposed to entities they never previously verified.

Differences Between CeFi and DeFi Platforms

Centralized Finance (CeFi) and Decentralized Finance (DeFi) apply rehypothecation differently:

CeFi platforms: Operations are often opaque—users deposit funds into a “black box” without knowing who the counterparty is or how much leverage is used. Platforms can rehypothecate without clear restrictions or disclosures.

DeFi platforms: Rehypothecation often exists through liquidity protocols or wrapped tokens, but the process is generally transparent. Users can track where their assets are allocated on the blockchain. However, DeFi introduces different risks—smart contract bugs can lead to irreversible losses.

CeFi platforms offer control through trust, while DeFi offers transparency through technology. The choice depends on your risk tolerance.

How You Can Protect Your Assets

1. Control your own funds: The most effective way to avoid rehypothecation risk is to manage your cryptocurrencies yourself using non-custodial wallets. Holding your private keys means your assets cannot be loaned out or rehypothecated.

2. Read terms carefully: Before using a platform, look for clauses about “ownership transfer” or the platform’s right to “pledge, re-pledge, or hypothecate” your assets. Transparency is key.

3. Be skeptical of high yields: If a platform offers significantly higher returns than the market average, it often indicates riskier rehypothecation strategies. Higher returns mean higher risk.

4. Institutional custodians: Some institutional custodians offer segregated wallets for client funds, meaning they do not commingle assets. This provides additional security.

Final Considerations

Rehypothecation is a double-edged sword. It provides the liquidity the market needs to operate and allows users to earn yields, but it also introduces systemic risks that can lead to complete loss of funds during bear markets.

An old saying in the crypto community is: “If the keys aren’t yours, they aren’t your coins.” For most individual investors, the best protection against rehypothecation risk is to take control. Understanding how platforms can use your assets is the first step toward safer management of your cryptocurrencies.