The issues no one talks about: Commingling and rehypothecation in the crypto market

Commingling and Rehypothecation: two activities which contribute significantly to the bottom line.

Commingling and Rehypothecation are all grist to the traditional banking mill—at least as far as Wall Street is concerned, they are. Commingling is when clients’ assets—e.g. loan collateral—are mixed with the institutions’ own assets. The ‘pooling’ of assets can make it difficult to determine which assets belong to the institution and which belong to clients. In crypto markets, if commingling wherever to occur, so forming a centralised repository or ‘omnibus’ wallet of assets, that account could become a prime target for hackers. It also would call into question the security and transparency of how client’s digital assets were being handled and stored. This is not best practice for safeguarding clients’ assets, and it is most definitely not best practice for ensuring a healthy market.

Rehypothecation occurs when a financial institution uses assets which have been posted as collateral for a loan by a client, for its own purposes. Usually that involves repledging the loan collateral, under the institution’s name, to one or more third parties to cover the institution’s own loan obligations. That procedure allows a bank (for example) to build up a chain of loans using the same piece of collateral. The longer the chain becomes, so does the risk of one or more parties in the chain defaulting and if there is a default, the chain breaks. Rehypothecation poses this same risk to the crypto lending market.

Question number one

When an individual or an institution wishes to lend out their digital assets in order to generate additional alpha, one consideration overrides all others: “Do I risk losing what I'm giving you?” In that respect, there are two key areas to consider; the first is custody; the second concerns best practice.

Custody

As yet, there are no rules about the use of custodians in crypto. And few established custodians have experience of handling and safe guarding digital assets. Until the custody of digital assets becomes a regulated activity, market participants have to consider other factors which arguably, are as important as regulatory status. For example: does the crypto firm segregate clients’ assets? How are they recording and accounting for these assets? Are their terms and conditions transparent and equitable? Have they instigated best practices in all aspects of their activities, and are they putting their clients’ interests first? Is the firm financially stable and should a default occur, what is the liquidation process to safely return the clients’ assets?

Best practice

Given the nature of lending across the crypto market, the prospect of a client’s digital assets being mingled with an exchange’s proprietary assets or other clients’ assets would be unacceptable. Borrowers and lenders must have the reassurance of knowing that while their assets are held by the exchange, they are being deployed only as collateral for a loan or as interest on a transaction. Adapting the tried and trusted tri-party structure seen in traditional securities lending markets, a digital asset lending exchange can act as security trustee and collateral manager in order to remove the burden from its market participants by taking on all operational components of the transaction. Furthermore, the ultimate owner of the digital asset should be identifiable at all times. As long as the holder of a digital asset is in possession of their private key, they—and only they—own their digital asset. For those reasons, assets must not be commingled or released elsewhere for other uses; they should instead be secured in cold storage.

An arguably less significant aspect of risk avoidance is the issue of transaction accounting. For example, this could be booking to a different general ledge which is for clients only. Although the UK’s Financial Conduct Authority (FCA) has specific requirements on how dealings should be documented in the capital markets such as Client Money and Assets Reporting (CMAR), these standards are yet to be applied specifically to the crypto industry. Applying the same standards of reporting and accounting for recording of assets and asset reconciliation are a vital to managing risk on behalf of market participants in the crypto lending market. As such, all events and transactions should be fully documented in the books and records of the firm or exchange.

At Lendingblock we strive to meet the needs of our clients, our business and the overall crypto industry. So, wherever we can implement—or establish—best practise, we do, and we are.

If you are interested in borrowing and lending your firm’s digital assets, click here to create an institutional account.

The issues no one talks about: Commingling and rehypothecation in the crypto market
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