Rehypothecation. Commingling. These two words are entering the vocabulary of bitcoin enthusiasts. Soon, they will roll off tongues as freely as the term “fiat currency” does today, thanks to the entry of Wall Street incumbents into bitcoin, because rehypothecation and commingling are pervasive Wall Street practices that enable the financial system to create more claims to an underlying asset than there are underlying assets. This can offset Bitcoin’s algorithmically-enforced scarcity and, all else equal, suppress its price.
Rehypothecation and commingling are “inside baseball” terms about collateral—used and applied by a narrow group of people working in far-flung corners of Wall Street’s collateral- and credit risk management departments. But, owing to the entry of ICE (parent of the NYSE) into physically-settled bitcoin futures, these terms are now relevant to bitcoiners.
Before diving in, here’s some background. Prior to the financial crisis of 2008, credit risk was widely distributed across banks in the financial system. During the financial crisis, many banks went bust or needed bailouts. After the financial crisis, the regulatory response was to centralize credit risk—to concentrate it in the core of the financial system, which is where it is today. Policymakers thought that risk could be better monitored and managed if it were centralized into a small number of institutions that regulators could watch more closely.
In other words, “too big to fail” didn’t go away. It just changed geography. It now resides at the core of the financial system, in its exchanges, clearinghouses, and central derivatives counterparties. These centralized institutions in their various forms—together, I’ll abbreviate them as CCPs—now stand in the middle of client trades and assume the counterparty risk that banks used to take to each other bilaterally. Because they are at the core of the system, these CCPs are literally too big to fail.
In short, much of the financial system’s credit risk is now located in the CCPs.
ICE is one of the largest operators of CCPs in the world.
And ICE is now entering bitcoin.
The “C” Word, In Plain English
Commingling means that the CCP or custodian will hold client collateral (bitcoins, in this case) in a commingled, or “omnibus account,” rather than segregating them for each client in their own wallets.
In simplistic terms, commingling reduces the probability of the CCP going bust but increases the severity of the losses if it ever does. Commingling means today’s obligations can be settled with collateral received yesterday, so it reduces the probability of a shortfall today. It also means that different types of collateral (bitcoins, cash, US Treasury securities, etc.) can substitute for each other because counterparties only post the net of all their balances, not the gross amount on each trade.
Bitcoiners will immediately cry foul about commingling. Huge “honeypots” for hackers! Bitcoin is a digital bearer asset and Wall Street has no experience managing those! Every time the private keys are exposed, hacking risk goes up! Bitcoin is designed to settle on-chain and gross, not netted, off-chain and delayed! And can anyone really understand the risks of jamming bitcoin into Wall Street’s commingled, delayed-net-settled business model?!
Commingling is standard in Wall Street’s collateral agreements, and you can see examples here and here. Specifically, paragraph 6(c) of Credit Support Annex (CSA) to ISDA Master Agreement (International Swaps and Derivatives Association)—a ubiquitous contract form almost no one ever changes—allows the secured party to:
“sell, pledge, rehypothecate, assign, invest, use, commingle or otherwise dispose of, or otherwise use in its business any Posted Collateral it holds…”
Net-net, commingling in omnibus accounts means counterparties have no transparency into where collateral that they pledge ends up, and no way to audit whether a CCP’s liabilities exceed the amount of assets in the omnibus account (either in aggregate or for a particular asset type). And such credit risks can easily build inside CCPs without the ability to detect them, thanks to the “R” word.
The “R” Word, In Plain English
Rehypothecation, in simple terms, results in multiple parties reporting on their financial statements that they own the same asset. It is the process by which a lender receives an asset as collateral for a loan, and then pledges that collateral to cover its own exposure to a separate party, which then pledges that same collateral to a different party, and so on and so forth. The length of collateral chains can be several parties long, and there’s no means by which to track that length in real-time—i.e., no means by which to determine how many fractionally-reserved assets have been created within the financial system.
Repo accounting under US GAAP allows each of these parties to record that they own the same asset as long as each records a different dollar of debt on its balance sheet (here’s a great illustration of how that works).
The accounting is why I sometimes call rehypothecation insidious and subtle. Individual financial institutions appear solvent—they hold an asset against their debt. But, at a systemic level, there’s no way to back out the double/triple/quadruple/quintuple counting of that same asset to understand how solvent the financial system is in aggregate—or whether an individual institution is, in fact, solvent if all double-counting were backed out.
Some regulators are concerned about the financial stability issues caused by rehypothecation of collateral, such as Britain’s FSA and Fed Chairman Jerome Powell. And CFTC Chairman J. Christopher Giancarlo has been warning about this for years. Here’s a good example from a 2016 speech, in which Giancarlo detailed the “practical impossibility of a single national regulator collecting sufficient quality data…to recreate a real-time ledger of the highly complex, global swaps trading portfolios of all market participants.”
In the Q&A afterward, he continued: “At the heart of the financial crisis, perhaps the most critical element was the lack of visibility into the counterparty credit exposure of one major financial institution to another. Probably the most glaring omission that needed to be addressed was that lack of visibility, and here we are in 2016 and we still don’t have it.”
’s Manmohan Singh is the foremost expert on collateral chains. He has combed through the footnotes of banks’ financial statements around the world, attempting to quantify the risk Giancarlo discussed, and he estimates collateral is re-used 1.8 times (as of year-end 2015, the most recent data available). This means only one of the 2.8 people who think they own a U.S. Treasury bond, for example, actually does own it—namely, the original owner of the bond and the 1.8 parties to which the bond was re-pledged. Singh’s data show the 2.8 number has improved since the financial crisis, when 4 parties reported that they owned the same asset. Here, here, here, here and here are among the many insightful writings by Singh on this topic. Singh has recommended that regulators’ financial stability assessments be adjusted to back out “pledged collateral, or the associated reuse of such assets,” but policymakers have not heeded his wise advice.
The “R” and “C” words, rehypothecation and commingling, are as antithetical to how Bitcoin works as they are integral to how Wall Street works. Many institutional investors simply cannot avoid these practices due to outdated regulations, such as the SEC’s custody rule and the requirement to use central clearing—though some, such as developer Christopher Allen’s #SmartCustody efforts—are trying to give institutions real alternatives, hoping to create impetus to change those outdated rules. The risks involved in rehypothecating and commingling bitcoin are very different than those of other financial assets.
How so? ICE could simply agree never to rehypothecate or commingle its clients’ bitcoins. If it did that, no problems would ever arise.
But that’s not how CCPs work. Rehypothecation and commingling are major components of how CCPs make money—if they did neither, CCPs would need to charge clients a lot more money for the risks they assume. Plus, there are fat profit margins in rehypothecating collateral, especially for types of assets that are “hard to borrow” or trade “special.” Bitcoin is the epitome of “hard to borrow,” owing to its natural scarcity and because so many of the 17 million outstanding bitcoins are squirreled away in cold storage. It’s clear why CCPs want in.
But there’s more—the centralization of risk in the financial system is not just in CCPs—asset custodians also centralize risk, and they, too, commingle and rehypothecate. Owing to the SEC’s custody rule, most institutional investors use third-party asset custodians. ICE intends to become a crypto custodian as well, and Goldman Sachs may follow. More to come regarding institutional custody for crypto in a separate post.
In sum, regulations force many institutional investors to store assets centrally and trade with central counterparties—they really can’t trade peer-to-peer in the same way individual bitcoin owners can, and all but hedge funds and the very largest state pension funds probably can’t self-custody their bitcoins.
There are many issues for the CFTC, SEC and Fed to consider regarding Wall Street’s rehypothecation and commingling of bitcoins. Preventing the problems is easy—but preventing them would require sea changes to how Wall Street does business, and that’s almost certainly wishful thinking.
This is why “commingling” and “rehypothecation” are coming to bitcoin.