Bitcoin Fractional Reserve: The Rehypothecation Risk

Written by BTSE

September 5, 2020

Bitcoin Fractional Reserve: The Rehypothecation Risk

written by @thevladcostea

Bitcoin is making its way into the mainstream, as it gradually becomes entrenched in the legacy financial system – but how does a fixed supply asset fare in a world of fractional reserve?

As institutions begin allocating capital towards Bitcoin, more people who otherwise wouldn’t trust a historically volatile stateless currency will buy in to hedge against fiat inflation. Thanks to institutional money, Bitcoin gains legitimacy as digital gold.

However, there are also some risks involved in this process of mainstream integration. Most of them derive from the nature of the fiat world and how the institutions themselves work. In most cases, when big financial actors invest a small percentage of their portfolio in Bitcoin, it’s not like they buy the actual coins, move them into a wallet of their own, create a multi-sig to grant access to all executives, and then proceed to HODL in cold storage. The reality is a lot more boring and somewhat disenchanting to Bitcoin enthusiasts.

In scenarios like the one above, not only does Bitcoin turn into a KYC/AML-compliant asset that gets routinely surveilled by blockchain analysis firms, but it also becomes subject to lending, tokenization, and rehypothecation. To people working in the banking industry, this may sound exciting and an excellent opportunity to speculate on the growth of Bitcoin. But to the cypherpunk types who adopted Satoshi Nakamoto’s currency for its anti-establishment and politics-agnostic values, these new use cases may seem dangerous for the fungibility of BTC.

When Paul Tudor Jones used a small percentage of his hedge fund money to invest in Bitcoin, he didn’t actually buy bitcoins. He never set up a wallet, didn’t bother to generate a receiving address, and didn’t feel the excitement of waiting for the first network confirmation. Instead, he underwent the institutional route by purchasing Bitcoin futures. For this, no coins have been moved on the blockchain – only a contract was signed, as the two parties agreed on a monetary transaction that relies on the legacy financial system.

Conversely, Microstrategy’s recent purchase of .1% of the entire Bitcoin supply appears to be legit in technical terms. It remains to be seen to what extent the software company truly believes in the project and acts in good faith in relation to its values. If it sets a good example, then other corporations may follow. If it actively invests in breaking Bitcoin’s fungibility and turning BTC into a compliant asset, the result is going to echo to the ears of institutional speculators who also seek to monetize transaction data.

Now that Bitcoin is becoming corporate, another important question follows: how will institutions that historically rely on government bailouts and subsidies deal with a hard asset which has no printing press or lender of last resort?

Perhaps this is part of the reason why some financial firms choose to deal with futures contracts: these are regulated and may be subject to government bailouts. Then again, on which basis is the new money going to get printed?

BTC is hard money and benefits from a provable scarcity that cannot be inflated or manipulated in any way. This fact may be hard to grasp by institutions that can take massive risks while being fully aware that the governments of the world have set precedents for complete bailouts. Above a safety net, they can deal with fractional reserves and lending of assets that they don’t actually have.

So can Bitcoin become subject to fractional reserve? With futures and assets such as GBTC, companies can easily trade BTC that don’t actually exist. This doesn’t mean that there is inflation in the Bitcoin network, as the blockchain transactions don’t get impacted directly. It only means that companies offering bitcoin lending and savings products can take their customers’ deposits, rehypothecate them for a profit, and potentially get in trouble when scarcity really kicks in.

Should these fractional reserve lending services collapse, the Bitcoin network will not be affected and will keep its scheduled issuance of new coins without issues. In that event, at a certain size, it is entirely possible that these institutions could be bailed out by the government with fiat. With that said, the ones hurt the most are the users who deposit their bitcoins: essentially, they will not get their scarce hard money back and may end up receiving the fiat equivalent at the time of loss – especially if price fluctuations make it impossible to purchase enough Bitcoin to make everyone whole.

The main lesson here: a truly scarce asset with no lender of last resort cannot possibly be fully insured by the equivalent of FDIC insurance in the face of a large-scale loss or bank run.


Putting Your Bitcoin to Work – Earning Interest

The prospect of receiving interest in Bitcoins sounds really appealing. After all, it’s hard money that “you put to work” so it generates more by being traded by a regulated institution. However, it’s important to realize that it is mathematically impossible for all the fractional reserve trading, rehypothecation of funds, and other standard fiat practices to be sustainable on Bitcoin without adding inflation.

It is important to understand the risks associated with normalized financial instruments when it comes to their juxtaposition upon true scarcity. It is equally important to understand why full ownership and actual custody matter when protecting your nest egg. The bitcoins that you hold in your wallet and which you can access with your private key are verifiable and part of the limited existing supply. There is no replacement for the scarce bits of digital gold, and no ETF or futures market can command the network to inflate the supply.

While institutions can offer the possibility of steady returns, this comes at the cost of sacrificing other guarantees provided to you by the security of the Bitcoin network. When you deal with 3rd parties and financial derivatives, there is a degree of trust that they will operate in good faith while withstanding the wild volatility of the market.

In the end, no one can tell you how to use your own money. This is a task we all must undertake ourselves, and hopefully, it results in many who have spent time understanding Bitcoin also being reasonably responsible with it.

Do you consider the interest rate you receive to be worth the potential loss of coins? Do you worry about the impacts of fractional reserve, chain analytics, and other aspects of traditional finance beginning to integrate with Bitcoin? Are you concerned that large entities may gain undue influence over the direction of the protocol in time? Or do you perhaps see this as an inevitable hurdle to be cleared as new users begin to use Bitcoin as they see fit for them?

While you consider some of the points above, it remains an excellent idea to learn about self-custody, understand your threat model, and seek to create a security framework that helps you HODL your bitcoins for multiple years. Exercise extreme caution when dealing with any 3rd party custodian, even if they promise that they’re insured – there is no guarantee that the insurance money will cover all losses in Bitcoin terms. Practice good security with hardware wallets and metal plates, learn about multi-sigs and Shamir Backups, and look into cold storage solutions.

Regardless of your choice for individual sovereignty, just remember to understand and consider all risks while also appreciating the absolute scarcity of the underlying asset you’re dealing with. If you’re holding any Bitcoin right now, you already have more than most people on the planet. Don’t blow your lead.


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Note: BTSE Blog contents are intended solely to provide varying insights and perspectives. Unless otherwise noted, they do not represent the views of BTSE and should in no way be treated as investment advice. Markets are volatile, and trading brings rewards and risks. Trade with caution.

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