Since its introduction after the financial crisis, bitcoin has had an antagonistic relationship with Wall Street. However, the dynamics of that relationship seem to have changed in recent times. The cryptocurrency’s characteristics and mainstream popularity have made it an attractive investment vehicle for the same set of people.
Wall Street’s embrace of bitcoin comes with its own set of problems. Specifically, commingling and rehypothecation, two practices that enable investment firms to multiply their profits, could change the way that the cryptocurrency works and complicate its original intentions.
Forbes contributor and Wall Street veteran Caitlin Long has written a detailed explanation on this topic in a column. According to her, rehypothecation and commingling will centralize risks associated with bitcoin and cryptocurrencies to exchanges, clearinghouses, and central derivatives counterparties. Centralized risk translates to greater vulnerability because this would offer hackers a single point-of-attack to cripple the cryptocurrency ecosystem.
What Are Commingling And Rehypothecation?
Typically, banks and financial services companies segregate collateral from individual parties based on different parameters, such as owner and loan type. This practice makes for clean accounting and enables them to return the said collateral when it is due.
As its name denotes, commingling refers to a mixing of collateral from multiple parties into a single “omnibus” account. Commingling is standard practice in Wall Street and has become popular to avoid or reduce the probability of custodian counterparties (or CCPs) failing to honor their end of the bargain.
There are two harmful potential consequences to commingling. First, the practice makes it difficult to distinguish between assets and liabilities in a CCP’s balance sheet because they are not required to disclose individual amounts. As a result, there is no way to know whether they have enough assets to cover their liabilities. Commingling also centralizes cryptocurrency holdings to a single account, thereby making the account an attractive target for thieves and hackers. For example, a CCP may hold cryptocurrencies in a single “omnibus” wallet instead of distributing them across multiple online wallets. In turn, these wallets become repositories for hackers to target, if they wish to crash the cryptocurrency ecosystem.
Rehypothecation further complicates bitcoin’s identity. Put simply, rehypothecation allows CCPs to use given bitcoin as collateral several times. “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 the same collateral to a different part,” explains Long.
This means that there is a chain of loans which can be traced back to the same asset. A loan default by a single party within that chain or a successful custodian hack could bring the entire setup tumbling down. Further complications related to rehypothecations arise from the fact that the same asset will be accounted for on multiple balance sheets, obfuscating its origins.
As the cryptocurrency ecosystem grows, the ripple effects of a crash could result in severe damage to unrelated assets, much the same way that the housing crisis affected different and unrelated parts of the world economy. (See also: The 2007-08 Financial Crisis In Review.)
Can These Risks Be Mitigated?
Long says the problems associated with centralized risk can be mitigated by disallowing rehypothecation and commingling for bitcoin. However, the chances of such an occurrence are low because it would drastically reduce profits for CCPs. Bitcoin’s manufactured scarcity makes it an especially valuable asset for Wall Street. Rehypothecation of bitcoin could allow financial services firms, such as Goldman Sachs, to mint profits by building up a chain of loans using the same stash of bitcoin in its custody. According to Long, rehypothecation and commingling related to bitcoin is the reason why Intercontinental Exchange (ICE) announced its foray into bitcoin. (See also: NYSE Parent ICE Is Planning A Bitcoin Exchange.)
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