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Example of Rehypothecation of Collateral in Crypto Shadow Banking

Crypto shadow banking is our industry’s biggest secret, where billions of dollars are borrowed & lent on an un-collateralized basis, between some of the world’s biggest market makers, proprietary trading firms, hedge funds, and lending platforms.

Crypto shadow banking was the source of the massive, liquidity-driven bull market, as well as ongoing collapse & contagion. One of the most dangerous activities in crypto shadow banking, which brought down the whole ecosystem, is the secretive process of rehypothecation of collateral.

Rehypothecation generates credit from assets & allows multiple transactions to be collateralized by the same asset. For instance, a trader pledges assets as collateral for a loan with a broker, and then the broker re-uses it for its own purposes. While the process might seem straightforward, the unstable chain of transactions supported by the same collateral is not well understood. I will provide two examples that vividly illustrate the complexity of crypto shadow banking.

Perhaps the most famous example of the catastrophic consequence of rehypothecation was the lucrative Grayscale Bitcoin Trust (GBTC) “premium arbitrage”, which led to the demise of 3AC, Genesis, and Grayscale. Till February 2021, the GTBC traded at a premium to the spot Bitcoin price, so an arbitrageur could borrow Bitcoins, make an “in-kind investment” into GTBC, and sell the GTBC shares after 6 months, pocketing the premium.

In practice, it worked as follows; 3AC borrows BTC from Genesis and passes BTC to Genesis to create GTBC shares via Grayscale as an Authorized Participant. 3AC then pledges those shares back to Genesis for a USD loan. If the premium is large enough, the loan is worth more than the BTC borrowed at the beginning. 6 months after creating GTBC, 3AC can try to sell to lock in the profits.

The top crypto project engages with a market maker through a liquidity Service Level Agreement, requiring a treasury loan of native tokens worth $10 million. Market maker sees that market conditions require only half of the native tokens to provide liquidity and decides to sell the remaining half of $5 million of native tokens for stablecoins. Market maker pledges those stablecoins with a prime broker as collateral for a margin account to trade nominal amounts several times the posted collateral. Prime-broker lends out those stablecoins to a hedge fund, against lower quality collateral, with lower liquidity & volume. Finally, the hedge fund deploys the stablecoins to do a Bitcoin carry trade, of buying spot BTC & shorting BTC futures, earning the yield from contango.

World’s regulators are tapping into the dark, trying to understand the causes of the collapse. In the current crisis, crypto industry leaders & experts have an opportunity to provide insights into how the industry really operates & transparently explain crypto shadow banking activities.

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