Why it matters
Rehypothecation transforms custody into credit exposure. A client believes they own bitcoin; the custodian has pledged that same bitcoin elsewhere. If the custodian's counterparty fails or the custodian faces margin calls, client bitcoin becomes entangled in obligations the client never consented to.
This practice contributed to catastrophic failures in the crypto industry. Platforms that rehypothecated client assets could not honor withdrawals when market conditions deteriorated.
How it works
The mechanism: A client deposits bitcoin with a custodian. Instead of holding it in segregated storage, the custodian posts that bitcoin as collateral for a loan, lends it to a trading desk, or uses it to meet margin requirements. The custodian owes the client bitcoin while simultaneously owing it elsewhere.
The risk: In normal conditions, the custodian can honor withdrawals by unwinding positions or using other client deposits. In stress, this becomes impossible. Everyone wants their bitcoin at once, but the custodian has pledged it multiple times.
Disclosure: Rehypothecation may be permitted in fine print of custody agreements. Clients often do not realize their bitcoin is being used this way until withdrawals are halted.
Example
A custody platform accepts 500 BTC from clients. It posts 400 BTC as collateral to borrow dollars for proprietary trading. When bitcoin price drops sharply, the platform faces margin calls and client redemptions simultaneously. It cannot satisfy both. Withdrawals are suspended, and clients discover they were unsecured creditors in a trading operation.
