Mixing Chain Forks With Rehypothecated Bitcoins Could Cause Financial Market Collapse


Regular people are increasingly realizing that leverage-based financialization is the direct cause of unstable and unfair financial markets—bull/bear markets of growing amplitude, and ever-increasing inequality as the rich get richer but the poor are left behind. And, as “real money” institutional investors—pension funds, mutual funds, insurers—dig into this new asset class and learn how to custody it, they may realize how much they’ve been on the losing end of securities lending and rehypothecation practices.

Chain forks and rehypothecated bitcoins don’t mix well and could cause the financial system to experience losses if it has any uncovered exposure to bitcoins amid a hard fork. The chain-fork issue is confusing. Chain splits, for example, seem so simple—if you own bitcoin before a hard fork, you own the post-fork coins too, right?! Nope, not when uncovered bitcoin exposures are involved—these are positions in a bitcoin-substitute that are not 100% collateralized with real, on-chain bitcoins. The uncovered amount is the amount not backed by real bitcoins.

However, a mystery emerges. How does the financial system come up with the 2 new post-fork coins to meet its obligation? It promised 5 bitcoins to customers but holds only 3 in its custody, so it received only 3 of the post-fork coins. Consequently, its total uncovered exposure after the fork is now the 2 pre-fork coins plus 2 post-fork coins. The system must immediately credit its customers’ accounts with all 5 post-fork coins, but it has only 3.

The financial system has no easy out. It must cover the shortfall immediately. How will it immediately come up with the 2 post-fork coins?

It would need to purchase them into a what could be a very illiquid secondary market. Why would it be so illiquid? Because forked coins could take several days to start trading in large volume as few holders begin to trade them immediately, and as engineers at crypto exchanges typically take time to determine the feasibility and security implications of adding the new coin. But the financial system owes those post-fork coins to its customers immediately.

Uncovered exposures build gradually within the traditional financial system, mostly owing to commingling and rehypothecation of securities. This can take many forms, including securities lending, repurchase agreements, derivatives and prime brokerage. But the end effect is the same—uncovered, fractionally-reserved exposures build within the system slowly and mostly undetectable.

It’s likely that the bitcoin fork itself causes the system’s uncovered exposure to become measurable for the first time. It’s likely no one (including regulators) knew how big the exposed position was before the fork. The magnitude of uncovered vulnerability usually isn’t discoverable until a triggering event requires an accurate accounting, which is when the game of musical chairs stops.

There’s an easy way to circumvent this problem from ever happening—simply don’t let any unsealed positions in bitcoin build within the economic system. Not even intra-day (because large intra-day moves can create uncovered “gaps” in margin posting). Every monetary institution should simply follow these rules; Never blend bitcoin, Never rehypothecate bitcoin, and Perpetually require 100% collateralization of any bitcoin-substitute, even intra-day.

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