Community Notes debunks spot bitcoin ETF rehypothecation

A licensed attorney in Florida posted a viral tweet claiming that Coinbase’s rehypothecation was to blame for bitcoin failing to rally. Sasha Hodder of Florida Coastal School of Law — a school known less for its quality and more for closing entirely — claimed that CEO Brian Armstrong was to blame for bitcoin’s sideways (‘crabbish’) price action since spot bitcoin ETFs listed on US exchanges.

According to her theory, which gained over 780,000 impressions as of publication time, “Coinbase is somehow rehypothicating [sic] its prime lending customers’ bitcoin to fund bitcoin ETFs.”

Apparently, passing the Florida bar does not guarantee that an attorney knows how to spell rehypothecating — nor does it guarantee they know how capital markets work.

Read more: ECB bitcoin report triggers Crypto Twitter, catches community note

The post quickly gained a Community Note, a feature of Elon Musk’s social media platform X. According to this verified user’s note, upvoted by enough readers to persist underneath Hodder’s post, “There is no actual evidence that Coinbase is doing this and a later post from the author clarifies this is just pure speculation.”

Bitcoiners hate rehypothecation

Bitcoiners have a natural aversion to asset rehypothecation because it is a founding motivation for the creation of Bitcoin. Banks, including central banks, constantly rehypothecate their capital in order to collateralize loans and satisfy the low capital buffer needed for fractional reserve banking.

Rehypothecation is the practice of leveraging customers’ assets for new trades. Once a customer deposits $100 into a money market account, for example, most of that cash is rehypothecated to trade bonds, for example. This is common practice around the world. 

Rehypothecation allows banks to create money via fractionally reserved loans. Inflation requires rehypothecation.

At its best, rehypothecation allows multiple parties to earn a positive return on the same asset. At its worst, rehypothecation liquidates the assets of a nonconsensual customer. As an example of illegal rehypothecation, Sam Bankman-Fried lost hundreds of millions of dollars of FTX customers’ illegally rehypothecated money by trading MobileCoin without their authorization.

That decision — plus many other criminal decisions — landed him a 25-year prison sentence.

Bitcoin rehypothecation is bad for price multiplier

Rehypothecation also has another drawback for Bitcoiners: it reduces the price multiplier on which marginal purchases boost bitcoin’s price. 

Put simply, there’s only a small fraction of bitcoin’s circulating supply available for purchase on spot exchanges. Each $1 of buying, therefore, has more than $1 of price impact on the price of all (on- and off-exchange) bitcoin. 

Investors calculate the price multiplier effect parabolically, with a low multiplier for small quantities that rises parabolically as the quantity rises toward the available supply of spot bitcoin on exchanges.

Spot ETFs were also supposed to contribute to bitcoin’s price multiplier effect by allowing traditional investors and passive investment funds to reduce the supply of bitcoin off spot exchanges like Coinbase.

However, if exchanges like Coinbase somehow rehypothecated their customers’ bitcoin, including the bitcoin backing ETFs, then each marginal $1 purchase would no longer remove $1 worth of spot bitcoin from the exchange — destroying the price multiplier effect. 

For this reason, Bitcoiners refer to rehypothecated bitcoin as a form of ‘paper bitcoin’ — a claim on bitcoin but not the asset itself.

Theory without evidence

In summary, despite how antithetical rehypothecation would be for Bitcoiners’ desire to abandon traditional finance practices like fractional reserve banking — not to mention rehypothecation’s anti-multiplying price effect — there is no evidence that Coinbase is actually rehypothecating the bitcoin it holds on behalf of spot ETFs. 

Read more: Bitcoin ETFs have first net outflows in weeks

In the end, some market observers wonder why the spot Bitcoin ETFs haven’t caused the price of bitcoin to rise. The answer is more complicated than an invented theory that Coinbase is rehypothecating the bitcoin in spot ETFs. Bitcoin trades in a globally distributed network of thousands of exchanges operating around the clock. 

The actions of millions of market participants engaging in trades and price discovery are far too complex to reduce to a single allegation against Coinbase. The spot bitcoin ETFs are contributing to bitcoin’s price alongside myriad other factors.

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