What is Rehypothecation? Why Granite Doesn’t Rehypothecate

Rehypothecation is a common tool in both TradFi and DeFi that refers to the practice of using a borrower’s collateral to generate additional yield. In DeFi, this is done by lending it out to other borrowers. 

While this increases returns for users (and revenues for the protocol), it also introduces liquidity risk for borrowers - the possibility that they may not be able to withdraw their collateral even after paying back their debt.

Granite prioritizes security above all else and does not allow for rehypothecation of borrowers’ collateral.

What is Rehypothecation and Why Is It Used?

When you deposit your collateral in most DeFi platforms, it doesn’t just sit safely in the protocol. Instead, it is lent out to other users to potentially generate returns that turn into yield for borrowers and revenues for the protocol. This turns borrowers into de facto lenders as their collateral is rehypothecated. 

Rehypothecation unlocks value from what would be idle collateral assets, increasing the capital efficiency of the protocol. The issue, though, is that this happens by default on most protocols, and borrowers are often unaware of the risks they incur by becoming lenders.

The Risks of Rehypothecation

Rehypothecation introduces liquidity risk from a duration mismatch on lent collateral assets. 

Liquidity risk refers to the possibility that a user may be unable to withdraw their deposited assets from the protocol due to those assets being lent out to borrowers. This risk exists because DeFi loans do not have a specific term but rather are open ended with no due date, which creates an inherent duration mismatch since the duration is effectively infinite.

Protocols must contain enough of any given asset to meet withdrawal demand at all times. But like many things in DeFi, that demand can be incredibly hard to predict. Let’s break this down with a simple example:

• Alice Deposits BTC as Collateral: Alice deposits 10 BTC as collateral in a DeFi lending platform, intending to borrow stablecoins like USDC.
  
  
• Alice Borrows USDC: Based on her collateral, Alice borrows 50,000 USDC from the platform.
  
  
• Bob Borrows BTC: Bob enters the platform and borrows all remaining BTC in the protocol using XYZ as collateral. The platform uses Alice’s deposited BTC, pooled with other users’ collateral, to lend to Bob. Now there is no more BTC in the protocol.
  
  
• Alice Tries to Withdraw: Alice repays her USDC loan and tries withdraw her BTC, but she faces a problem: Bob hasn’t returned the borrowed BTC yet, and there isn’t any BTC left in the collateral pool for her to withdraw.

Even though Alice has repaid her debt, her collateral isn’t immediately available because it’s lent to Bob (and other borrowers). She must wait for Bob to either repay his loan or get liquidated, or for the protocol to find liquidity from other depositors. Alice may need that BTC for urgent purposes, but it is simply unavailable. This is a liquidity crisis.

In a worst-case scenario, if many users like Bob fail to return their borrowed BTC and their collateral cannot be appropriately liquidated, Alice may never recover her BTC.

Liquidity risk can create bad debt risk for the protocol and LPs when it impacts liquidations. In the previous example, if Alice had not repaid her USDC loan and her BTC collateral value had dropped into the liquidation zone, liquidators would not be able to liquidate her position since there would be no BTC collateral present to pay for the liquidation. This could accrue bad debt for the protocol, since her account would not be liquidatable until more BTC were added to the protocol.

Managing Rehypothecation Risks

DeFi lending protocols manage liquidity risk through over-collateralization and variable interest rates that change based on how much of an asset’s pool has been borrowed. In these models, the interest rate increases as more of an asset is borrowed. This, in turn, incentivizes borrowers to pay back their loans and also motivates lenders to deposit more of the asset.

However, interest rates are just incentive mechanisms, not hard and fast rules, and borrowers can always decide to hold on to the borrowed asset instead of paying back the loan. Liquidations should theoretically manage this risk, but this has not always been the case during rapid market movements.

Granite Prioritizes Security Over Yield

Many Bitcoin holders believe that it could become the most valuable asset they will ever own. They view it not just another investment, but as the gateway to financial sovereignty, and it should be treated as such. The risk of losing Bitcoin through rehypothecation is an unnecessary gamble, especially for such a high-stakes asset.

Most platforms offer a relatively small return on rehypothecated BTC - often 1-3%. So ask yourself: is a 3% return worth risking 100% of your Bitcoin?

Borrowers deserve the highest level of security and transparency when they’re looking for a loan. That’s why we’ve done away with rehypothecation on Granite.

Since your collateral is never lent out on Granite, it remains readily available at all times. This practice drastically reduces the risks associated with lending and minimizes the chances of unexpected complications. As long as you can pay off your loan, your collateral will always be available for you to withdraw when you need it.

In other words: there is always collateral in the banana stand. The Bluths had the right idea.

Moreover, non-rehypothecation offers a higher level of predictability and transparency. Borrowers can be confident that when they use Granite, their assets aren’t being exposed to additional risks beyond their control. This simplifies the lending process as there are fewer variables and external factors that could impact their position.

Conclusion

Rehypothecation introduces significant risks to your assets, often without your direct knowledge or consent. By lending out your collateral, DeFi protocols can expose you to withdrawal risk and other dangers that can undermine the security of your investment.

Granite chooses not to engage in rehypothecation because we believe that the security of your assets should always come first. By keeping your collateral where it belongs — fully reserved and readily available — we ensure that your funds are protected against the uncertainties and risks associated with rehypothecation.

With Granite, you don’t have to make that trade-off. Your collateral is not rehypothecated. It stays in the protocol, ensuring that you can withdraw it whenever you want. And while you won’t earn a yield on it, what you gain is far more valuable: peace of mind.

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