Restaking vs. Rehypothecation: A New Risk in Crypto Finance

Restaking and 'ehypothecation' are distinct but related concepts in the realm of finance and cryptocurrency. While both involve the use of collateral and can amplify risks, they differ significantly in their structures, obligations, and risks.

Restaking, introduced in 2024, allows new projects to 'borrow security' from staking protocols like Ethereum by packaging staked tokens into new, liquid tokens that can be staked elsewhere. This innovation provides new products access to existing security through the market while generating additional yield for stakers. However, Ethereum co-founder Vitalik Buterin and others have expressed concerns about the potential risks associated with restaking and liquid staking, drawing parallels with 'ehypothecation' or collateral re-use, which played a significant role in the collapse of Lehman Brothers and the Great Financial Crisis.

Despite superficial similarities, restaking and rehypothecation differ dramatically in their specific structures, obligations, and risks. Rehypothecation is a form of borrowing, and its risks are similar to any kind of leverage: More borrowing equals more significant returns but more damage when things go in the wrong direction. Lehman Brothers' heavy use of collateralized debt obligations (CDOs) is a key example of rehypothecation. CDOs packaged many home loans into a single asset that generated loan interest, and their structure obscured their instability. That was made far worse when the CDOs were used to back up more loans, which went back into even more real estate assets. When the housing market turned terrible in 2007, Lehman's turbo-leveraged real estate holdings crashed against massive outstanding obligations.

Lehman's bankruptcy also illustrates how rehypothecation amplifies counterparty risk. FirstBank Puerto Rico had pledged $63 million in collateral to Lehman Brothers to secure interest rate swaps before the collapse. That collateral was technically owed back to FirstBank but was initially sold to Barclays as part of Lehman's liquidation. FirstBank ultimately failed in its legal efforts to reclaim collateral from its collapsed counterparty.

That's one significant way restaking differs from rehypothecation: Thanks to smart contracts and onchain assets, a failed restaking arrangement is unwound quickly and automatically rather than relying on slow processing by back offices. Auto-liquidation carries risks, but the ability to enforce onchain obligations should not be overlooked.