Too Big To Fail Banks & Bitcoin Custody
Regulatory actions needed following the repeal of SAB 121
Today the SEC has repealed the controversial Staff Accounting Bulletin No. 121 (SAB 121). This regulatory pivot opens the door for traditional banks to begin custodying cryptocurrency in much the same way they custody cash and other assets. At first glance, it appears to be a significant stride toward mainstream acceptance of digital assets. Investors, institutions, and retail consumers alike may rejoice at the newfound “legitimacy” that comes with big banks stepping into digital asset custody.
However, the implications of this regulatory about-face come with enhanced responsibility that I suspect many aren’t prepared for. While some forms of crypto may operate under frameworks that include governance tokens, issuers, or corporate structures capable of “bailing out” failing systems, Bitcoin is different – VERY different. It has no issuer, no central authority, and no capacity for anyone to mint additional coins in the event of a crisis. This non-negotiable scarcity is part of what makes Bitcoin so compelling and transformative—but it also places the digital asset at the risk of massive disruption when traditional financial institutions attempt to apply their usual business models of fractional reserves, under-collateralized lending, and, most concerning of all, rehypothecation.
Rehypothecation—the practice of financial institutions reusing clients’ collateral (in this case, Bitcoin) to finance their own trading and lending activities—has repeatedly proven disastrous in the crypto space. High-profile collapses such as FTX, BlockFi, and Genesis have taught us the same lesson over and over: under-collateralized, fractional-reserve practices wrapped in complicated financial engineering spells calamity for depositors and investors.
The repeal of SAB 121, while motivated by a desire to stimulate innovation and reduce regulatory overreach, could give Too Big To Fail (TBTF) banks the green light to replicate these same practices—only at a far larger scale. Such a crisis could ripple through financial markets, and ultimately harm millions of people who have outsourced their trust to institutions who have “gambled” away their savings.
To prevent this scenario, Congress must pass legislation that bans the rehypothecation of Bitcoin outright, for any and all institutions—be they small retail lenders or systemically important banks. The Securities and Exchange Commission (SEC) also has a role to play in crafting protective measures, ensuring banks, brokers, and exchanges cannot commingle or reuse customer Bitcoin for their own profit-seeking activities. This article explores the background of these concerns, lays out the risks of unchecked rehypothecation, and concludes with a passionate call to action for legislators, regulators, and the American public to safeguard the future of people entrusting institutions to custody their Bitcoin.
Understanding Rehypothecation and Its Dangers
Rehypothecation refers to the well-established practice in traditional finance where a brokerage or bank, holding a customer’s collateral, uses that same collateral to secure its own loans or financial dealings. In the traditional securities and bond markets, this practice is widespread, often done with the assumption that the underlying assets are liquid and the bank or brokerage is trustworthy enough to return customer collateral upon request.
However, Bitcoin operates on a fundamentally different playing field. Because there is no centralized issuer or lender of last resort for Bitcoin, once institutions fail to deliver on redemptions, there is no entity that can simply create more BTC to fill the gap. Traditional markets, especially in times of crisis, have come to rely on government bailouts or quantitative easing measures to re-liquefy the system. With Bitcoin, that “safety valve” does not exist. The supply is fixed at 21 million coins, period. If an institution does not have the Bitcoin it owes to depositors or lenders, it cannot magically print more, nor can it rely on the government to do so. The fundamental mismatch between the irreversibility of Bitcoin’s supply cap and the “flexibility” of rehypothecation means that uncovered positions will inevitably lead to defaults.
This risk is not merely theoretical. Since Bitcoin’s inception, crypto lending platforms, exchanges, and brokerages have collapsed under the weight of under-collateralized Bitcoin loans. FTX, BlockFi, and Genesis all saw their once-promising lending products implode when market conditions tightened and depositor withdrawals accelerated. In each case, part of the puzzle was the misuse of customer Bitcoin, lent out and re-lent in a cascading chain of obligations. When the music stopped, these companies discovered they didn’t have the Bitcoin they were contractually obligated to return.
Most heartbreakingly, average depositors—often everyday Americans with aspirations of building savings—took the brunt of the losses. They believed their Bitcoin was safe with these platforms, only to find out their funds had been “borrowed” without their explicit understanding. Deceptive marketing that touted “low-risk, high-yield” crypto savings accounts often concealed the underlying labyrinth of rehypothecation, margin, and leverage trades. In the end, it was ordinary people, not the well-capitalized institutional insiders, who found themselves left out in the cold.
The Implications of SAB 121’s Repeal
Staff Accounting Bulletin No. 121 (SAB 121) was originally issued to clarify how companies should account for obligations to safeguard crypto-assets for customers. It effectively forced certain institutions to keep digital assets, including Bitcoin, on their balance sheets as liabilities—thereby discouraging unscrupulous practices. Many in the crypto sector believed SAB 121 was overly strict and hampered innovation, preventing banks from comfortably entering the crypto custody space.
The repeal of SAB 121 is sending a loud signal to financial institutions: “Go ahead, compete in the crypto markets.” On the surface, this might appear to be a libertarian-friendly move that fosters innovation and competition. But for those who appreciate the unique attributes of Bitcoin, the repeal sets off alarm bells. Traditional banks are used to operating under fractional reserve systems. They are used to employing depositors’ money for lending, trading, and profit maximization. Indeed, fractional reserve banking is arguably the cornerstone of modern finance. Yet bringing these practices into the realm of Bitcoin custody, especially with zero legislative or regulatory guardrails, poses a potentially catastrophic systemic risk.
Banks that are “Too Big To Fail” (TBTF) also carry with them the moral hazard of anticipating government bailouts if their bets sour. They have a long history of securitizing and rehypothecating assets in pursuit of short-term profit, often with the implicit assumption that, if the worst happens, the Federal Reserve or the Treasury Department will step in. In the post-2008 financial crisis era, such bailouts became part of the public consciousness. While these institutions might expect a similar safety net in the context of Bitcoin, the harsh truth is that no government can print more Bitcoin.
Bitcoin’s Unique Strength
And The Responsibility That Comes With It
Bitcoin’s greatest strength is its immutability: the rules of its supply are embedded into the protocol itself, immune to political manipulation or corporate capture. This reliability is what has driven so many to view Bitcoin as “digital gold,” a long-term store of value that is resistant to inflationary policies. Historically, gold has served as a hedge against economic uncertainty, but even gold’s supply can see incremental increases through mining. Meanwhile, Bitcoin adheres to a strict, mathematically-enforced issuance schedule that ends at 21 million coins.
Yet this very rigidity makes Bitcoin ill-suited to the freewheeling world of rehypothecation. Traditional finance leans on elasticity. In normal times, banks use customer deposits to lend out multiple times over, collecting interest along the way, making profit. In stressful times, central banks step in with emergency loans or money-printing programs to alleviate liquidity crunches. If depositors demand their assets back all at once, banks rely on the lender of last resort to prevent a classic bank run scenario.
In a future where major banks custody and rehypothecate Bitcoin, a run on the bank could result in depositors discovering that the coins they “owned” do not actually exist in one-to-one reserves. All it takes is a sharp drop in the market, a liquidity crisis, or mass redemptions for the entire scheme to unravel. Without the ability to mint additional BTC, the bank or exchange would be forced to default on its Bitcoin obligations.
Preventing rehypothecation is thus central to protecting everyday citizens that don’t have time to be an expert on banking and rehypotication. Ensuring each Bitcoin is accounted for, in an overcollateralized custody environment, keeps the system honest and ensures that the public’s safety remains intact.
Lessons from FTX, BlockFi, and Genesis
The spectacular failures of FTX, BlockFi, and Genesis serve as a warning for what could happen on a much bigger scale once major banks pile into Bitcoin custody. Each of these firms offered “high-yield” products underpinned by complex lending and borrowing arrangements. At the root of it all was Bitcoin, lent out multiple times without sufficient collateral.
FTX: At its peak, FTX was one of the largest crypto exchanges in the world. The company’s meltdown revealed that customer funds were not fully backed. In many cases, user BTC deposits were used to secure proprietary trading bets or funneled into affiliated entities. When users demanded withdrawals en masse, FTX did not have enough Bitcoin (or any other assets) to make good on those claims.
BlockFi: Promising yields on Bitcoin and other cryptocurrencies, BlockFi grew rapidly. However, the platform was not transparent about the degree to which it relied on under-collateralized loans. When market conditions deteriorated, BlockFi faced a liquidity crisis and had to halt withdrawals, trapping depositor assets.
Genesis: Genesis suffered heavy losses due to exposure to high-risk counterparties. Despite having a reputation as a “regulated and trusted” lender in the space, Genesis misjudged the fragility that arises when you lend out Bitcoin multiple times over. When borrowers defaulted, Genesis did not have the reserves to meet its obligations.
In all three instances, ordinary depositors were the biggest losers. These stories confirm that under-collateralization and rehypothecation are a dangerous combination—one that is diametrically opposed to the core principles of Bitcoin.
The Case for Banning Bitcoin Rehypothecation
To protect consumers, maintain market integrity, and uphold the very essence of Bitcoin, Congress must act boldly and outlaw rehypothecation of Bitcoin for all entities, from individual brokers to massive banks. While some may argue that such a ban stifles financial innovation, the counter-argument is that Bitcoin itself is the innovation. Allowing banks to twist Bitcoin’s underlying properties to fit fractional-reserve models is akin to forcing a square peg into a round hole—inevitably leading to friction and structural stress.
A ban on rehypothecation would:
Protect Consumers: Rehypothecation disputes often result in endless legal battles and labyrinthine bankruptcy proceedings. By outlawing the practice, depositors are spared from the risk of being entangled in these complexities. Moreover, an ever-increasing number of Americans now hold indirect exposure to Bitcoin through “wrapped” products, such as ETFs, without fully understanding how custody of the underlying asset is managed. Many of these investors lack the time or technical expertise to scrutinize the activities of “trusted” custodians who may engage in risky lending practices. Preventing rehypothecation ensures that even these less sophisticated or time-constrained market participants—who often seek Bitcoin’s perceived safety—are not inadvertently caught in the fallout of custodial misdeeds. By safeguarding the integrity of assets across all investment vehicles, from direct holdings to complex ETF structures, a rehypothecation ban protects the broader public from the hidden dangers of over-leveraged Bitcoin.
Encourage Responsible Innovation: A ban on Bitcoin rehypothecation does not ban lending outright. Instead, it compels institutions to embrace fully collateralized or over-collateralized models. Such frameworks can still offer competitive yields while aligning more honestly with Bitcoin’s fixed supply dynamics.
Prevent Systemic Risk: The last thing the economy needs is a blow-up of a TBTF bank due to reckless, uneducated Bitcoin rehypothecation. Make no mistake: It’s NOT Bitcoin creating this risk. Instead it’s the haphazard handling and normalized fractional reserve banking practices that presents systemic risk. By removing fractional-reserve practices from the Bitcoin ecosystem, we reduce the likelihood that a bank run could cascade into a systemic crisis for TBTF that might be mishandling Bitcoin custody. These new rules aren’t specific to America. Everyone in the world will need to learn to overcollateralize deposits or else deal with the fall-out and consequences. Politicians or traditional banking interests blaming Bitcoin for its “inflexibility” might as well be complaining about the weather. Fractional reserve banking and undercollateralized lending is a barbarous relic. Countries that understand this early have a unique competitive advantage over the ones who don’t.
A Call for Congressional Legislation
Prohibit Bitcoin Rehypothecation
To preserve the core strength of Bitcoin’s immutable supply, it is paramount that all financial institutions and custodians be expressly forbidden from rehypothecating customer-held BTC. By disallowing the reuse, lending, or encumbrance of Bitcoin in custody, Congress can eliminate the fractional reserve practices that so often lead to catastrophic shortfalls. A federal statute should state—unambiguously—that Bitcoin custodians may not, under any circumstances, employ customer assets for their own benefit. These restrictions safeguard retail and institutional investors alike, ensuring no entity can secretly repurpose or over-leverage Bitcoin positions at the expense of depositors.
Preventing rehypothecation not only boosts consumer confidence but also fortifies the broader financial system against future crises.
Prohibiting Government Bailouts Using Bitcoin Strategic Reserves
To further protect consumers, any Federal or State Bitcoin Strategic Reserve—established either through direct legislation or via executive mandate—must never be used to bail out institutions that violate anti-rehypothecation laws. The days of “robbing everyone to offset the poor decisions of a few” must be brought to an unequivocal close. A clear clause should state that under no circumstances may the assets of a Federal or State Bitcoin Strategic Reserve be deployed—directly or indirectly—to indemnify, backstop, or otherwise bail out any financial institution, broker-dealer, exchange, or custodian that has failed to comply with anti-rehypothecation requirements. This includes any institution found in violation of the statutory ban on rehypothecation or related consumer protections.
The legislation must explicitly prohibit any roundabout use of such reserves, whether through affiliated entities, financial intermediaries, or proxy institutions. This ensures that no portion of Bitcoin held in reserve can be quietly channeled to prop up firms engaged in unlawful practices. By cutting off the prospect of a safety net, policymakers force custodians to adopt sound risk management practices from the outset—an outcome that benefits both the overall financial system and individual depositors.
Segregation of Customer Assets
Segregating customer Bitcoin from a custodian’s proprietary funds is a foundational measure that prevents the blurred lines often exploited by unscrupulous operators. Any legislation must require custodians to maintain discrete, on-chain addresses for each depositor’s Bitcoin, precluding the commingling of assets. These clear divisions not only simplify audits but also provide depositors with visible assurance that their Bitcoin remains undisturbed and unencumbered.
To reinforce security, Congress should further require that custodians implement multisignature technology, placing at least one private key under the client’s control. By distributing access in this manner, any unauthorized use of customer Bitcoin becomes far more difficult. Segregating assets and mandating multisig solutions align perfectly with Bitcoin’s decentralization ethos, mitigating risks of fraud, accidental mismanagement, and single points of failure.
Proof of Reserves
Regular proof-of-reserves audits must become a statutory obligation for any entity holding Bitcoin on behalf of others. These verifications, performed by independent auditors and backed by cryptographic proof (such as Merkle trees), offer transparent reassurance to depositors that their Bitcoin is indeed accounted for. By mandating quarterly audits and requiring public disclosure of the results within a strict timeframe, Congress can promote consistent accountability in a rapidly evolving sector.
Imposing severe penalties for non-compliance or misrepresentation is equally crucial. Custodians found falsifying or withholding audit data should face significant enforcement. In a marketplace once rife with manipulated balances and empty assurances, strict proof-of-reserves regulations serve as a backbone of trust, letting customers verify that their assets are safe, liquid, and genuinely under the custodian’s stewardship.
Regulatory Coordination
American leadership in designing transparent Bitcoin regulations can influence global norms. By engaging with international counterparts—from the Financial Stability Board to other jurisdictional agencies—U.S. policymakers can steer worldwide best practices, promoting stable markets and reducing the likelihood that bad actors. Such cooperation cements the United States as a credible, innovation-friendly hub that nonetheless refuses to compromise on robust consumer protections. The time to lead is now.
Conclusion
Bitcoin was conceived in the aftermath of the 2008 financial crisis, created as a decentralized alternative to the entrenched, fractional reserve based banking system. Its allure lies in its incorruptible supply, open-source protocol, and promise of self-sovereignty for its users. Yet, as it grows in popularity and institutional adoption, the urge to layer traditional financial products on top of it—particularly those involving rehypothecation—threatens the safety of uninformed citizens that seek it’s safety but don’t have time or expertise to be concerned of “trusted” custodians. This is especially true with wrapped products like ETFs where the custody of the underlying Bitcoin is obfuscated away from the uninformed customer.
American banks now have the regulatory green light to enter Bitcoin custody in a big way. If we do not establish firm guidelines and prohibitions, the next wave of Bitcoin-lending catastrophes could dwarf the collapses of FTX, BlockFi, and Genesis, putting ordinary savers and the broader financial system through turbulent times. The time to act is now.