Prudential Treatment of Cryptoassets by Credit Institutions
"Certain cryptoassets have exhibited a high degree of volatility, and could present risks for banks as exposures increase" Basel Committee on Banking Supervision.
The Basel Committee on Banking Supervision (“BCBS”) issued a consultation paper on 10 June 2021 setting out its expectations on the prudential treatment of cryptoassets by credit institutions. (the “Consultation Paper”). This Consultation Paper follows on from BCBS’ discussion paper issued in December 2019 which sought an industry response on the topic. The Consultation Paper sets out a more defined prudential framework based on the following three guiding principles:
(1) same risk, same activity, same treatment;
(2) simplicity; and
(3) minimum standards.
Overall, the Consultation Paper’s main aim is to provide minimum requirements that can be integrated into national level legislation in respect of credit institution’s exposure to cryptoassets.
Although banks’ exposures to cryptoassets are currently limited, the BCBS acknowledged that the continued growth and innovation in cryptoassets along with the heightened interest of some banks, could increase global financial stability concerns and risks to the banking system. For this reason the BCBS has determined that specified prudential treatment of cryptoassets was required.
Cryptoassets are defined in Annex 1 as:
“private digital assets that depend primarily on cryptography and distributed ledger or similar technology”.
Interestingly, the BCBS has specifically omitted central bank digital currencies from the scope of the Consultation Paper along with any dematerialised securities held on the books and rights held through central securities depository or custodian also fall outside the scope of the Consultation Paper.
Existing Prudential Requirements
EU capital adequacy regulations, which under Basel III and the Capital Requirements Regulation (“CRR”), currently set out exposure limits to various different classes of assets. However, there are currently no cryptoasset specific provisions in either of these capital adequacy frameworks. Basel III allows for the treatment of “other assets” while the CRR includes provisions around “other non-credit obligation assets”. Neither of which adequately deal with the risk weighting / assignment of exposure to cryptoassets for credit institutions.
The BCBS proposes to divide cryptoassets into two distinct groups (Group 1 and Group 2) with the latter considered higher risk and subject to a new conservative prudential capital treatment. Cryptoassets must satisfy each of the following BCBS classification conditions in order to be categorised as a Group 1 cryptoasset:
(i) The cryptoasset is either a tokenised traditional asset or has a stabilisation mechanism that is effective at all times in linking its value to an underlying traditional asset or a pool of traditional assets;
(ii) All rights, obligations and interests arising from cryptoasset arrangements that meet the condition above are clearly defined and legally enforceable in jurisdictions where the asset is issued and redeemed. In addition, the applicable legal framework(s) ensure(s) settlement finality;
(iii) The functions of the cryptoasset and the network on which it operates, including the distributed ledger or similar technology on which it is based, are designed and operated to sufficiently mitigate and manage any material risks; and
(iv) Entities that execute redemptions, transfers, or settlement finality of the cryptoasset are regulated and supervised.
Cryptoassets that fail to satisfy the above classification conditions will instead be classified as Group 2 cryptoassets.
Capital Requirements proposed in the Consultation Paper
The Consultation Paper sets out minimum risk-based capital requirements for Group 1 cryptoassets, dividing them into two sub-groups. In effect, Group 1 cryptoassets are eligible for treatment under the existing Basel Framework (with some modifications and additional guidance).
Group 1(a) - Tokenised traditional assets
Under the proposal, tokenised cryptoassets may be treated as equivalent to traditional assets for the purposes of calculating minimum capital requirements for credit and market risk provided that the relevant cryptoasset poses the same level of credit and market risk as traditional (non-tokenised) assets (with further consideration for capital add-ons).
Tokenised traditional assets such as bonds, loans, equities, commodities or cash held in custody all fall under this category provided they confer the same level of legal rights as ownership of these traditional forms of financing. These rights include rights to cash flows, insolvency claims, and other rights. In order to fall within the Group 1(a) categorisation, cryptoassets of this nature will need to be redeemable at any time and there can be no restriction on their transfer.
Group 1(b) - Cryptoassets with effective stabilisation mechanisms (stablecoins)
Unlike Group 1(a) cryptoassets, stablecoins are not required to confer the same level of legal rights as ownership of a traditional asset. These cryptoassets may instead seek to link their value to that of a traditional asset or a pool of traditional assets through a stabilisation mechanism. However, similar to Group 1(a) cryptoassets, stablecoins must be redeemable for underlying traditional asset(s) (e.g. cash, bonds, commodities or equities).
The Consultation Paper included two ‘stablecoin’ structures as illustrative examples and examined how capital requirement rules would be applied in each case. It is notable that these examples are quite restrictive in nature and this approach will undoubtedly hamper the development of private stablecoins and all but block their use by credit institutions. When combined with the exclusion of central bank digital currencies from the scope of the Consultation Paper’s proposals, the way is paved for central bank issued digital currencies such as the proposed Digital Euro or Digital Dollar. This represents a double blow to any private stablecoins with a more complex structure.
Group 2 – Native cryptocurrencies
Group 2 cryptoassets, at a minimum, cover more ’mainstream / native’ cryptocurrencies such as Bitcoin. When compared to Group 1 cryptoassets, the BCBS considers Group 2 cryptoassets to pose additional credit and market risks, as well as other unique risks. As a result, the BCBS proposes a simple, conservative and somewhat controversial maximum 1250% risk weighting in respect of all long and short positions associated with Group 2 cryptoassets.
If implemented, this would require banks to hold risk-based capital at least equal in value to their Group 2 cryptoasset exposures (i.e. 1 Euro held for every 1 Euro of Group 2 cryptocurrency held by a bank). The risk weighting will be calculated separately for each Group 2 cryptoasset to which the relevant bank / credit institution is exposed.
The Consultation Paper also describes the responsibilities of a bank in respect of reviewing the risks associated with its exposure to cryptoassets and the responsibilities of national supervisors with respect to the supervisory review process under which they may consider applying add-ons to capital requirements.
Banks will be expected to establish rigorous management policies and procedures in respect of risks arising from their holdings in cryptoassets as set out under the BCBS framework. The Consultation Paper highlights the following risks which are particularly pertinent to cryptoassets:
(i) risks attributable to operational and cyber risk: including Information, Communication and Technology (ICT) risk;
(ii) risks attributable to money laundering and financing of terrorism; and
(iii) risks attributable to the underlying technology.
The Consultation Paper also recommends that national supervisors review the appropriateness of the above mentioned policies and procedures. National supervisors should also ensure that they have the adequate authority to require a bank to remedy any deficiencies.
Disclosing Exposure Level
The BCBS has confirmed that it does not intend to propose new leverage ratio, large exposures, and liquidity ratio requirements as part of the Consultation Paper or in the near future. As such, the existing BCBS framework would be applied to all groups of cryptoassets with respect to these minimum requirements. Meaning that banks be required to disclose their long and short exposure to cryptoassets (regardless of which group it falls into) in line with the general guiding principles on disclosures for banks (i.e. Pillar 3 under the current BCBS framework).
Finally, the Consultation Paper suggests that cryptoassets would not currently qualify as eligible high-quality liquid assets. However, the BCBS has not ruled out the prospect of certain cryptoassets qualifying as such in the future.
The BCBS notes in the outset of the Consultation Paper that the proposed policy development for cryptoassets is likely to be an iterative process, involving more than one consultation. The BCBS have invited all interested parties to submit comments on all aspects of the preliminary proposals by Friday 10 September 2021 via the following link.