The Basel Committee on Banking Supervision (Basel Committee), a committee of global central bankers and regulators, issued a Consultative Document on June 10 on the prudential treatment of cryptoasset exposures for international banks (the Proposal). The Basel Committee has asked for comments by September 10, 2021.

Notwithstanding the relatively limited exposure that international banks have incurred thus far with respect to cryptoassets, the Proposal identifies the growth of cryptoassets and related services as a potentially significant source of risk for banking organizations and overall financial stability. Such risks include liquidity risk, credit risk, market risk, operational risk (including fraud and cyber risks), money laundering/terrorist financing risk, and legal and reputation risks.

Although the Proposal is styled as a discussion of prudential treatment of cryptoassets, all but one page of the document is devoted to the risk-based regulatory capital treatment of such assets. Under the Proposal, cryptoassets would be evaluated for such risks, classified into one of two groups (Group 1, including subgroups 1a and 1b, and Group 2) and assigned a regulatory capital risk-weighting based on their classification. Most cryptocurrency assets, such as Bitcoin, that are held on a banking organization’s balance sheet or with respect to which a banking organization has an off-balance sheet exposure, would be treated as higher-risk Group 2 assets and will be subject to a 1,250% risk-weighting for regulatory capital purposes—roughly equivalent to a dollar-for-dollar deduction from capital. Qualifying tokenized assets (if they pose the same level of credit and market risk as traditional assets) and stablecoin assets, on the other hand, would constitute Group 1a and Group 1b assets, respectively, and would generally be risk-weighted in relation to the nature of their exposures to the underlying assets, albeit with the possibility of a regulatory capital “add-on” to account for operational risk.

In addition to their tokenization and stabilization features, qualifying Group 1 cryptoassets would need to satisfy the following conditions:

(i) The rights, obligations, and interests of the asset are clearly defined and legally enforceable in jurisdictions where the asset is issued and redeemed

(ii) 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

(iv) Entities that execute redemptions, transfers, or settlement finality of the cryptoasset are regulated and supervised

The Proposal provides further details on each of the conditions.

Banking organizations and their regulators would have defined roles and responsibilities for determining and monitoring compliance with the classification conditions. Banking organizations would be responsible for (i) assessing on an ongoing basis whether a cryptoasset is compliant with the classification conditions; and (ii) demonstrating to supervisors how a cryptoasset fulfils these conditions. Regulators would be responsible for (i) reviewing and assessing banking organizations’ analysis and risk management and measurement approaches; and (ii) approving the banking organizations’ demonstration of whether and how a cryptoasset qualifies as a low risk asset.

Under the Proposal, banking organizations would be expected to establish policies and procedures governing identification and assessment of the risks that are unique to cryptoassets or related activities on an ongoing basis. Banking organizations also would be expected to inform their supervisory authorities of their policies and procedures, assessment results, as well as actual and planned cryptoasset exposures or activities in a timely manner.

Regulators then would review the appropriateness of banking organizations’ policies and procedures for identifying and assessing those risks not captured by the minimum capital requirements and would be encouraged to ask banking organizations to remedy any deficiencies as part of the supervisory process.

With respect to other prudential requirements, the Proposal does not specify any proposed new regulatory requirements for cryptoassets. Instead, other regulatory requirements such as the leverage ratio, large exposure limits, and liquidity ratios would be supplemented by additional guidance where applicable in order to take account of cryptoasset exposures.

The Proposal builds on the contents of the Committee's 2019 discussion paper and responses received from a broad range of stakeholders, as well as ongoing initiatives undertaken by the international community.

Key Takeaway

The regulatory processes governing the treatment of cryptocurrency assets are still in the very early stages, and therefore much may change before any final action is taken, either at the international or national levels. But if global regulators continue down the path toward what can only be characterized as a conservative (although not necessarily inappropriate) treatment of cryptoassets, regulatory actions such as the Proposal, if finalized, will create powerful incentives and have a material impact on banking organizations’ willingness and ability to engage in activities in this space. While the Proposal may seem draconian to some, various industry groups have welcomed the prospect of enhanced regulation of cryptoassets as a sign of banking regulators’ recognition of the heightened interest that some organizations have taken in cryptoassets and the need to adequately address the risks associated with crypto activities.