Last week the Basel Committee published an important proposal for regulation on the crypto front, which, if adopted, is likely impact the way in which traditional financial institutions interact with crypto assets for decades to come. Basel Committee consults on prudential treatment of cryptoasset exposures.
This paper sets out the Basel Committee's proposals for prudential regulation of internationally active banks' exposure to crypto assets. The consultation is open for comment until 10 September this year. As in the case of all capital accords, this will not be law, and it will be for each jurisdiction to implement - which could of course take some time. However, given how quickly the crypto space is evolving, we would not be surprised if supervisors were to require banks to comply with some or all of the proposals (and further consultations promised), even before they are implemented, under Pillar2.
The Committee emphasises that these would be minimum requirements and each country could if they wish implement stricter standards if they like, even banning exposures to crypto assets. But a ban is not what the Basel Committee proposes. Instead, it adopts a conservative approach to such exposures.
It will be interesting to see whether jurisdictions apply the rules to all banks (as the EU does with the capital accords) or just to internationally active ones (as the US does and as the Bank of England is proposing for "non systemic" banks). We think that in the case of crypto, something simpler for smaller institutions would not necessarily be right: the Basel committee emphasises the potential systemic issues; if smaller banks are allowed to hold crypto and not as much capital they could themselves pose risk to the wider system.
Like the UK FCA (see PS19-22) and the EU (see the MiCA proposal), the Basel Committee categorises tokens, distinguishing those that are already in the scope of regulation - "security tokens" from other tokens. Of the other tokens, stablecoins, can, subject to stringent conditions (see below) benefit from the existing Basel framework. Others, such as those most commonly traded, bitcoin, Ethereum and Litecoin, are designated "Group 2 cryptoassets". The Committee proposes a new regime for them. Central Bank Digital Currencies (CBDCs) are not within the scope of the paper.
The Committee's guiding principle in relation to tokens in scope of regulation - Group 1a - is the same as that adopted in relation to other digitalised products and services: if they embed the same risks, they should be treated the same. The Basel Committee stresses that tokens that need to be redeemed or converted into traditional assets will not qualify for Group 1a - this must be right. So cryptoassets will be subject to the same Pillar 1 requirements for credit, market and other risks, and a capital add-on under Pillar 2 for anything not captured under Pillar 1, if they embed the same rights as traditional assets. A key add-on is for the additional operational risk. So far, so good.
The proposed conditions for treating a stablecoin as a Group 1b asset and therefore in the current framework are so strenuous as in our view that it would seriously discourage banks taking exposure to many stablecoins - and if the conditions cannot be met, the coin must be treated as a Group 2 asset.
The Basel Committee, no doubt in response to the Tether debacle (see here for the settlement reached with the New York attorney), proposes an "effective at all times" condition. Banks exposed to stablecoins are supposed to ensure that all stablecoins are backed 1:1 by a reserve on a daily basis. This seems onerous, especially given:
- the Committee's further suggestion that those that execute redemptions, transfers or settlement finality of stablecoin should be regulated or supervised. Could banks not rely on requirements imposed on these entities?
- that the conditions that banks must satisfy to look through a fund to its underlying assets to calculate exposures are less strict. They refer instead to sufficient and frequent information regarding the underlying exposure verified by a third party. Why not apply similar criteria to stablecoins?
Even where a stablecoin comes within Group 1b, the risk weighted exposure amounts being suggested are onerous. For a direct exposure to the issuer, the consultation suggests that RWA be calculated as the sum of an exposure to the reserve assets and a loan to the issuer.
Group 1a assets may be used as financial collateral subject to the normal conditions, but not Group 1b assets as "they add counterparty risk not present in a direct exposure to a traditional asset". This doesn't quite stack up. Several assets currently allowed as financial collateral add credit risk: for instance, both cash on account with the institution and on account with a third-party institution can qualify.
Note that if the accounting treatment for the relevant cryptoassets is that they are intangibles and should be deducted from Common Equity tier 1 capital, then they will effectively be treated the same as Group 2 assets.
The Basel Committee proposes a very conservative treatment for Group 2 assets - basically banks will need to hold capital equal to the exposure (rather than capital equal to the usual 8% of the risk weighted value of an exposure). The Basel Committee explains that the reason for applying a 1,250% risk weight is that, like for intangibles, capital should be enough to absorb a complete write off. This seems to us super-conservative: although assets like bitcoin have proven to be very volatile, no one now expects a scenario where they will have no value whatsoever.
Other important recent publications from regulators on crypto include:
Published 17 June 2021, FCA research shows that more consumer own and are aware of crypto assets. FCA estimates that about 2.3 million UK consumers - 4.4% of the population - now own cryptocurrencies, but that understanding is worse than it was last year. FCA highlights that those who buy on the back of advertisements are much more likely to regret their purchase. FCA says they will take these finding into account to progress further work. It seems to us that the more consumers lose money, based on poor understanding, the more likely it is that the FCA will impose licensing requirements on cryptoasset providers on top of the existing AMLD5 registration requirements.
On 10 June 2021, the BIS Innovation Hub announced an experiment using wCBDC for cross-border settlement. The Swiss National Bank, Banque de France and a private sector consortium including Credit Suisse, Natixis, R3, SIX Digital Exchange and UBS are taking part. For us, this is a significant development which could show how distributed ledger technology could improve the world-wide payment system, something which some stablecoins were aiming for.
The Bank of England calls for input from the payments industry, payments users, financial institutions and tech providers on its discussion paper on Digital Money published on 07 June 2021. Although HM Treasury proposed in a consultation paper on the regulation of cryptoassets in January 2021 that stablecoins should be in the first phase of legislative changes, the Bank of England says that it has not yet made any decisions on how to supervise stablecoins. The Bank is broadly supportive of innovation in payments, but worries about the stability and trustworthiness of a systemic stablecoin (to be distinguished from non-systemic stablecoins and e-money).Another concern is the possible impact on commercial bank money if commercial banks' access to retail deposits is much reduced.
The Bank confirms that the expectations published by the FPC for stablecoins will inform a new regulatory framework for stablecoins:
- Payments regulation will apply to payment chains that use stablecoins. The operator must either be a bank or a non-bank which does not lend money, but has backing assets to cover the coin issuance at all times. Other entities in the chain may also need to be regulated depending on what they do.
- In addition, if stablecoins operate like money, they must meet the same standards in terms of stability of value, robustness of legal claim and the ability to redeem at par in fiat.
The Bank of England advocates a transitional arrangement to test systemic stablecoin or CBDC, but cautions that it should be carefully calibrated to minimise risk.
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