Basel Committee Issues Guidance on Prudential Treatment of Cryptoasset Exposures

On June 10, 2021 the Basel Committee on Banking Supervision (“Basel Committee”) issued a public consultation paper (the “Report”), requesting comments on its preliminary proposal for the prudential treatment of banks’ exposure to cryptoassets. Currently, banks do not have large exposures to cryptoassets. However, the Basel Committee was of the view that the absolute size of the cryptoasset market and the unique risks it presents warranted more policy guidance.

The Basel Committee previously offered some guidance on these risks. In March 2019, the Basel Committee released a newsletter on the minimum supervisory expectations for banks that acquire cryptoassets or provide related services. In addition, in December 2019, the Basel Committee published a discussion paper with views from stakeholders on the prudential treatment of cryptoassets.

The Report sets out a proposed framework for prudential treatment of cryptoasset exposures. In addition, the Report provides guidance for banks and supervisors on mitigating cryptoasset-specific risks.

Key Principles

As a preliminary matter, the Report outlines the following fundamental principles with respect to the prudential treatment of cryptoasset exposures:

  • “Same risk, same activity, same treatment”: prudential treatment should account for crypto-specific risks, but otherwise a cryptoasset should be regulated the same as its corresponding traditional asset if they are truly economically equivalent.
  • “Simplicity”: the pace of innovation in the cryptoasset market warrants starting with a simple framework that can be revised if needed.
  • “Minimum standards”: the Report proposes minimum prudential standards. Jurisdictions can comply with the regime by setting more conservative measures or prohibitions.

Categorization of Cryptoassets as Group 1 versus Group 2:

The Report proposes that cryptoassets be classified into two groups:

  • Group 1 cryptoassets must meet a series of conditions intended to identify “stablecoins” and tokenised traditional assets. Group 1 is further subdivided into 1a and 1b. Assets such as tokenized corporate bonds would fall into Group 1a. Stablecoins would fall into Group 1b.
  • Group 2 is a residual category that captures all cryptoassets not in Group 1. This would include, for example, bitcoin.
  • Digital representations of fiat currencies and central bank digital currencies (CBDCs) are excluded from the Report; therefore these assets do not fall into either group.

Assets in Group 1 would be subject to less conservative minimum risk-based capital requirements than Group 2 assets.

At a high level the Report proposes the following capital treatment:

 

Group 1a: Tokenised traditional asset

Group 1b: Stablecoins

Group 2: Other cryptoassets
(eg. bitcoin)

Central bank digital currencies
(CBDCs)

Proposed capital treatment

Capital requirements at least equivalent to those of the corresponding traditional asset

Given that Group 1b assets can have a variety of stabilization mechanisms with differing risks, the Report does not provide comprehensive capital requirements, instead it provides specific examples and outlines the treatment of each.

New conservative 1250% risk weighting

N/A (out of scope)

A cryptoasset must meet all of the following conditions to fall into Group 1:Group 1 Requirements:

  1. “The cryptoasset either is 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.”
  • This condition ensures that only tokenised traditional assets and stablecoins fall into Group 1.
  • The “effective at all times” condition requires banks to monitor the difference in price between the cryptoasset and the underlying asset. The difference cannot exceed 10 basis points more than three times in a year. If this occurs, the bank must remedy the stabilization mechanism and ask to have the cryptoasset reassessed.
  • Cryptoassets that reference other cryptocurrencies as the underlying asset or use protocols to control the supply of the cryptoasset (algorithm-based stablecoins) do not meet this requirement.
  1. Cryptoasset arrangements must have clearly defined and legally enforceable rights and obligations such that they can ensure full transferability and settlement finality. Further, banks must ensure stablecoins are fully redeemable for the underlying asset at all times.
  2. The functions of the cryptoasset and its network, including its ledger, must be designed and operated to “sufficiently mitigate and manage any material risks”.
  • As such, the functions of the cryptoasset cannot create material risks that could impair its transferability, settlement finality or redeemability. To satisfy this condition, the transactions on the network and its participants must be traceable.
  1. “Entities that execute redemptions, transfers, or settlement finality of the cryptoasset are regulated and supervised.”

Cryptoassets that fail to meet these four conditions fall into Group 2.

Group 1 is further subdivided into 1a and 1b. Tokenised traditional assets, such as tokenized corporate bonds, would fall into Group 1a. Stablecoins would fall into Group 1b. Importantly, a Group 1a cryptoasset must confer the same legal rights as the traditional asset it represents. If the cryptoasset must be converted into the traditional asset before the holder receives the legal rights incident to the traditional asset, the cryptoasset would fall into Group 1b.

Capital Requirements for Group 1a Cryptoassets

The Report aims to promote “technology neutrality”. Therefore, if the cryptoasset is a digital representation of a traditional asset, and both assets convey the same legal rights, then the assets should be treated equally. As such, Group 1a assets would generally be subject to the same rules as the corresponding traditional asset to determine the appropriate risk weight.

However, the liquidity and other characteristics of the tokenised traditional asset may differ from those of the corresponding traditional asset. Thus,

  • banks must not assume that the Group 1a cryptoasset meets the same credit and market risk standards as its corresponding traditional asset; and
  • Group 1a cryptoassets will not be eligible as credit mitigation collateral if they exhibit increased illiquidity and volatility during market shocks relative to the traditional asset.

Capital Requirement for Group 1b Cryptoassets

Given that Group 1b assets can have a variety of stabilization mechanisms with differing risks, the Report does not define comprehensive capital requirements. Instead, the Report sets out two examples:

  1. The cryptoasset has an underlying asset pool and the holders of the cryptoasset can redeem the underlying asset directly from the redeemer.
  • The bank faces the risk of the underlying asset and the redeemer defaulting.
  • The bank must sum the credit risk-weighted assets of: (i) directly holding the underlying traditional asset, and (ii) the value of the cryptoasset multiplied by the risk weight of an unsecured loan to the redeemer.
  1. The holder and redeemer are intermediated by another institution, a “member”.
  • In addition to the risks faced in Example 1, members face the risk of being obligated to purchase all outstanding cryptoassets. Thus, the credit-weighted asset would be equal to the value of the cryptoassets the member may be obligated to buy, multiplied by the risk weight applicable to an unsecured loan to the redeemer.
  • Non-member holders must also include the risk-weighted asset of the member defaulting.

Due to the added exposure to risk of default by a redeemer and/or a member, Group 1b cryptoassets would not serve as collateral for credit risk mitigation.

Capital Requirements for Group 2 Cryptoassets

The Report stresses simplicity and conservatism for the Group 2 cryptoasset capital requirement regime. The risk-weighted asset is the maximum absolute value of the bank’s cryptoasset long or short position, multiplied by 1250%. The risk weight of 1250% is to ensure that banks must hold risk-based capital at least equal in value to their Group 2 cryptoasset exposure. This conservative regime is to protect senior creditors and depositors from the volatility of Group 2 cryptoassets. The Report also notes that this calculation may not accurately capture the risk of a short position or a derivative, so these exposures may require adjustments.

As with Group 1b cryptoassets, Group 2 cryptoassets would not be considered collateral for the purposes of credit-risk mitigation.

Other Ratios

The Report does not propose any new regulatory requirements to the treatment of cryptoassets under the leverage ratio, large exposures framework, or liquidity ratio requirements.

Cryptoasset-Specific Risks

The Report also highlights risks that are particular to cryptoassets which banks must also account for in order to full comply with the Basel Pillar 1 requirements.

  • Operational and cyber risk. Cryptoassets face the risk of private-key theft and attacks on its network that may lead to data breaches and unauthorized transfers.
  • Risks of the underlying technology. Banks must ensure the trustworthiness and robustness of the network and ledger. This includes considering the reliability of transaction validation and the node operators that facilitate and record transfers.
  • Increased risks of money laundering and financing of terrorism.

Supervisors play a key role in reviewing a bank’s policies to counter these additional risks. The supervisor should also have the authority to propose stress test analyses and require additional risk mitigation measures.

Disclosure Requirements

The Report also indicates that banks should adhere to the existing Basel Framework Pillar 3 disclosure principles by communicating their exposure to cryptoassets and the main risks associated with that exposure, “including descriptions of (i) business activities related to cryptoassets, and how these business activities translate into components of the risk profile of the bank; (ii) risk management policies of the bank related to cryptoasset exposures; (iii) scope and main content of the bank’s reporting related to cryptoassets; and (iv) most significant current and emerging risks relating to cryptoassets and how those risks are managed.”

In addition, the Report recommends banks disclose information with respect to material cryptoasset exposures on a regular basis, including exposure amounts, capital requirements and accounting classification, and with respect to Group 1 cryptoassets, that banks also provide disclosure in the existing disclosure templates that apply to the underlying assets.

For more information about our firm’s Fintech expertise, please see our Fintech group’s page.

Authors

Subscribe

Stay Connected

Get the latest posts from this blog

Please enter a valid email address