Last week, whilst El Salvador was contemplating reforms that should eventually allow Bitcoin to be used for everyday payments, a thousand people in China were arrested for being part of a network accused of fraud connected with cryptocurrencies. This anecdote is illustrative of a more general observation: cryptoassets are a double-edged sword. Thirteen years after the creation of Bitcoin, they continue to grow rapidly and to attract attention from governments, financial analysts, the media and investors; but they are also giving rise to a range of concerns, attracting the attention of regulatory institutions.
Among these, the Basel Committee on Banking Supervision (BCBS) acknowledges that the cryptoasset market remains small relative to the size of the global financial system, but is of the view that the growth of cryptoassets has the potential to raise financial stability concerns. The risks underlying these concerns range from liquidity risk, credit risk, market risk, operational risk (including fraud and cyber risks), money laundering and terrorist financing risk to legal and reputation risks. "The Committee is of the view that the growth of cryptoassets and related services has the potential to raise financial stability concerns and increase risks faced by banks."
Against this backdrop, the BCBS has published a consultative paper seeking stakeholders' views on a preliminary proposal for the prudential treatment for cryptoassets. Although further development is expected, the proposals bring more clarity as to where the regulatory regime for cryptoassets may be heading.
This post aims to give an insight into the BCBS's preliminary proposals.
The approach adopted by the BCBS is two-fold. On the one hand, it suggests a similar treatment of identical risks, regardless of whether these risks arise from exposure to cryptoassets or more traditional assets ("same risk, same activity, same treatment"). At the same time, it aims to define and target the riskiest cryptoassets so that they can be subject to a more conservative prudential treatment. To this end, the prudential treatment proposed by the BCBS relies on a classification of cryptoassets divided in two groups.
Group 1 would comprise tokenised assets (i.e. assets whose ownership rights have been converted onto a blockchain) and stablecoins (i.e. assets which feature stabilisation mechanisms by being pegged to an underlying reference asset).
However, the nature of the tokenised asset is only one element of the categorisation test. To be in "Group 1", cryptoassets would also be required to fulfil all of the following conditions:
- the rights, obligations and interests arising from these cryptoassets would need to be clearly defined and legally enforceable in jurisdictions where the cryptoasset is issued and redeemed;
- the functions of the cryptoasset and the network on which it operates would need to be designed and operated to sufficiently mitigate and manage any material risks; and
- entities that execute redemptions, transfers, or settlement finality of the cryptoasset would need to be regulated and supervised.
Cryptoassets falling within the scope of Group 1 would be subject to at least equivalent risk-based capital requirements (based on the risk weights for the underlying exposures under the existing Basel Framework) as the traditional underlying or reference assets for the purpose of calculating minimum capital requirements, provided they bear an identical level of risk. Although the Committee does not set out the capital treatment for every type of cryptoasset with stabilisation mechanisms, it provides two illustrative examples which suggest adjustments depending on the specific risks carried by these assets.
Cryptoassets which fail to meet any of the classification conditions above (and may be seen as more speculative and riskier in nature), including Bitcoin, or stablecoins that don’t meet all of the conditions above would belong to "Group 2". A more conservative treatment would be applied to them, reflecting the higher level of risk they represent. In particular, a 1,250% risk weight will be applied, effectively meaning that banks would be required to hold capital at least equal to the Group 2 cryptoasset exposures they have.
The paper also discusses other risks that arise in connection with exposures to crytpoassets. These include additional operational and cyber risks targeting the DLT platforms and risks attributable to the underlying technology.
In relation to Pillar 3 disclosures, banks will be required to provide qualitative information that sets out an overview of the bank’s activities related to cryptoassets and the main risks related to their cryptoasset exposures.
Central bank digital currencies are left out of the scope of the new prudential treatment envisaged by the BCBS in its consultation paper.
The BCBS's proposal appears sensible, both in its classification of assets and in the prudential treatment it envisages. Although this prudential framework is at the consultation stage, two trends nonetheless emerge which may be worth noting.
First, the classification conditions proposed may impose an increased administrative and financial burden on banks. The latter will be responsible for assessing on an ongoing basis whether a cryptoasset is compliant with the classification conditions. Most notably, the onus will be on them to check that stablecoins effectively track the underlying asset.
In this context, the requirement to prove that obligations arising from the cryptoasset will be clearly defined and legally enforceable in relevant jurisdictions may prove to be particularly onerous given the potentially large number of in scope jurisdictions and the current state of the law. Admittedly, the consultative paper does not impose any express obligation to obtain legal opinions. Yet, the prohibitive treatment applied to Group 2 assets will encourage banks to seek Group 1 classification for the cryptoassets they hold. In practice, this effectively means that banks will seek to obtain legal opinions in all concerned jurisdictions.
Perhaps more importantly, the BCBS aims to define minimum standards and is by no means a prescriptive ceiling on regulations: local regulators may thus wish to introduce more conservative treatments of cryptoassets leading to different treatments across different jurisdictions. Just like banks, issuers of cryptoassets will be keen to ensure that their assets fall into Group 1 to ensure they remain attractive. Hence, the classification conditions, in particular satisfaction that the network is designed and operated to mitigate and manage material risks and the requirement that entities are regulated and supervised, may have the effect of leading to a more regulated and structured market for cryptoassets.
The consultation is due to close on 10 September 2021, and further consultations are expected to follow.
The prudential framework should apply the concept of technology neutrality.