Cryptoassets Not In My Back Yard says the Basel Committee

The Basel Committee on Banking Supervision issued on 10 June 2021 a consultation paper on the proposed prudential treatment of cryptoassets. This consultation builds on an earlier paper published in December 2019 including feedback from industry, and lays minimum requirements that can be augmented at national level.

On the positive side, the Committee has for the first time legitimised banks holding inventory of so called tokenised securities and derivatives which are traditional financial assets created in digital, encrypted, form normally on a Distributed Ledger Technology platform.

The headline messages are:

• The Committee proposes a classification system that divides cryptoassets into three broad categories:

1. Tokenised securities and derivatives;
2. Cryptoassets with stabilisation mechanisms/underlying traditional assets;
3. Cryptoassets of no innate value (e.g. Bitcoin)

• The proposal will treat tokenised securities and derivatives broadly like the conventional form of the same assets with adjustments for enhanced operational risk (unquantified at this stage) and some potential differentiation should liquidity be more limited
• The usage of tokenised securities and derivatives as collateral may be subject to restriction depending on the depth of liquidity in the market and speed of realisation – not for now eligible as High Quality Liquid Assets
• A positive approval regime proposed to allow banks to have any cryptoassets on their balance sheet
• Complex and onerous regime for stablecoins and an incentivisation for banks themselves to be issuing stablecoins
• Outright prudential condemnation of Bitcoin and other cryptoassets without innate value – effectively a deduction or 1250% risk weight where off balance sheet items
• Banks required to disclose extent and granular holdings of cryptoassets on a regular basis
• Bitcoin derivatives attracting penal treatment effectively requiring risk weighting at maximum loss possible

Cryptoassets classification

Eligibility criteria for class 1a

Applies to tokenised form of traditional financial assets other than rights held through Centralised Securities Depository or Custodians. Strict legal enforceability and certainty as to settlement finality standards must be met. Realisation/redeemabilitymust be possible at any time without restriction on transfer. Treatment akin to conventional financial assets of the same type and/or characteristics under the existing regime with a proposed 'add-on' for operational complexity and added risks posed by the use of a reasonably nascent technology that has not been tested to scale on global financial markets. When assessing market risk, account must be taken of depth of liquidity and whether the value of the security/derivative should reflect a more limited liquidity pool. Eligibility for collateral provisions as an effective credit risk mitigation limited to the extent that the tokenised asset is not readily realisable under the existing eligibility criteria applicable to traditional financial assets. Not HQLA eligible until further notice.

Eligibility criteria for class 1b

Strict criteria to define what stabilisation mechanisms qualify to make a stablecoin eligible including volatility limits measured against Net Asset Value of underlying portfolio. Multiple 'add on' and duplication of risks included to reflect risks posed by underlying assets, issuer/redeemer and any risk resulting from commitment to other holders to redeem their stakes. Potential look through to the underlying assets and onerous monitoring and verification roles for banks wanting to utilise the regime for third party stablecoins. In short, an extremely unpalatable regime that is in practice unworkable and so will deter banks from having any dealings with stablecoins other than those issued by banks themselves in which case the counterparty risk is a known quantity. Stablecoins cannot qualify as eligible collateral for credit risk mitigation purposes. Another nail in the coffin of private stablecoins in favour of Central Bank Digital Currencies and private stablecoins offered by banks as part of the transition to tokenised capital and cash markets.

Class 2 treatment

Bitcoin and similar cryptoassets or cryptocurrencies are effectively prudentially condemned and are subject to a deduction or a similar treatment if off balance sheet so a risk weight of 1250% to the absolute value of long and short positions (i.e. no netting). Derivatives on Class 2 follow the same rules and banks will have a choice between the outcome of the computation inputting the underlying value or the maximum loss under the instrument. No separate trading/banking book treatment. Class 2 assets not eligible as collateral for credit risk mitigation purposes and any lending of Class 2 cryptoassets will carry a 25% haircut.

Pillar 2 and other risks

The Committee has reiterated its risk averse approach to the need for banks to have a rigorous process to identify other risks involved in connection with the holding of cryptoassets including but not limited to AML, cyber, operational and reputational. Such risks to be clearly identified and subjected to potential 'add ons' in capital cost as appropriate and proportionate. There is also an onerous and granular disclosure proposal on a regular (to be clarified) basis and which holistically shows any material (to be clarified) exposures to any of the cryptoassets categories.

CBDC out of scope

Central Bank Digital Currency is at this stage out of scope of the framework pending further development. As noted above, expectations are that once in issue, it will be granted a much more favourable treatment akin to physical cash and or the holding of reserve accounts with the central banks.