The Basle Committee on Banking Supervision (BCBS), the global standard setter for regulatory standards for banks, issued a consultation paper on the prudential regulation of crypto-assets and related services. The paper includes proposals for the capital treatment of certain crypto-assets, which would boil down to a full deduction from capital. The proposals, if adopted, will effectively bar banks from holding certain crypto assets. Interested parties are invited to comment on the consultation paper until 12 March 2020.
The bulk of the minimum regulatory standards set out by the Committee are requirements for banks which intend to hold crypto-assets or provide related services: banks should understand the risks related to crypto-assets and have a clear and robust risk management framework; they should disclose any material position in crypto-assets and it should inform its regulator of crypto-asset exposures. This is all common sense and well justified.
Much more serious is the approach taken by the Committee for the capital treatment of certain crypto-assets, i.e. the capital a bank would have to hold if it holds crypto-assets. According to an illustrative example included in the consultation paper, “high-risk crypto-assets” in the banking book would be subject to a full deduction from Common Equity Tier 1 (CET1) capital. This means that a bank would have to hold 100 cents of capital for each Dollar of high-risk crypto-assets, corresponding to a 1250% risk weight and follows an approach advocated by the European Central Bank. This goes well beyond the 800% risk weight Switzerland’s FINMA is currently applying to crypto-assets. The banking book comprises assets, which are presumed to be held until maturity by the bank.
Crypto-asset exposures held in the trading book would also be subject to the equivalent of a full deduction treatment for market risk and credit valuation adjustment (CVA) risk. In addition crypto-asset exposures with residual risks would be subject to a residual risk add-on. The consultation paper does not provide a sample calculation, but it appears that the capital costs for holding crypto-assets in the trading book would be higher, possibly much higher, than for any other asset class. Moreover, banks would not be permitted to use the internally-modeled approaches for any crypto-asset exposures when calculating market risk, counterparty credit risk and CVA risk capital requirements, leaving only the standardized approach.
The capital treatment would be confined to what the paper calls high-risk crypto-assets. According to the Committee, these are assets which have no intrinsic value and are not explicitly and directly linked to, or backed by, assets with intrinsic values; and the holding of the assets does not give rise to a contract between the holder and another identified issuer. This definition would capture fully decentralized cryptocurrencies like Bitcoin or Ether, but not stablecoins or other coins or tokens backed by, or representing, financial or non-financial assets. This focus on fully decentralized tokens is in line with the principle that activities with the same risk should be subject to the same regulatory treatment, one of the guiding principles of the report. Only crypto-currencies can indeed be considered to be a wholly new, separate asset class, whereas other coins or tokens deploy economic functions and risks equivalent to other asset classes. The consultation paper therefore quite correctly points out that their regulatory treatment should be build on the existing regulatory framework.
The bulk of the consultation paper is focused on due diligence and governance standards for banks holding crypto-assets in a broader sense or offering related services. The Committee notes that crypto-assets have thus far typically exhibited a high degree of volatility and are considered to be immature products given the lack of standardization and constant product evolution. Accordingly, the Committee is of the view that crypto-assets may potentially present a number of financial and non-financial risks for banks, including liquidity, credit and counterparty and market risks as well as cyber and operational, legal and reputational risks.
The Committee therefore demands banks acquiring exposures to crypto-assets or providing related services to meet the following minimum standards:
- Due diligence: A bank should conduct comprehensive analyses of the risks and should ensure that it has the relevant and requisite technical expertise to adequately assess the risks resulting from crypto-assets.
- Governance and risk management: The bank should have a clear and robust risk management framework that is appropriate for the risks of its crypto-asset exposures and related services. Given the anonymity and limited regulatory oversight of many crypto-assets, a bank’s risk management framework for crypto-assets should be fully integrated into the overall risk management processes.
- Disclosure: A bank should publicly disclose any material crypto-asset exposures or related services as part of its regular financial disclosures and specify the accounting treatment for such exposures.
- Supervisory dialogue: The bank should inform its supervisory authority of actual and planned crypto-asset exposure or activity in a timely manner and provide assurance that it has fully assessed the permissibility of the activity and the risks associated with the intended exposures and services, and how it has mitigated these risks.
The consultation paper provides a clear outline of the prudential framework under which banks holding crypto-assets or offering related services will have to operate in the foreseeable future. If adopted, banks will be faced with excessive capital costs for holding crypto-assets. This will prevent banks from providing services vital for the development of digital asset markets, including market making and firm underwriting of crypto-assets. Since the standards of the Basle Committee are not legally, but de facto binding for member jurisdictions this would effectively close off the banking system from crypto-assets.