BCBS believes that certain cryptoassets have exhibited a high degree of volatility, and could present risks for banks as exposures increase, including liquidity risk; credit risk; market risk; operational risk (including fraud and cyber risks); money laundering / terrorist financing risk; and legal and reputation risks.
On June 10, 2021, the Basel Committee on Banking Supervision (BCBS) published a new Consultative Document on the regulatory treatment of cryptoassets. This comes almost a year after the publication of the initial Discussion Paper on this topic in December 2019, for which I have written the following summary.
The article above among other topics goes into more detail about the three general principles of prudential treatment of cryptoassets defined by BCBS. Therefore, the regulatory cryptoasset journey continues!
The centerpiece of this Consultative Document are the capital requirements for credit and market price risks for cryptoassets, which can be divided into two groups by a new classification procedure. In addition, as already mentioned in the last year‘s article, further regulatory requirements, such as those relating to large exposure requirements and liquidity ratios, are consulted and proposals are being made for the integration of cryptoassets into the Pillar III disclosures.
Classification of Cryptoassets
To determine the regulatory treatment of cryptoassets, the BCBS differentiates between two groups of cryptoassets and has developed therefore four classification criteria for this purpose. If all of the four criteria are met, the cryptoasset is to be allocated to group 1. Group 1 cryptoassets include tokenized traditional assets (Group 1a) and cryptoassets with effective stabilization mechanisms (Group 1b). Otherwise, the allocation is made to group 2.
Cryptoassets must meet all the conditions below in order to be classified as Group 1 cryptoassets on an ongoing basis:
- The cryptoasset is a tokenized traditional asset (Group 1a) or a cryptoasset with a stabilization mechanism (Group 1b), a so-called stabelcoin. Such a mechanism links the performance of the cryptoasset to that of an underlying traditional asset or pool of traditional assets.
- All contractual rights and obligations related to cryptoassets must be clearly defined and legally enforceable. A transfer, and in the case of stablecoins, redeemability must be guaranteed at all times.
- The functions of the cryptoasset and the network on which they are implemented must be set up to adequately manage and mitigate material risks. By this, the BCBS means the obligation to develop robust risk governance and risk control policies and to apply them in practice.
- In addition, companies that provide transfer or settlement systems related to cryptoassets should be regulated and supervised. The same applies to companies that operate services in connection with the stabilization mechanism for Group 1 cryptoassets.
If all the four above mentioned criteria are met, the cryptoasset shall be classified to Group 1. Further in detail explanations about the four criteria can be found in the Consultative Document in Chapter 1.1. Cryptoassets that fail to meet any of the conditions above will be classified as Group 2 cryptoassets.
Banks are responsible for:
- assessing on an ongoing basis, wether a cryptoasset is compliant with the classification conditions;
- demonstrating to supervisors how a cryptoasset fulfils these conditions (e.g. approriate risk management policies, procedures, governance, human and IT capacities in place to evaluate the risks of cryptoassets).
Supervisors are responsible for:
- reviewing and assessing banks‘ analysis and risk management and measurement approaches;
- approving the bank‘s demonstration of whether and if so how a cryptoasset qualifies as a Group 1 asset.
Requiring supervisory approval is necessary to ensure consistent application of classification conditions by banks. To ensure a consistent application across jurisdictions, there is a need for strong coordination among supervisors.
Capital Requirements
Based on the classification described above the Consultative Document proposes a different treatment with respect to capital requirements for banks.
Group 1 Cryptoassets:
In general, this group is reserved for treatement under the current applicable requirements of the Basel framework. The main consideration here is that a tokenized cryptoasset can be granted the same level of rights as its non-digital counterparts. The BCBS is thus pursuing one of its guiding principles of an as technology-independent regulatory path as possible. For Group 1b cryptoassets with a stabilization mechanism the bank has to take into consideration additionally to the risk weighted assets based on the direct holding of the underlying asset, also the holding multiplied by the risk weight applicable to an unsecured loan to the redeemer .Wether the new types of assets in Group 1 are assigned to the banking book or trading book, or whether they are treated in accordance with the standardized approach to credit risk or a model based on internal ratings, is subsequently derived from the rules governing corresponding traditional assets.
Group 2 Cryptoassets:
For this group of cryptoassets, the BCBS proposes a newly developed approach to regulatory treatment that is significantly more conservative than that for Group 1 assets mentioned above.
Thus, the risk weighted assets (RWA) calculation is performed using a risk weight of 1‘250% multiplied by the greater of the total amount of all positive (long) and all negative (short) positions in a cryptoasset.
RWA = RW x max [abs (long), abs (short)]
It should be noted that the calculation must be performed separately for each type of cryptoasset in this Group 2. The use of the 1‘250% risk weight is thus equivalent to a capital deduction and reflects the skepticism of the BCBS with regard to cryptoassets.
A classification in the banking book is not applicable, as the conservative risk weight is already supposed to cover credit risks as well as market price risks.
Other Regulatory Requirements
At this point the BCBS is not proposing to prescribe any new regulatory treatment for the leverage ratio, large exposures framework, or liquidity ratio requirements.
Liquidity Ratios (LCR and NSFR):
As discussed in the December 2019 Discussion Paper, the BCBS does not consider cryptoassets to be eligible as highly liquid assets (HQLA). However, in terms of further use in the LCR and NSFR, those in Group 1 are assigned the same treatment as conventional assets, whereas for Group 2 cryptoassets, assets must be assigned a 0% inflow rate and liabilities a 100% outflow rate for the LCR calculation. Similarly, for the NSFR Group 2 cryptoassets must be subject to a 100% required stable funding factor, while liabilities must be subject to a 0% available stable funding factor.
Large Exposure:
For large exposure purposes, the treatment of cryptoassets will follow the same principles as for other exposures. The bank must identify and apply the large exposure limits to each specific counterparty or group of connected counterparties to which it is exposed. Where the cryptoasset exposes the bank to the risk of default of more than one coutnerparty, the bank must compute for each counterparty the respective amount to which it is exposed to default risk for large exposure purposes. At this point it also should be emphasized, that according to BCBS the above mentioned approach should not apply to cryptoassets without an issuer, as in the case of Bitcoin. Bitcoin as well as physical exposures of gold and other commodities or currencies do not give rise to a large exposure requirement due to no default risk exposure for banks.
Leverage Ratio:
In line with the leverage ratio standard, cryptoassets are included in the leverage ratio exposure measure according to their face value for financial reporting purposes. In case that the cryptoasset exposure is an off-balance sheet item, the relevant credit conversion factor set out in the everage ratio framework will apply in calculating the exposure measure.
SREP Requirements
Banks with direct or indirect exposures to any form of cryptoassets are subject to the supervisory review and evaluation process (SREP) set out in the Basel framework. As already mentioned above, the bank should establish policies and procedures that describe the processes used to identify and assess the risks that are unique to cryptoassets or related activities on an ongoing basis and implement these accordingly. According to the Consultative Document banks are also expected to inform their supervisory authorities of their policies and procedures, assessment results, as well as the associated risks and how they have mitigated such risks.
The risk definition includes operational and cyber risks (e.g. cryptographic key theft, compromise of login credentials, DDoS attacks). Therefore, the institution should increase the surveillance of operational risk, including ICT risks, which includes:
- Governance requirements and risk management on ICT Risks;
- ICT related incidents;
- Requirements on testing of ICT tools and systems;
- Requirements on ICT third-party risk management.
Risks attributable to the underlying technology, which have to be closely monitored by the banks are:
- Stability and reliability of the ledger technology and its source code, governance and protocol;
- Validating design of the DLT (permissionless or permissioned);
- Service accessibility (private and public key handling);
- Trustworthiness of node operators and operator diversity.
In addition to the technology risks, banks should provide banking services to virtual asset service providers (VASP) or to clients with virtual asset activity involvements or engagement of themselves by applying a risk-based approach as set out by the Financial Action Task Force (FATF) to fight money laundering activities and financing of terrorism.
Pillar I Requirements
To address additional credit and market risks of Group 1 cryptoassets that are not sufficiently captured in the capital treatment stated above, according to BCBS the supervisory authorities should be authorized to modify the Pillar I treatment accordingly. The Consultative Document lists four parameters with which the supervisors could adjust the minimum requirements for Pillar I.
Disclosure Requirements
Last but not least the Consultative Document states some disclosure requirements that banks have to fulfill on a quarterly basis according to the general Pillar 3 disclosures of the Basel Framework. They will be subject to publish detailed information on all material Group 1a, 1b or 2 cryptoassets exposures, in particular with respect to the direct and indirect amounts of risk positions, capital requirements and their accounting treatment. In addition to that, banks must include Group 1 cryptoassets in the relevant existing disclosure templates for traditional assets (e.g. credit risk and market risk).
Besides of the quantitative information described above, banks must provide qualitative information that sets out an overview of the bank‘s activities related to cryptoassets and main risks related to their cryptoasset exposures, including:
- Business activities related to cryptoassets and inclusion into the risk profile of the bank;
- Risk management policies of the bank related to cryptoasset exposures;
- scope and main content of the bank‘s reporting related to cryptoassets
- most significant and emerging risks relating to cryptoassets and how those risks are managed.
Conclusion
The BCBS‘s framework outlined in the Consultative Document already poses a variety of challenges not only in regard of classification, but also regarding credit and market risk calculations as well as other minimum requirements for the banks that intend to engage in this exciting and dynamic environment. Be it the creation of an adequate IT landscape, the development of new or adaptions of existing risk management policies and systems or the implications on the regulatory reporting processes.
Feedback to the 18 questions in the Consultative Document can still be submitted to the BCBS until September 10, 2021. I recommend to use this opportunity to actively shape the prudential regulation of this already heavy discussed and highly interesting topic. I look forward to feedback and comments on the BCBS document or also on my article!
Sources
- BCBS Consultative Document — Prudential treatment of cryptoasset exposures — Issued for comment by 10 September 2021 — June 2021
www.bis.org/bcbs/publ/d490.pdf - BCBS Discussion paper — Designing a prudential treatment for cryptoassets — Issued for comment by 13 March 2020 — December 2019
www.bis.org/bcbs/publ/d490.pdf
