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Basel Committee Second Consultation on the prudential treatment of banks cryptoassets

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    Following their June 2021 consultation (see our briefing on this here), the Basel Committee on Banking Supervision has published a second public consultation on the prudential treatment of banks' exposures to cryptoassets. The second consultation builds on the proposals contained in the first consultation whilst introducing certain significant clarifications and amendments. 

    Following industry feedback, the Committee is considering changes including:

    • introducing tougher requirements in order for stablecoins to be eligible for inclusion under the Group 1b classification;
    • introducing a so-called "infrastructure add-on" for Group 1a and Group 1b assets to reflect unforeseen risks posed by distributed ledger technology infrastructure; and
    • treatment of cryptoassets as collateral and for the purposes of liquidity risk management.

    As with the first consultation, there is no detail in relation the treatment of central bank digital currencies - the Committee states that it will be giving further consideration to the treatment of these as and when they are issued.

    Summary of changes to the previous consultation

    The consultation builds on the proposals made in the June 2021 consultation and factors  concerns and submissions from industry respondents. 

    It maintains the broad structure of the June 2021 consultation, with cryptoassets divided into two groups:

    1. Group 1: These are  assets which fully meet a set of stringent classification conditions and are therefore considered to pose lower risks. These assets include tokenised traditional assets (Group 1a) and assets with effective stabilisation mechanisms (Group 1b) and are subject to at least equivalent capital requirements as set out in the existing Basel Capital Framework; and
    2. Group 2: These are assets which fail to meet the classification conditions for Group 1 and therefore pose higher and additional risks as compared to Group 1 assets, meaning that they are subject to a newly prescribed 'conservative capital treatment'.

    Standards text

    A specific standards text for cryptoassets exposures (SCO60) has been published to be included, once finalised, in the Basel Framework. The text sets out the Committee's proposals for classifying and treating cryptoassets under the prudential framework.

    Refinement of classification conditions

    The second consultation includes a revised stabilisation test for Group 1b (stablecoins) and other refinements to the classification conditions set out in the first consultation, which provide further detail and clarification on the classification of cryptoassets.. 

    The Committee had originally proposed a quantitative test, requiring that banks need to monitor the difference between the market value of the cryptoasset and the market value of the traditional asset 'pegged' on a daily basis and that this difference should not exceed 10 basis points on more than three occasions over any given year. Under the revised proposals, a stablecoin in Group 1b, would need to meet two tests: 

    • Redemption risk test - reserve assets must be sufficient to enable the stablecoin to be redeemable at all times and composition and management of reserve assets must meet certain conditions; 
    • Basis risk test - a holder of the stablecoin must be able to sell it in the market for an amount that closely tracks the peg value.  

    The basis risk test retains the same threshold proposed under the original quantitative test (the 10 basis points difference threshold) but with a "second threshold" (set at 20 basis points more than 10 times over any given year) to reduce cliff effects. The Committee is proposing that where a stablecoin meets all the criteria for inclusion in Group 1b but only narrowly passes the basis risk test, it would be subject to an add-on to risk weighted assets rather than be automatically classified as a Group 2 cryptoasset. 

    The Committee is also considering an alternative to the basis risk and redemption risk test that would recognise that banks' exposures to stablecoins issued by regulated entities, and in particular banks, are generally lower risk than those issued by unregulated entities.  
    Stablecoins referencing other cryptoassets and algorithmic stablecoins are expressly excluded from Group 1b.

    Only group 1a cryptoassets are eligible for recognition as eligible collateral for risk mitigation purposes. 

    Permissionless blockchain

    The Committee comments that cryptoassets underpinned by permissionless blockchains would, under current specification, be highly unlikely to fit the criteria set out in Group 1. It is seeking feedback in relation to possible amendments to the classification conditions that would be required to permit the inclusion in Group 1 of cryptoassets that use permissionless blockchains.  

    Infrastructure risk add-on

    The Committee is proposing to introduce an 'add-on' to risk weighted assets to cover DLT infrastructure risks relating to Group 1 cryptoassets. The Committee notes that the infrastructure underlying cryptoassets is still relatively new, and may pose additional, unknown, risks as a consequence. As a result, the following add-ons are proposed for the risk weighting of Group 1 assets:

    • for exposures in the banking book, total credit RWA must be increased by an amount equal to 2.5 per cent of the exposure value. This is equivalent to increasing the risk weight that would apply to the exposures by 2.5 percentage points; and
    • for exposures in the trading book, total market RWA must be increased by an amount equal to 2.5 per cent of the exposure value. This is equivalent to a market risk capital charge of 0.20 per cent of the exposures.

    Recognition of hedging for certain Group 2 cryptoassets

    Following from strongly advocated submissions, the Committee is minded to recognise the risk-reduction effect of  hedging transactions with respect to certain Group 2 cryptoassets. In doing so, the Committee is acknowledging the risk-reducing benefits that hedging on highly liquid cryptoassets like bitcoin can bring. The consultation proposes  new 'Group 2a assets which meet the hedge recognition criteria, meaning that adapted, and less punitive, market risk rules apply to these assets (and related derivatives), with netting and a 100 per cent capital charge applying. The Committee has however maintained its view that only the simplified/standardised approach to market risk should be relevant to Group 2 cryptoassets,  thus assimilating cryptoassets in this category with commodities. The Committee maintained its view that only Group 1 cryptoassets are eligible for being included in an Internal Model for calculating market risk. 

    Removal of accounting classification link

    The Committee had proposed in the June 2021 consultation that cryptoassets classified as intangibles under relevant accounting standards would be deducted from Common Equity Tier 1 (CET1) along with other intangible assets such as goodwill. The Committee has changed its approach and is now proposing that the prudential treatment should be delinked from the intangible accounting classification.

    Operational risk clarifications

    The consultation clarifies the operational risk and resilience proposal from the first consultation in order to delineate more clearly the risks covered under the operational risk framework and those captured in the credit and market risk frameworks, given concerns that were raised by respondents in this area.

    Detail on the application of liquidity rules

    Additional detail is proposed on the application of liquidity risk requirements as follows: 

    • Only holdings of Group 1a cryptoassets will  be eligible for HQLA if they are tokenised versions of a traditional asset that itself would qualify as HQLA (e.g. tokenised bond) and the tokenised asset itself meets the HQLA eligibility criteria;  
    • Group 1a cryptoassets and cryptoliabilities (i.e. bank issued tokenised liabilities) will be treated the same as the equivalent non-tokenised traditional assets under the LCR and NSFR;
    • LCR and NSFR treatment of cryptoassets and cryptoliabilities would vary based on the following classification: tokenised claims on a bank, stablecoins (including bank issued) and other cryptoassets.

    Group 2 exposure limit

    The Committee is proposing to introduce a total exposure limit for all Group 2 cryptoassets outside of the large exposure rules given the lack of a 'counterparty risk' components shared by many Group 2 cryptoassets.  A provisional limit will be set at 1 per cent Tier 1 capital to be reviewed periodically. The limit applies to the aggregate amount of  all Group 2 cryptoassets on gross exposure basis with no netting or recognition of diversification benefits; measurement of derivative exposures will be done through  a delta-equivalent methodology. 

    A few thoughts

    Despite clarifying a number of the questions raised by the first consultation and making a number of important improvements for Group 2 cryptoassets, the proposals continue to take a distinctly conservative line with respect to the prudential treatment of unbacked cryptoassets and stablecoins. 

    Whilst stablecoin treatment has been modified to prevent a 'cliff effect' in classification, the eligibility criteria has hardened further to a degree that makes us sceptical that many (or any) current stablecoins in circulation could be eligible for inclusion as Group 1b.

    The Committee wrestle with permissionless blockchain networks appears to us to be stemming from a misconception about the operation and risks posed by such networks.  It appears to conflate KYC concerns around the constituent members in the relevant network involved in the validation process and any potential 'whitelisted pockets' that can be monitored effectively by a 'sponsor' or 'originator'.  We believe that the Committee can be persuaded through advocacy to soften its position within set parameters. 

    We continue to see a significant opportunity for banks to issue stablecoins that would be eligible as Group 1b cryptoassets, subject to significantly diluted eligibility criteria relative to non-bank issuers.  

    The 'infrastructure add on' surcharge looks unnecessary and would be more appropriately captured in operational risk which banks are well versed with in their ordinary course of business when engaging with new technology and infrastructure.  In any event, the scale of cryptoassets adoption is such that the Committee will have opportunities to intervene during the scaling up process. 

    The consultation is open until 30 September 2022 and responses can be submitted here..

    The information provided is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to.
    Readers should take legal advice before applying it to specific issues or transactions.

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