Basel legitimises crytoassets but not on its patch

Earlier this month the Basel Committee on Banking Supervision (BCBS) proposed legitimising banks holding inventory of tokenised securities and derivatives on their balance sheets for the first time.

These proposals will have a material impact on the ability of banks to engage in cryptoassets and/or stablecoins, thus creating the desired incentive framework to reduce the risks to the banking system from “riskier” cyptoassets. This will likely push the holding of more volatile cryptoassets into unregulated/unsupervised financial institutions. At the same time, BCBS leaves open the distinct possibility Central Bank Digital Currencies (CBDC), once issued, will be granted a much more favourable capital treatment than other crypoassets possibly akin to physical cash or the holding of reserves with the central banks.

The approach of segmenting cryptoassets and specifying eligible criteria ensures cryptoasset issuers adhere to the eligibility criteria if they want holders of their assets to be attractive from a capital perspective. These capital requirements will likely be supplemented overtime by additional guidance to take account of cryptoasset exposures to the leverage ratio, large exposure limits, and liquidity ratios.

The proposals require banks to have a rigorous process to identify other risks involved with the holding of cryptoassets including AML, cyber, operational, and reputational risks under Pillar 2 and there is a proposed capital 'add-on' for operational complexity and added risks posed by the use of a reasonably nascent technology that has not been tested on global financial markets.

The eligibility criteria will incentivise how central banks want tokenised cryptoassets and stablecoins to develop. The rights, obligations, and interests of the asset need to be clearly defined and legally enforceable in jurisdictions where the asset is issued and redeemable to ensure settlement finality. The distributed ledger or technology on which it is based should be designed and operated to sufficiently mitigate and manage any material risks. Stablecoins require volatility limits measured against the Net Asset Value of the underlying portfolio.

The classification conditions, in particular the requirement that the cryptoassets are designed and operated to mitigate and manage material risks alongside the requirement that entities are regulated and supervised, will likely lead to a more regulated and structured market for cryptoassets.

Banks will be required to disclose their holdings of cryptoassets and the main risks related to these exposures. They will need to determine, monitor, and assess compliance on whether a cryptoasset is compliant with the eligibility criteria and classification conditions, verify that stablecoins effectively track the underlying asset, and also demonstrate to supervisors how a cryptoasset fulfils these conditions. 

Cryptoassets (and or stablecoins) which fail to meet any of the eligibility criteria, such as Bitcoin, are deemed more speculative and riskier and banks exposures to them will have a much more conservative capital treatment, i.e. no netting, no eligibility as collateral for credit risk mitigation purposes and a 1250% risk weight to hold these cryptoassets, akin to holding lower quality securisation tranches.

These proposals will likely be finalised in December when the Financial Stability Board (FSB) expects to complete the regulatory framework for global stablecoins. In the EU, these proposals will likely appear as revisions to the CRD/CRR when the EU starts the process of transposing the final Basel III framework after the summer.