Following a second consultation last summer, the Basel Committee on Banking Supervision (BCBS) has now finalised its prudential standard on cryptoasset exposures. Some key concessions have been made, notably in relation to the proposed infrastructure risk add-on for Group 1 cryptoassets. However, the final framework remains conservative, particularly in relation to unbacked cryptoassets, which is perhaps no surprise given recent events. Member governments have committed to national implementation by 1 January 2025.
A new global standard
Just as many of us started to wind down for the festive period, the BCBS released its final standard on the prudential treatment of cryptoasset exposures. Once implemented, this will have direct implications for a broad range of digital asset arrangements entered into by banks across the globe. It could also influence prudential requirements for other types of institution.
The standard has been a long time coming, and follows two in-depth consultations, as summarised in our recent webinar and blogpost. However, the timing has turned out to be particularly apt, falling amid the so-called “crypto winter”. Recent events in the crypto sector have strongly fuelled debate around the need for further regulation and global standards, including to limit potential contagion effects and financial stability risks, as prudential regulation is designed to do.
The BCBS has made a few significant changes in response to industry feedback.
Most notably, its proposed capital add-on for DLT infrastructure risks will no longer apply by default. The Committee had previously suggested that tokenised traditional assets and stablecoins, in each case which met the onerous classification conditions for (preferential) “Group 1” treatment, should automatically be subject to an additional fixed 2.5% infrastructure capital add-on, due to their use of novel technologies. This prompted strong industry pushback, in particular to the prospect of creating an uneven playing field and undermining the economic viability of innovations designed to improve efficiencies and reduce risks in the financial markets.
The final standard retains the ability for authorities to impose an infrastructure risk add-on for specific projects, based on observed weaknesses. However, the reversal of the presumption of additional risk as well as the increased flexibility for national authorities will generally be seen as a big win for financial market innovators.
Another notable relaxation relates to the quantitative test that stablecoins must meet in order to qualify for Group 1. The second consultation proposed a two-part test, covering redemption risk (i.e. the risk of the asset reserve falling short of the amount needed to meet redemption requests) and basis risk (i.e. the risk of the stablecoin’s market value falling relative to the asset by reference to which it is stabilised). The final standard has dropped the basis risk element. However, this has gone hand in hand with a new requirement for the stablecoin to be issued by a prudentially regulated entity, as well as some bolstering of the redemption risk test.
Notwithstanding the concessions, the framework remains highly conservative, both in relation to the treatment of Group 2 cryptoassets, i.e. all those that do not meet the classification conditions for Group 1, and in relation to the strictness of the classification conditions for Group 1.
Regarding Group 2, the punitive 1250% risk weight continues to apply, subject to modification for cryptoassets that meet the hedging recognition criteria proposed in the last consultation. There also remains a tight cap on aggregate exposures to Group 2 cryptoassets. This continues to be set at 1% of Tier 1 capital, although some favourable measures have been introduced:
- to ensure banks that take steps to hedge exposures are not penalised under the limit (with exposures now measured as the higher of the gross long and gross short position in each cryptoasset, rather than the aggregate of the absolute values of long and short exposures, as previously proposed); and
- to mitigate the cliff effects of exceeding this 1% threshold (with Group 2b capital treatment applying only to the amount by which the limit is exceeded, rather than to all Group 2 exposures, provided that a higher threshold of 2% is not exceeded).
Tough standards in relation to unbacked cryptoassets are perhaps not surprising in light of recent events. However, it remains to be seen precisely what impact this will have on banks considering entering the crypto markets, including in relation to those Group 2 cryptoassets that will benefit from hedging recognition.
In relation to the classification conditions for Group 1, the BCBS has helpfully removed the requirement for satisfaction of these conditions to be pre-approved by a regulatory supervisor. However, the conditions themselves remain complex and onerous and are likely to rule out certain deployments and business models, as we have previously discussed. In particular, the BCBS has acknowledged that public DLT arrangements will struggle to meet the conditions and, more generally, it is unclear how strictly the classification conditions will be interpreted.
The final standard will soon be incorporated into the consolidated Basel Framework.
Authorities from BCBS members have agreed to implement the standard by 1 January 2025. The BCBS standard is a minimum standard so there is likely to be some degree of divergence in implementation.
The BCBS plans to monitor implementation and issue additional refinements over time. It has flagged up front that it will, in particular, be considering:
- the introduction of new quantitative tests to distinguish stablecoins suitable for Group 1 qualification;
- whether deployments on permissionless blockchains should be capable of qualifying for Group 1 treatment (the current standard appears to rule these out on a blanket basis);
- whether Group 1b cryptoassets (i.e. stablecoins) should be capable of qualifying as eligible collateral for credit risk mitigation purposes (the current standard reserves this status for Group 1a, i.e. tokenised traditional assets);
- the criteria and application of hedging recognition criteria for Group 2 cryptoassets; and
- the thresholds in relation to the exposure limit on Group 2 cryptoassets,
all of which could have significant implications going forward.