BCBS consults on draft standards for the prudential treatment of cryptoasset exposures

https://www.linklaters.com/en/insights/blogs/fintechlinks/2022/july/bcbs-consults-on-draft-standards-for-the-prudential-treatment-of-cryptoasset-exposures
https://lpscdn.linklaters.com/-/media/digital-marketing-image-library/images/03_sectors/fintech/thumbnail_700x300/fintech_thumbnail_blockchain_fintechlinks_700x300.ashx?rev=db5d69b9-152f-442e-9e3b-126c162def6d#

Following an initial consultation last summer, the Basel Committee on Banking Supervision (BCBS) has published draft international standards for the prudential treatment of cryptoassets. These standards go well beyond the treatment of unbacked cryptoassets like Bitcoin, and could potentially determine the economic viability of a broad range of digitalisation projects. The BCBS has been receptive to some concerns raised by the financial industry in response to its initial consultation. It has also tightened and clarified its initial proposals in a number of areas. Stakeholders have until 30 September 2022 to respond.

A second consultation

Last June, the Basel Committee on Banking Supervision (BCBS) published a proposed framework for the prudential classification and treatment of “cryptoassets” by prudentially regulated firms. The term “cryptoassets” was defined in broad terms, as “private digital assets that depend primarily on cryptography and distributed ledger or similar technology”. Currently, there is a substantial degree uncertainty and international divergence around how prudential standards apply in this area. As a result, the BCBS’s efforts have largely been welcomed by the financial industry.

At the same time, some of the specific features of the proposed framework were cause for concern. In particular, the proposals were criticised for unjustifiably treating a wide spectrum of different arrangements as equivalent from a risk perspective, while continuing to leave considerable room for uncertainty (see our previous publication). A widely supported joint industry response noted that the framework “would create material impediments to regulated bank participation in cryptoasset markets”.

The BCBS has now published its second consultation paper, which sets out the full text of the proposed standards, for incorporation into the consolidated Basel Framework. The draft reflects various changes to the initial proposal, a number of which respond to industry concerns.

Key changes

The key changes to the initial proposal are outlined below:

  • Refinement of classifications conditions

    The proposed framework continues to distinguish between “Group 1” cryptoassets which meet certain classification conditions and “Group 2” cryptoassets, which do not. Group 1 comprises both Group 1a (tokenised traditional assets) and Group 1b (cryptoassets with effective stabilisation mechanisms). The capital treatment for Group 1 cryptoassets will generally be based on the existing Basel Framework (subject to certain add-ons), whereas Group 2 will be subject to a punitive 1250% risk weighting and an aggregate exposure limit (as discussed below). The framing of the conditions therefore has a fundamental bearing on how the framework will apply. The conditions initially proposed were broadly criticised both for lack of clarity and for setting the bar for Group 1 inappropriately high. The BCBS has revised the conditions in response to those concerns and invited feedback on the revisions. Among other things, the BCBS is considering whether qualification as a Group 1b cryptoasset should require satisfaction of a “redemption risk test” and a “basis risk test” or, instead, an issuer which itself is prudentially regulated.
  • Infrastructure risk add-on for Group 1 cryptoassets

    The BCBS is now proposing to introduce an “infrastructure risk add-on” to address the unforeseen risks associated with distributed ledger technology, given its relative novelty. This would apply to Group 1 cryptoassets. Precisely where the boundary would fall in relation to applications of DLT by centralised market infrastructures is not clear. The proposal says that dematerialised securities which are issued through DLT or similar technologies are considered to fall within scope whereas “dematerialised securities that use electronic versions of traditional registers and databases which are centrally administered” fall out of scope. Hybrid structures are not discussed.

    The proposed calibration of the add-on is 2.5% of the exposure value. For exposures in the banking book, this is equivalent to increasing the risk weight that would apply to the exposures by 2.5%. For exposures in the trading book, this is equivalent to a market risk capital charge of 0.2% of the exposures.

  • Recognition of hedging of certain Group 2 cryptoassets

    The BCBS has conceded that Group 2 cryptoassets which meet a specific set of “hedging recognition criteria” should be allowed to benefit from modified versions of the market risk requirements which allow a limited degree of hedge recognition in the calculation of a bank’s net exposure. This is in direct response to industry feedback that certain unbacked cryptoassets in which there is a highly liquid and transparent two-way market (such as BTC and ETH) can be hedged effectively, including with related derivatives or exchange traded products.
  • Removal of account classification link

    Under the revised proposal, the capital requirements that apply to cryptoassets are no longer linked to their classification as tangible or intangible assets under the accounting standards. This is intended to address concerns that linking capital treatment to an evolving accounting framework could lead to uncertainties and inconsistencies between jurisdictions.

  • Operational risk clarifications

    The revised proposal provides more detail on how the risks relating to cryptoasset activities can be mapped to the different risk categories of the Basel capital framework (notably, credit risk, market risk and operational risk). It also outlines how banks can address operational risks through their risk management processes and the supervisory review process.

  • Detail on application of liquidity rules

    The draft framework now includes more detail on the application of the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). The draft clarifies, for example, that a tokenised version of an asset that qualifies as a high quality liquid asset (HQLA) will be considered HQLA only to the extent the tokenised form of the asset also meets the HQLA criteria. The draft also clarifies the liquidity treatment in relation to crypto-liabilities (i.e. cryptoassets issued by the relevant bank).

  • Group 2 exposure limit

    The existing Basel Framework includes limits on large exposures to particular counterparties. However, these rules were not designed for an environment in which there may be no counterparty (as is the case for certain cryptoassets). BCBS is therefore proposing a new exposure limit to apply to all Group 2 cryptoassets which fall outside the existing large exposure rules. The provisional limit (to be reviewed periodically) is proposed to be set at 1% of Tier 1 capital. This would apply to gross exposures (with no netting or recognition or diversification benefits) and would include both direct and indirect exposures.

Feedback

Once finalised, the BCBS framework will serve as a minimum international standard for the prudential treatment of cryptoasset exposures. Its precise formulation could have a significant impact on the economic viability of a wide range of cryptoasset and DLT projects by prudentially regulated firms. Much is likely to turn on the detail. Stakeholders have until 30 September 2022 to respond.

https://www.linklaters.com/en/insights/blogs/fintechlinks/2022/july/bcbs-consults-on-draft-standards-for-the-prudential-treatment-of-cryptoasset-exposures