The Basel Committee on Banking Supervision has stuck to its guns on the prudential treatment of crypto assets. Unsurprisingly, it has taken a very conservative approach with some banks complaining that it will curb innovation. By Justin Pugsley.
What is happening?
On December 16, the Basel Committee published its ‘sort of’ final report on the prudential treatment of crypto assets. Given the recent volatility in crypto assets and a string of bankruptcies in the sector featuring the exchange FTX, the committee was largely faithful to nearly all its original proposals.
The committee would like jurisdictions to implement these rules by January 1, 2025, but given its mistrust of crypto, it would like that to happen as soon as possible.
Very broadly, the committee has divided crypto assets into two groups, each with two subgroups. Group 1 is for less volatile crypto assets that are either (1a) tokenised traditional assets; or (1b) have effective stabilisation mechanisms. Group 2 assets are classified as either having a (2a) limited degree of permitted hedging; or (2b) where hedging is not recognised.
Safer Group 1 assets, such as fully backed and regulated stablecoins, will be subject to the existing Basel framework. Riskier Group 2 assets come with a 100% charge where hedging is permitted (Group 2a) and a capital charge of 1250% of risk weighted assets where hedging is not recognised (Group 2b).
Bank exposures to Group 2 crypto assets should be limited to 1% of Tier 1 capital. Exposures above the 1% limit will be hit with a Group 2b charge. This was a small victory for banks, as the committee originally wanted to apply the maximum charge to all Group 2 holdings for a threshold breach. However, if Group 2 exposures surpass 2%, then all holdings in that category will be hit with the maximum charge. Some banks had been lobbying for a maximum 5% exposure limit.
The committee will allow exposures to be measured as the higher of the gross long and short position in each crypto asset, rather than the aggregate of the absolute values of long and short exposures. The report also comes with a host of prescriptive measures dealing with redemption risk tests, liquidity, leverage ratios, large exposures and operational risk.
Why is it happening?
It is very clear from their reports and speeches that policy-makers within the Bank for International Settlements take a dim view of crypto assets and decentralised finance. They see it as riddled with flaky governance, fraud, scams, volatility and as too opaque for comfort. They are very wary about traditional banks becoming too deeply embroiled in a sector that has hardly developed a good reputation for financial probity and stability.
What do the bankers say?
Bankers think the committee has been too conservative. They are particularly peeved about the 2.5% infrastructure risk add-on related to the use of distributed ledger technology (DLT). Not only that, but national supervisors will be given leeway to impose extra capital charges if they have reservations over the sturdiness of this tech.
The committee took this approach because it is concerned about the novelty of the technology and that it could lead to unexpected system failures. However, should DLTs prove reliable and robust, there is a chance that this charge could be lifted in time.
Meanwhile, the committee is still pondering the finer details over the treatment of permissionless blockchains for Group 1 assets, appropriate statistical tests to reliably identify low-risk stablecoins and calibration of the Group 2 exposure limit. So, this new chapter to the Basel framework is not yet finished.
Will it provide the incentives?
Data shows that most banks have very limited exposure to crypto beyond possibly holding these assets on behalf of clients as custodians. The confirmation of the committee’s prudential approach will largely keep these exposures small, though the truly determined might gain more exposure through the use of derivatives.
However, as more of the crypto sector comes within the regulatory parameter, there will definitely be more scope for banks to ‘safely’ experiment with crypto and develop exciting new products and drive operational efficiencies.
Sensibly, the committee is taking a ‘better safe than sorry’ approach. It would only take a couple of major banks to fall foul of crypto in a big way to trigger a negative chain reaction across the financial system. Given high inflation, looming recession and geopolitical tensions, the last thing bankers and supervisors need right now is to get caught up in crypto’s all too frequent crises.
