Can BIS develop a cryptoasset regulatory framework without limiting the innovation process?

Can BIS develop a cryptoasset regulatory framework without limiting the innovation process?

Fri 14 Oct 2022

In summer 2022, the Bank for International Settlements (BIS) published its second consultation paper on the prudential treatment of cryptoasset exposures. The guidelines outlined in the proposed document follow an initial discussion paper released in 2019 and a first consultative document issued in 2021. The complete text is set up as a new standard to be added in the form of a new chapter of the consolidated Basel Framework SCO60: Cryptoasset Exposures.

However, although the regulator has incorporated the input received during the public comment phase of the first consultation, the initial media response from the wider “crypto” industry to the second document was adverse. A closer look at crypoasset classification, risk assessments and capital requirements give some clues as to what the framework would look like.

Classification and risk test criteria

Group 1 cryptoassets fully meet a set of classification conditions and include Group 1a tokenised traditional assets and Group 1b assets with stabilisation mechanisms. Assets in Group 1a are digital representations of traditional assets using cryptography, DLT or similar technology to record ownership. They shall offer the same level of legal rights as ownership of the traditional assets and will hold no feature that could prevent obligations to the bank from being paid in full. Also, such assets will pose the same level of credit and market risk as the traditional form of the asset, and no additional counterparty credit risk should exist when compared to their non-tokenised version. To fit in Group 1b, the assets must have a stabilisation mechanism that is effective at all times in linking their value to a traditional asset or a pool of traditional assets.

The 2022 consultation document introduced two new risk tests for Group 1b. First, a redemption risk test focusing on the sufficiency of the reserves and their management. Secondly, a basis risk test on the correlation between the stablecoins’ value and the peg value. Additional risk-weighted asset (RWA) adjustment will be calculated when assets from Group 1b do not fully pass the basis risk test. The test is considered not fully passed when the peg-to-market value difference exceeds 10bp more than three times in the prior 12 months but does not exceed 20bp more than ten times in the same period.

All Group 1 assets must comply with properly documented arrangements and ensure full transferability, settlement finality and redeemability within five calendar days of request for Group 1b. Material risks must always be sufficiently mitigated and managed for the cryptoassets and the network on which they operate. Also, the cryptoassets service providers (CASPs) should be regulated and supervised or subject to appropriate risk management standards.

Banks are responsible for assessing compliance with the above conditions and demonstrating it to the supervisors.

Classification conditions for Group 2 cryptoassets

Group 2 are cryptoassets that fail to meet the classification conditions listed above and, similar to Group 1, will be divided into two subgroups. For Group 2a, the regulator suggests a split based on added hedging recognition criteria. For the bank’s cryptoasset exposure to be considered Group 2a, it should be: 

  • a direct holding of a spot Group 2, where a derivative or exchange traded funds (ETF)/exchange traded notes (ETN) exist
  • a cash-settled derivate or ETF/ETN referencing a Group 2 cryptoasset
  • a cash settled derivative or ETF/ETN referencing another derivative or ETF/ETN
  • A cash-settled derivative or ETF/ETN referencing a cryptoasset-related reference rate published by a regulated exchange

All of these must be traded on a regulated exchange, be explicitly approved by a market regulator for trading, or cleared by a qualifying central counterparty (QCCP). In addition, the bank’s exposure must be considered highly liquid and sufficient data shall be available over the past 12 months.

Group 2b cryptoassets do not meet the above hedging recognition criteria and are subject to a conservative treatment not permitting hedging recognition. Unless meeting the hedging conditions is demonstrated to the supervisor by the bank, Group 2 cryptoassets will be considered Group 2b.

Allocation to banking or trading book?

When determining whether to allocate cryptoassets to the banking or the trading book, RBC25 should be considered. The boundary criteria of the non-tokenised equivalent traditional assets for Group 1a and the reference assets for Group 1b should be used when determining if a Group 1 cryptoasset is to be assigned to the banking or trading book. Group 2a should be treated according to the proposed market risk rules, similar to FX and commodities risk, while Group 2b should receive the standardised conservative prudential treatment.

Group 1 capital requirement recommendations

When determining credit risk, cryptoassets shall be subject to the rules set out in the credit risk standard (CRE). The consultation document suggests that tokenised traditional assets are subject to the same rules determining credit risk-weighted assets (RWA) as non-tokenised traditional assets. For assets with stabilisation mechanisms, the banks must analyse the specific structure of the security, identify all possible exposures, and capitalise each credit risk separately. While Group 1a assets may be recognised as collateral after banks analyse their liquidation time period and the depth of the market liquidity in downturn, Group 1b are never eligible collateral for purposes of recognition as credit risk mitigation. This is because the redemption process may introduce additional counterparty risk not present in a direct exposure to a traditional asset. Also, if Group 1b faces the risk of default of the redeemer, the securities become worthless.

The calculation of capital requirements for the market risk of Group 1 cryptoassets shall be performed according to the procedures described in MAR40 for the simplified standardised approach (SSA).  When the standard approach (SA) is applied, MAR20MAR23 should be followed, and the cryptoassets must be mapped to the current risk classes set out in the sensitivities-based method. The internal models approach (IMA) is also allowed, and MAR30MAR33 must be followed.

Noting its concerns that the distributed ledger technology (DLT) infrastructure is still evolving and may pose unforeseen risks, the Committee proposes that banks increase their total RWA for Group 1 cryptoassets by 2.5% of the exposure value. This will not apply to assets backed by a central bank or sovereign entity.

Capital requirement permissions and treatments for Group 2 cryptoassets

The internal model approach is not permitted at all for Group 2 cryptoassets, and there is a different treatment for the two subgroups. For Group 2a, modified versions of the SSA (MAR 40) and SA (MAR20-MAR23), which permit a limited degree of hedge recognition in calculating the bank’s net exposure, shall be followed. These modified approaches retain a conservative 100% capital surcharge but permit, to a limited extent, the recognition of hedging of banks’ long and short exposures. For derivatives from Group 2a, a modified version of the standardised approach to counterparty credit risk is allowed. Overall, the altered standards in the consultation document define the appearance of a separate risk class which is tailored to a list of specifications for both SSA and SA.

For Group 2b cryptoassets, there is no separate trading and banking book treatment and the conservative treatment intended to capture both credit and market risk should be used.  For Group 2b funds of cryptoassets, equity investments, derivatives, or short positions in any of these, the RWA calculated under the conservative approach should be reported as part of the bank’s credit RWA.  The committee suggests a risk weight of 1250% to the greater of the absolute value of the aggregate long positions and the absolute value of the aggregate short positions in the cryptoasset. The suggested number is certainly not conducive to banks’ engagement with cryptoassets from Group 2b. However, the Committee proposes to permit banks to screen Group 2 cryptoassets against the hedging recognition criteria listed in the classification paragraphs for Group 2a above.

Additional requirements and goals

Banks are expected to apply a limit to their aggregate exposures to Group 2 direct and indirect cryptoasset holdings of 1% of their Tier 1 capital at all times. The goal here is to impose limits to exposures of cryptoassets where there is no counterparty – like Bitcoin. This requirement will be reviewed periodically and revised in the process of market development.

The capital requirements described above do not depend on categorising cryptoassets as either tangible or intangible under accounting standards. Hence there are no uncertainties in the prudential treatment and the potential for inconsistent treatments across banks and jurisdictions. In addition, the legislative document outlines disclosure requirements for the banks and a clearer description and division between operational risks and market and credit risks of crypto exposures.

The revised text defines risk management and supervisory review for the banks, as well as liquidity and debt requirements. Further details and a more extensive treatment of the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) have been presented. The LCR and NSFR treatment of cryptoassets and crypto liabilities shall depend on whether they are Group 1a tokenised claims on a bank, or Group 1b and Group 2 stablecoins which meet all Group 1 classification conditions apart from the basis risk test and being redeemable at all times, or other cryptoassets. The treatment for Group 1a under the LCR and NSFR, including their eligibility for high-quality liquid assets (HQLA), will be the same as the equivalent non-tokenised traditional assets.

What’s next?

The consultation period for responses ended on 30 September 2022, and the Basel committee intends to publish final standards before year-end. While the regulatory text noted that the field is developing and changes will be considered in future reviews, the industry is still looking for a framework to optimise regulatory supervision without limiting the innovation process. Time will show if this can be accomplished.