Basel Committee Seeks Public Comments on Prudential Framework for Cryptoassets

On June 10, 2021, the Basel Committee on Banking Supervision (“Basel Committee”) took another step on the road toward the establishment of a global standard for the prudential regulation of cryptoassets by issuing a public consultation titled Prudential Treatment of Cryptoasset Exposures.¹ The document contains a discussion of the major risks presented by cryptoassets and proposes a framework for the prudential regulation of cryptoasset exposures by banking organizations (the “Proposed Framework”), building on the Basel Committee’s 2019 discussion paper and the public comments received on the paper.² The Proposed Framework seeks to ultimately provide legal clarity to banking organizations on regulatory requirements for cryptoasset-related activities and to ensure a level of global consistency for these standards.

To date, the absence of clear bank regulatory standards for cryptoasset-related activities—as well as public skepticism of the legitimacy and future of cryptoassets by some prudential regulators—has slowed the development and offering of cryptoasset services by banking organizations. Hence, the Proposed Framework is a necessary and positive development for banking organizations seeking the legal certainty needed to become active participants in cryptoasset markets. It also signals that global financial regulators increasingly recognize that cryptoassets are likely to be a permanent part of the global financial system going forward and that prudential regulations will need to incorporate their use.

Nevertheless, expectations should remain anchored as there is still significant work to do before such global standards becomes a reality. The Basel Committee stated that the Proposed Framework is likely to be part of an “iterative process, involving more than one consultation,” and, even if the Basel Committee finalizes a global standard, it would still need to be adopted by national prudential regulators.³ Furthermore, the Proposed Framework would impose a 100 percent (or greater) capital charge on the most common cryptoassets (including Bitcoin), which would, if adopted, significantly deter banking organizations from acquiring cryptoasset exposures. At this point, it is difficult to know if the Basel Committee views this capital standard as merely an initial proposal or if the Basel Committee has serious concerns about banking organizations acquiring significant cryptoasset exposures (or both). Either way, the public comments on the Proposed Framework are likely to shape the Basel Committee’s final proposal, especially given the continued rapid development of cryptoasset markets and unique technical issues presented by cryptoassets. The Basel Committee invited all interested parties to submit comments on the Proposed Framework by September 10, 2021.

Parties that potentially could be impacted by the Proposed Framework include:

• Banking organizations that currently are engaged in cryptoassets-related activities or that might do so in the future;
• Non-bank cryptoasset service providers, such as exchanges, that rely on banking organizations for critical financial services (such as fiat currency settlements of cryptocurrency transactions) or that might rely on banking organizations to provide infrastructure services that might one day undergird the existing cryptoassets service providers (similar to how banking organizations provide the foundation on which fiat money service businesses run)—or that might face competition from cryptoasset services offered by banking organizations; and
• Companies that currently (or might in the future) accept or use cryptoassets for payment transactions, or that hold cryptoassets for investment or other purposes (or might do so in the future), and that could rely on banking organizations to support these operations.

It is also important to note that while the Basel Committee excluded central bank digital currencies (“CBDC”) from its Proposed Framework, the US Congress has recently focused its attention on CBDC. This month, both the House Financial Service Committee and the Senate Banking Committee held hearings on the merits of a CBDC.⁴ Further, House Financial Services Committee Chair Maxine Waters has announced the creation of a Digital Assets Working Group of Democratic members of Congress that will work to develop legislation and policy proposals to “ensure there is responsible innovation in the cryptocurrency and digital asset space,” including “cryptocurrency regulation, the use of blockchain and distributed ledger technology, and the possible development of a U.S. [CBDC].”⁵ Partly in response to congressional interest in a CBDC, the Federal Reserve Bank of Boston and MIT established “Project Hamilton,” a collaboration to code and test a hypothetical CBDC.⁶ Project Hamilton plans to release a white paper in the third quarter of 2021 on its work with an open source license to allow the public to test a possible CBDC. Federal Reserve Chair Jay Powell also has stated that the Federal Reserve will issue a discussion paper in the summer of 2021 on the benefits and risks of a CBDC. Accordingly, the second half of 2021 will see further discussion of not only the proper prudential regulation for cryptoasset exposures of banking organizations but also the use of cryptoassets by the US government. How these discussions ultimately play out is still difficult to predict, but it is evident that rapid evolution of cryptoassets will continue to push US and global regulators to assess if and how cryptoassets should be incorporated into financial markets and appropriately regulated.

Below, we provide an overview of the Proposed Framework.

Cryptoassets

The Proposed Framework defines a “cryptoasset” as a digital asset (a private digital representation in value that can be used for payment or investment purposes or to access a good or service) that depends primarily on cryptography and distributed ledger or similar technology.

This definition is intended to encompass a broad range of items, such as dematerialized securities that are issued through distributed ledger technology, decentralized finance instruments, non-fungible tokens, and Bitcoin. Presumably, it also would include substantially similar items, such as Ether and USDC. However, it does not include central bank digital currencies or securities that are held with a central securities depository. Further, the Proposed Framework would not apply to cryptoassets held by a customer, such as cryptoassets that a banking organization holds off-balance sheet in custodial accounts.

The Proposed Framework categorizes cryptoassets into three categories: Group 1a, Group 1b, and Group 2. These categories only apply to cryptoassets that have not been deducted from Common Equity Tier 1 capital (e.g., due to classification of the cryptoasset as an intangible asset). Group 1 cryptoassets are subject to existing requirements regarding the allocation between banking book and trading book and the application of the standardized or internal model-based approaches, though the Basel Committee cautions against the use of the internal-based model approach due to the unique aspects of cryptoassets and, presumably, the lack of historical data.⁸

Group 1a

A Group 1a cryptoasset is a tokenized traditional asset that digitally represents traditional assets through the use of cryptography, distributed ledger technology, or a similar technology. Group 1a cryptoassets do not include cryptoassets that require conversion into traditional assets in order to acquire the same legal right as would be present in direct ownerships of traditional assets.

Group 1b

A Group 1b cryptoasset is a digital representation that seeks to link the value of the cryptoasset to the value of a traditional asset or a pool of traditional assets through a stabilization mechanism. The stabilization mechanism must limit fluctuations in the value of the cryptoasset to not more than 10 basis points of the value of the underlying traditional asset more than three times over a one-year period. The stabilization mechanism must also not reference other cryptoassets or use protocols to increase or decrease the supply of the cryptoasset. Group 1b cryptoassets must be redeemable for the underlying traditional assets (e.g., cash, bonds, commodities, equities).

All rights, obligations and interests arising from Group 1a and Group 1b cryptoasset arrangements must be clearly defined and legally enforceable in jurisdictions where the asset is issued and redeemed. In addition, the applicable legal frameworks must ensure settlement finality, and the functions of the Group 1a or Group 1a cryptoasset and the network on which it operates (including the distributed ledger or similar technology on which it is based) must be designed and operated to sufficiently mitigate and manage any material risks. Entities that execute redemptions, transfers, or settlement finality of the Group 1a or Group 1b cryptoasset must be regulated and supervised.

Group 2

A Group 2 cryptoasset is any cryptoasset other than a Group 1a or Group 1b cryptoasset and includes Bitcoin.

Prudential Regulation

The Proposed Framework is built on the principles that the prudential regulation of cryptoassets should (i) apply the same capital and liquidity requirements to cryptoassets that apply to traditional assets with the equivalent economic functions and risks, (ii) be simple in order to facilitate the evolution of cryptoasset regulation and (iii) constitute a minimum standard, above which jurisdictions could adopt heightened standards. In applying these principles, the Proposed Framework sets forth several proposals for the prudential regulation of cryptoasset exposures.

1. Risk-based Capital Requirements. Cryptoasset exposures would be assigned risk-weights based on the category of the cryptoasset and the nature of the underlying asset, unless the exposures are deducted from capital under the deduction framework (e.g., for assets classified as intangibles).
   • Group 1a. Group 1a cryptoassets would generally have minimum capital requirements equal to the credit and market risks applicable to traditional assets. However, the Basel Committee notes that if the risk characteristics of cryptoassets diverge from those of the traditional asset, then a banking organization would need to apply the appropriate risk standards rather than simply apply the same standards that apply to the traditional asset. Further, the Basel Committee emphasized that cryptoassets would be recognized for collateral only if a banking organization could (i) determine that the volatility in value and holding periods under distressed market conditions were not materially higher than with the traditional asset or (ii) address any material increase through increased “parameters applied for the traditional asset.”
   • Group 1b. The Basel Committee declined to provide specific minimum capital requirements for Group 1b cryptoassets due to the variety of ways that such an asset’s legal rights could differ from the ownership of the traditional asset to which its value is linked. Instead, the Basel Committee provided several examples of how capital requirements would apply to two stylized cryptoasset structures. In general, Group 1b cryptoassets generally would have risk-weights equal to the risk posed by the underlying traditional assets and any risk posed from an intermediary (e.g., redeemer of a stablecoin).
   • Group 2. Group 2 cryptoassets would have a 1250 percent risk-weight, which means that banking organizations would need to hold capital equal to the total amount of the exposure. In practice, this would impose a significant capital charge for any banking organization seeking to hold Bitcoin or similar cryptoassets.
2. Leverage, Large Exposure, and Liquidity Requirements. The Basel Committee did not propose any new provisions for the treatment of cryptoassets under the leverage ratio, large exposures framework, or liquidity ratio requirement. Rather, cryptoassets exposures would be included in a banking organization’s leverage ratio calculation, subject to the large exposure framework (i.e., single-counterparty credit limits), and covered by the liquidity coverage ratio and net stable funding ratio requirements.
3. Risk Management Requirements. Banking organizations would be required to implement appropriate risk management mechanisms for cryptoassets, including identifying and assessing unique risks associated with cryptoassets on an ongoing basis. In particular, the Proposed Framework emphasizes the need for banking organizations to consider and manage risks posed from operational and cyber risks (e.g., cryptographic key theft, compromise of login credentials, and distributed denial-of-service attacks), technology risk (e.g., stability of the digital ledger technology (“DLT”), validating design of the DLT, service accessibility, and trustworthiness of node operators), and money laundering and terror financing risks.
4. Disclosure. Banking organizations would be required to disclose quantitative and qualitative information on cryptoasset exposures in a manner that is consistent with existing Pillar 3 standards. These disclosures would include the business activities related to cryptoassets, the risk management policies governing cryptoassets, and the most significant current and emerging risks related to cryptoassets and how they are managed.
5. Supervisory Add-ons. Banking organizations would be required to comply with other jurisdiction-specific requirements that are identified by national supervisors, such as stress testing or internal limits. In particular, the Basel Committee contemplates that national supervisors would approve each banking organization’s proposed cryptoasset activities and risk management practices.
6. Supervisory “Gold Plating.” National supervisors would be permitted to gold plate the Basel Committee standards, such as by prohibiting the use of internal models to calculate required capital for cryptoasset exposures, requiring longer liquidity horizons to be used for cryptoassets, and measuring basis risk attributable to the differences between traditional assets and cryptoassets.