HomeServicesCompanyInsightsCareersContactE-Banking
The BCBS discussion paper “Designing prudential methods for handling crypto-assets”An appraisal of the BCBS discussion paper Conclusion
Thursday, 16 January, 2020
The Digital Regulator

The Basel Committee: Crypto-asset Regulation

Abstract

The Basel Committee on Banking Supervision (BCBS) issued a discussion paperdiscussion paperlink1 (12 December 2019) on the prudential standard for crypto-assets. The goal of this paper is to discuss the design of a prudential framework. It explains the risks characterising crypto-assets and notes the absence of a one-size-fits-all definition of crypto-assets.

In substance, the Committee believes that the lack of standardisation, the rapid development and the high volatility of crypto-assets justify a conservative global prudential standard. This illustrates for fully decentralised crypto-assets such as bitcoin and ether (80% of crypto-assets market capitalisation), in terms of the harshest possible Pillar 11 minimum capital requirement (as applied to the worst-rated securitisation tranches), borrowing from its 12 March 2019 statement the Pillars 2 and 3 standards applicable to the broader family of crypto-assets.

The forward-looking attitude of the Committee is commendable. In our view however, the initial direction is misguided. Such standards would stifle financial innovation and confine crypto-assets to an unregulated area. The Committee should acknowledge the complexity involved in formulating a standardised Pillar 1 measure of crypto-asset risk which would be both sufficiently accurate as a means to set regulatory capital and adequate to support financial innovation.

A global standard under Pillar 2 would be better suited, in the circumstances, to reconciling sustainable and beneficial financial innovation with an effective control of crypto-asset risks in the banking system. The prudential framework in place for banking book interest rate risk should serve as inspiration.

The BCBS discussion paper “Designing prudential methods for handling crypto-assets”

The Committee methodically analyses the risks incurred by banks when dealing with crypto-assets and highlights the absence of a one-size-fits-all crypto-assets definition. It illustrates target Pillar 1 capital and liquidity requirements for so-called “high-risk” crypto-assets and refers to its March 2019 statement for Pillars 2 and 3 aspects.

Crypto-assets give rise to traditional risks and carry specific risks.

The BCBS explains that banks dealing with crypto-assets incur – in addition to traditional risks including liquidity, credit, market, operational risk, money laundering / terrorist financing,implementation and reputation risks – specific risks driven by whether a conventional legal entity is involved or not when they are issued, the limited versus unlimited population of users, the mechanical or personal validation protocol, the prevailing legal regime and market data transparency.

The Committee adds that banks could be exposed to crypto-assets risk through a number of channels other than outright exposure, such as by issuing and validating crypto-assets, taking long positions in crypto ETFs, financing third-party investments in crypto-assets, lending and taking crypto-assets as collateral, proprietary and clients-based crypto trading, underwriting, custody, exchange and insurance services, using crypto-assets for internal or inter-bank operational processes.

No one-size-fits-all definition of crypto assets

The Committee observes that the currently available definition of crypto-assets – predicated by the general dependency on cryptography and DLT technology and the absence of physicality – is too general for the purpose of determining requirements for specific crypto-assets. The BCBS recognises that certain crypto-assets can serve economic functions similar to existing asset classes (such as mimicking equity or debt instruments) and can source their value in a way similar to traditional asset classes (associated cash flows, value of accessible services) and / or can be supply-constrained. The Committee makes clear that the guiding principle “same activity, same risk, same rule” would be applied.

Highest possible Pillar 1 charge for “high-risk” crypto-assets

The BCBS defines “high-risk” crypto-assets in terms of assets that are digital, do not have intrinsic value, are recorded on DLT, are secured cryptographically and are not traceable to an issuer entity in the conventional or legal sense. Bitcoin, ether and other similar assets (an estimated 80% of the crypto-assets market capitalisation as of end 2019) would be in scope. It proposes capital requirements for banking book exposures in terms of full capital deduction (reflecting a 1,250% risk-weighting factor – the highest possible, currently applied only to the worst externally rated securitisations).

Crypto-asset exposures held in the trading book would equally be most conservatively subject to the equivalent of full deduction treatment for market risk and credit valuation adjustment risk, and exposures bearing residual risks would be subject to the relevant add-on. Banks would not be permitted to use the internally-modelled approaches for any crypto-asset exposures.

Crypto-assets would not be eligible to serve as financial collateral for the purpose of the credit risk mitigation framework and would not be eligible as high-quality liquid assets for the purpose of the Liquidity Coverage Ratio and Net Stable Funding Ratio. Finally, exposure to crypto-assets would be included in the leverage ratio exposure measure and would be subject to the large exposure limits set out in the large exposure framework.

Standard Pillars 2 & 3 requirements

Regarding Pillars 2 and 3, the BCBS refers rather to its statement of March 2019, in which it specified the expectations applicable to banks authorised to acquire crypto-asset exposures or provide related services.

These expectations include: assurance that the bank has the relevant expertise to assess crypto-assets risks; implementation of a robust governance and risk management framework for crypto-assets and integration into the overall risk management processes; disclosure of material crypto-asset exposures or related services as part of its regular financial disclosures; prompt supervisory information about actual and planned crypto-asset exposure or activity.

An appraisal of the BCBS discussion paper

With respect to these preliminary, directional views issued for comment, we believe that a Pillar 1 charge is unsuited, in the circumstances, and that a Pillar 2 approach is a better way to reap the benefits of technological innovation in banking and finance in a regulated and controlled way.

A pillar 1 charge is premature. It would stifle innovation and promote unregulated activities

Crypto-assets are an immature asset class, linked to a developing technology poised to revolutionise banking, finance and the broader economy, and provide undisputed benefits, including enhanced efficiency, market liquidity and risk diversification. The Committee should allow these innovations to thrive in a regulated and risk-controlled environment.

It is premature to anticipate at which pace and with what scope the transformation will unfold. It is also too early to foresee when and in what form there will be sufficient stability and maturity in the crypto-markets to support the introduction of a meaningful formulaic Pillar 1 global prudential banking standard.

The Committee should first achieve a full understanding of the additional risk factors and exposure channels currently associated with crypto-assets and clearly isolate the intrinsic risk carried by crypto-assets from the broad operational risk currently surrounding their development (which in part originates from a currently immature and incomplete market infrastructure).

The Pillar 1 standard as currently illustratively proposed would just prevent banks from participating in the crypto-asset market and from offering services vital for the development of such markets – effectively promoting parallel, unregulated, activities and delaying innovation.

Pillar 2 is preferable. It allows reaping the benefits of technological innovation in a controlled way

During the ongoing rapid and intense development phase of crypto-assets, related activities, markets and infrastructure, it is preferable to leverage a more flexible supervisory review process. This process should be complemented by appropriate supervisory dialogue and cooperation, and by issuing qualitative standards (including for DTT / blockchain) for the digitisation processes. A Pillar 2 approach would make it possible to reconcile the need to be sufficiently conservative with the need to grant flexibility and allow further development.

The prudential framework in place for interest rate risk in the banking book should serve as an inspiration. It formulates clear risk management and governance expectations, a detailed (product-based) risk measurement framework, disclosure requirements. It positions capital adequacy within the context of the internal capital adequacy process; it provides supervisory principles for the identification of outliers (including international cooperation) and a standardised risk measurement framework that could be mandated to banks or offered as an option.

Conclusion

The Committee is considering whether to specify a global prudential standard for banks’ exposure to crypto-assets and if it decides to specify prudential handling of crypto-assets, it would issue a detailed consultation paper.

In our analysis, we have argued that while the forward-looking stance of the BCBS deserves all praise, the preliminary direction offered for comments and heavily biased towards the extremely conservative Pillar 1 capital charges is misguided, would prevent banks from participating in the crypto-asset market and from offering services vital for the development of such markets – effectively promoting parallel, unregulated, activities and delaying innovation as well as related benefits.

In the current circumstances, the BCBS should leverage a more flexible supervisory review process (Pillar 2) – for instance inspired by the current banking book interest rate risk framework – to fulfil its conservative needs, while ensuring the required flexibility and making allowance for further development.


1The Basel prudential framework rests on three pillars: formulaic minimum capital (risk-based and leverage ratio) & liquidity requirements (Pillar 1), supervisory review process (Pillar 2) and disclosure requirement (Pillar 3).
Download pdf
Share:
Subscribe to the research newsletter and get weekly updates about the latest articles of SEBAresearch
Subscribe to newsletter

Authors


Mattia Rattaggi
External Regulatory Analyst
METI Advisory AG
in
Yves Longchamp
Head of Research
SEBA Bank AG
in
research@seba.swiss | Disclaimer

Disclaimer

This document has been prepared by SEBA Bank AG (“SEBA”) in Switzerland. SEBA is a Swiss bank and securities dealer with its head office and legal domicile in Switzerland. It is authorized and regulated by the Swiss Financial Market Supervisory Authority (FINMA). This document is published solely for information purposes; it is not an advertisement nor is it a solicitation or an offer to buy or sell any financial investment or to participate in any particular investment strategy. This document is for distribution only under such circumstances as may be permitted by applicable law. It is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation or would subject SEBA to any registration or licensing requirement within such jurisdiction.

No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness or reliability of the information contained in this document, except with respect to information concerning SEBA. The information is not intended to be a complete statement or summary of the financial investments, markets or developments referred to in the document. SEBA does not undertake to update or keep current the information. Any statements contained in this document attributed to a third party represent SEBA's interpretation of the data, information and/or opinions provided by that third party either publicly or through a subscription service, and such use and interpretation have not been reviewed by the third party.

Any prices stated in this document are for information purposes only and do not represent valuations for individual investments. There is no representation that any transaction can or could have been effected at those prices, and any prices do not necessarily reflect SEBA’s internal books and records or theoretical model-based valuations and may be based on certain assumptions. Different assumptions by SEBA or any other source may yield substantially different results.

Nothing in this document constitutes a representation that any investment strategy or investment is suitable or appropriate to an investor’s individual circumstances or otherwise constitutes a personal recommendation. Investments involve risks, and investors should exercise prudence and their own judgment in making their investment decisions. Financial investments described in the document may not be eligible for sale in all jurisdictions or to certain categories of investors. Certain services and products are subject to legal restrictions and cannot be offered on an unrestricted basis to certain investors. Recipients are therefore asked to consult the restrictions relating to investments, products or services for further information. Furthermore, recipients may consult their legal/tax advisors should they require any clarifications. SEBA and any of its directors or employees may be entitled at any time to hold long or short positions in investments, carry out transactions involving relevant investments in the capacity of principal or agent, or provide any other services or have officers, who serve as directors, either to/for the issuer, the investment itself or to/for any company commercially or financially affiliated to such investment.

At any time, investment decisions (including whether to buy, sell or hold investments) made by SEBA and its employees may differ from or be contrary to the opinions expressed in SEBA research publications.

Some investments may not be readily realizable since the market is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. Investing in digital assets including cryptocurrencies as well as in futures and options is not suitable for every investor as there is a substantial risk of loss, and losses in excess of an initial investment may under certain circumstances occur. The value of any investment or income may go down as well as up, and investors may not get back the full amount invested. Past performance of an investment is no guarantee for its future performance. Additional information will be made available upon request. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in foreign exchange rates may have an adverse effect on the price, value or income of an investment. Tax treatment depends on the individual circumstances and may be subject to change in the future.

SEBA does not provide legal or tax advice and makes no representations as to the tax treatment of assets or the investment returns thereon both in general or with reference to specific investor’s circumstances and needs. We are of necessity unable to take into account the particular investment objectives, financial situation and needs of individual investors and we would recommend that you take financial and/or tax advice as to the implications (including tax) prior to investing. Neither SEBA nor any of its directors, employees or agents accepts any liability for any loss (including investment loss) or damage arising out of the use of all or any of the Information provided in the document.

This document may not be reproduced or copies circulated without prior authority of SEBA. Unless otherwise agreed in writing SEBA expressly prohibits the distribution and transfer of this document to third parties for any reason. SEBA accepts no liability whatsoever for any claims or lawsuits from any third parties arising from the use or distribution of this document.

Research will initiate, update and cease coverage solely at the discretion of SEBA. The information contained in this document is based on numerous assumptions. Different assumptions could result in materially different results. SEBA may use research input provided by analysts employed by its affiliate B&B Analytics Private Limited, Mumbai. The analyst(s) responsible for the preparation of this document may interact with trading desk personnel, sales personnel and other parties for the purpose of gathering, applying and interpreting market information The compensation of the analyst who prepared this document is determined exclusively by SEBA.

Austria: SEBA is not licensed to conduct banking and financial activities in Austria nor is SEBA supervised by the Austrian Financial Market Authority (Finanzmarktaufsicht), to which this document has not been submitted for approval. France: SEBA is not licensed to conduct banking and financial activities in France nor is SEBA supervised by French banking and financial authorities. Italy: SEBA is not licensed to conduct banking and financial activities in Italy nor is SEBA supervised by the Bank of Italy (Banca d’Italia) and the Italian Financial Markets Supervisory Authority (CONSOB - Commissione Nazionale per le Società e la Borsa), to which this document has not been submitted for approval. Germany: SEBA is not licensed to conduct banking and financial activities in Germany nor is SEBA supervised by the German Federal Financial Services Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht), to which this document has not been submitted for approval. Hong-Kong: SEBA is not licensed to conduct banking and financial activities in Hong-Kong nor is SEBA supervised by banking and financial authorities in Hong-Kong, to which this document has not been submitted for approval. This document is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in Hong-Kong where such distribution, publication, availability or use would be contrary to law or regulation or would subject SEBA to any registration or licensing requirement within such jurisdiction. This document is under no circumstances directed to, or intended for distribution, publication to or use by, persons who are not “professional investors” within the meaning of the Securities and Futures Ordinance (Chapter 571 of the Laws of Hong Kong) and any rules made thereunder (the “SFO”). Netherlands: This publication has been produced by SEBA, which is not authorised to provide regulated services in the Netherlands. Portugal: SEBA is not licensed to conduct banking and financial activities in Portugal nor is SEBA supervised by the Portuguese regulators Bank of Portugal “Banco de Portugal” and Portuguese Securities Exchange Commission “Comissao do Mercado de Valores Mobiliarios”. Singapore: SEBA is not licensed to conduct banking and financial activities in SIngapore nor is SEBA supervised by banking and financial authorities in Singapore, to which this document has not been submitted for approval. This document was provided to you as a result of a request received by SEBA from you and/or persons entitled to make the request on your behalf. Should you have received the document erroneously, SEBA asks that you kindly destroy/delete it and inform SEBA immediately. This document is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in Singapore where such distribution, publication, availability or use would be contrary to law or regulation or would subject SEBA to any registration or licensing requirement within such jurisdiction. This document is under no circumstances directed to, or intended for distribution, publication to or use by, persons who are not accredited investors, expert investors or institutional investors as defined in section 4A of the Securities and Futures Act (Cap. 289 of Singapore) (“SFA”). UK: This document has been prepared by SEBA Bank AG (“SEBA”) in Switzerland. SEBA is a Swiss bank and securities dealer with its head office and legal domicile in Switzerland. It is authorized and regulated by the Swiss Financial Market Supervisory Authority (FINMA). This document is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product.

SEBA is not an authorised person for purposes of the Financial Services and Markets Act (FSMA), and accordingly, any information if deemed a financial promotion is provided only to persons in the UK reasonably believed to be of a kind to whom promotions may be communicated by an unauthorised person pursuant to an exemption under the FSMA (Financial Promotion) Order 2005 (the “FPO”). Such persons include: (a) persons having professional experience in matters relating to investments (“Investment Professionals”) and (b) high net worth bodies corporate, partnerships, unincorporated associations, trusts, etc. falling within Article 49 of the FPO (“High Net Worth Businesses”). High Net Worth Businesses include: (i) a corporation which has called-up share capital or net assets of at least £5 million or is a member of a group in which includes a company with called-up share capital or net assets of at least £5 million (but where the corporation has more than 20 shareholders or it is a subsidiary of a company with more than 20 shareholders, the £5 million share capital / net assets requirement is reduced to £500,000); (ii) a partnership or unincorporated association with net assets of at least £5 million and (iii) a trustee of a trust which has had gross assets (i.e. total assets held before deduction of any liabilities) of at least £10 million at any time within the year preceding the promotion. Any financial promotion information is available only to such persons, and persons of any other description in the UK may not rely on the information in it. Most of the protections provided by the UK regulatory system, and compensation under the UK Financial Services Compensation Scheme, will not be available.

© SEBA / Grafenauweg 6, 6300 Zug, Switzerland

Research

more
Research report
Bitcoin, gold, and coronavirus
03 April, 2020
Does bitcoin as outside money stand a chance to weather the coronavirus storm? In this article, we present the empirical analyses of various crises and bitcoin bottoms.
Read more
Research report
Bitcoin is dead, long live Bitcoin
22 March, 2020
In this special edition of the Digital Investor, we present our take on the recent crash in financial markets. As the Coronavirus took the entire world by storm, financial markets across the board started tumbling in synchronisation. Amidst this crash, all the correlation theories seemed to be breaking down. Does this mean that digital assets will forever be correlated with broader markets? What happens in this new regime of zero interest rates? We think that in such an environment, cryptocurrencies, as outside money, can prove to be a much needed diversifier.
Read more
Research report
Forks: A double-edged sword
19 March, 2020
The Bridge is a publication designed to explain the key concepts behind blockchain and crypto-currencies. If you are unfamiliar with forks, this article is made for you. A fork is the action uses to change the rules that govern a blockchain ecosystem. What are the different types of forks? How do they impact different stakeholders in a blockchain ecosystem? We explain all of this in the March edition of the bridge.
Read more

Join us as we redefine finance.

Contact us
seba

SEBA Bank AG
Kolinplatz 15
6300 Zug
Switzerland

ServicesCompanyNews & InsightsCareersContact
Receive the newest insights, research and news from SEBA directly to your inbox
Newsletter subscription
© 2020 SEBA Bank AG