The Basel Framework is the global prudential regulatory framework applicable to banks that the Basel Committee on Banking Supervision (BCBS) has been developing since 1975. Since 2019, the BCBS has been working to include banks' crypto asset exposure and respective guidelines in the Basel Framework.
The triggers were the relative growth of crypto markets and the emergence of jurisdictions, such as Switzerland, characterised by initial exposures of banks to crypto assets and related service providers. The BCBS issued a first consultative document on the prudential treatment of banks’ crypto asset exposures in 2021, and a second one on 30 June 2022, which is in consultation until 30 September 2022. In what follows, we review the work done so far by the BCBS to include crypto asset exposures in the Basel Framework.
The Basel Framework and it's elements
As a way of introduction, the Basel Framework consists of the three pillars and some other elements. The three pillars in turn are made up of:
- Formulaic, risk-based minimum capital requirements for market, credit, and operational risks (according to a menu of approaches), and a leverage ratio (as a backstop to risk-based capital requirements).
- Supervisory review process, covering risk management and supervision, driving supplemental (capital) requirements and expectations regarding the management of interest rate risk in the banking book.
- Disclosure requirement, meant to foster market discipline.
Further the other elements consist of definitions of capital, formulaic liquidity standards (liquidity coverage ratio [LCR] and a longer-term net stable funding ratio [NSFR]), large exposure limits, and core principles for banking supervision.
BCBS tackles cryptocurrencies for the first time
On 13 March 2019, the BCBS issued a newsletter in which it anticipated the continued growth of crypto assets and the possibility that this development could increase the risks faced by banks, including those related to liquidity, credit, market, operational, money laundering, terrorist financing, legal, and reputation. The Committee formulated the expectation that banks authorised to acquire crypto asset exposures, or provide related services, should, at a minimum:
- Perform proper due diligence of exposures to crypto assets related to the mentioned risks.
- Adapt their governance, risk management, capital, and liquidity adequacy systems to ensure their robustness in view of the enhanced risks.
- Enhance transparency and disclosure.
- Foster an appropriate supervisory dialogue about these new exposures.
From the perspective of the Basel Framework, the expectations laid out in the newsletter relate to pillars 2 and 3. The Committee refrained from formulating pillar 1 capital and liquidity charges for crypto asset exposures, and from commenting on other elements such as leverage ratio, large exposures, and liquidity provisions.
First discussion paper
Furthermore building on the analyses and concepts proposed in the newsletter, on 12 December 2019 the BCBS issued a discussion paper on designing a prudential treatment for crypto assets, with the goal to engage with the industry in including banks’ crypto asset exposures in the Basel Framework. The view taken by the Committee was that the lack of standardisation, rapid growth, and high volatility of crypto assets justify a conservative global prudential standard. The key innovation was the formulation of a pillar 1 capital charge for exposures to crypto assets considered high risk, and setting it at the most possible conservative level.
The BCBS defined a category of "high-risk" crypto assets in terms of assets recorded on a distributed ledger technology (DLT), secured cryptographically, not issued by a jurisdictional authority of another identified issuer, having no intrinsic value, nor linked to or backed by assets with intrinsic value, and the holding of such assets not giving rise to contractual obligations between the holder and an identified issuer.
The BCBS identified Bitcoin (BTC) and Ethereum (ETH) as such assets, which constituted over 80% of the market capitalisation of crypto assets in 2019. The committee recognised the emergence of other types of crypto assets such as tokenised assets or stablecoins, but took the view that these other crypto assets warrant further assessment before specifying a prudential treatment.
Asset class of the highest risk
The Committee proposed to apply the harshest possible pillar 1 minimum capital requirement to banks’ exposures to such high risk crypto assets. This is done by applying a 1.250% risk-weight factor to the standard 8% of the original exposure. Holding USD 100 equivalent of bitcoin on the banking book would attract (100*8)/100)*(1,250/100), that is, USD 100 of core capital. This is the highest possible capital charge in traditional finance, and applied only to the worst externally rated securitisations. The holding of such exposure on the trading book would equally be most conservatively subject to the equivalent of full deduction treatment for market risk and credit valuation adjustment (CVA) risk, whilst exposures bearing residual risks would be subject to a relevant add-on.
Banks would not be permitted to use 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, or as high-quality liquid assets (HQLA) for the purpose of the LCR and NSFR. Exposures to crypto assets would be included in the leverage ratio calculation, and subject to the large exposure limits. The Committee referred to the expectations formulated in the march 2019 newsletter as far as the provisions of pillars 2 and 3 are concerned.
More precise classifications by the BCBS
On 10 June 2021, the BCBS issued for consultation the document "Prudential treatment of crypto asset exposures". The key innovation was the specification of various types and categories of crypto assets, beyond the high-risk or not-high-risk categories. The key continuity was the maintenance of the highest possible capital charge for banks’ exposures to crypto assets others than tokenised traditional assets and non-algorithmic stablecoins. Three groups of crypto assets were defined and the committee introduced the following categories:
- Group 1a: tokenised traditional assets
- Group 1b: non-algorithmic stablecoins
- Group 2: crypto assets
The committee proposed pillar 1 formulaic minimum capital charges against market and credit risk raised by exposures to each group, and specified qualifying conditions:
- Group 1a: The capital charge should be at least equivalent to those of the underlying traditional assets. The categorisation into group 1a would be subject to a set of specific conditions that the cryptoa sset must always meet cumulatively.
- Group 1b: There would be a new, dedicated pillar 1 guidance. Non-algorithmic stablecoins would only qualify for inclusion in group 1 crypto assets if they are redeemable for their underlying assets.
- Group 2: The capital charge would be calculated by applying a 1.250% risk weight to the standard 8% of the original exposure (see above). The risk-weighted assets would be calculated for each group 2 crypto asset separately. The risk weight would apply to the greater value between the absolute value of the aggregated long positions and the absolute value of the aggregated short positions.
There would be no distinction between banking and trading book positions. The proposed treatment would capture both credit and market risks, and the CVA risk. The BCBS also specified rules to calculate counterparty credit risks (CCR) for derivative exposures having group 2 crypto assets as underlying assets, and proposed rules for securities financing transactions and margin loans involving these crypto assets.
Second consultation document
On 30 June 2022, the BCBS published the "Second consultation on the prudential treatment of crypto asset exposures". The consultation paper amends and complements the first consultation document on several scores, whilst retaining the structure in "Groups", and proposes for the first time specific standards text for inclusion in the Basel Framework. On balance, the complexity of the regulatory framework increases whilst the rules become more conservative. Key amendments and complements to the June 2021 document include:
- Qualifying conditions for group 1: The committee solicits industry feedback on any modifications to the classification conditions that would be required to permit the inclusion in group 1 of crypto assets that use permissionless blockchains, and on the risk and ways to mitigate it that such modifications would raise.
- Qualifying conditions for group 1b: The document proposes to refine the categorisation conditions driving the inclusion of stablecoins in group 1b.
- Stablecoins would qualify for inclusion in group 1b only if they meet a redemption risk test (demonstrating that the reserve assets are sufficient to enable the crypto assets to be always redeemable) and basis risk test (aimed to ensure that the holder of a crypto asset can sell it in the market for an amount that closely tracks the peg value).
Crypto assets that meet all the classification conditions for inclusion in group 1b, but only narrowly pass the basis risk test, would be subject to an add-on to risk-weighted assets.
The BCBS recognises that banks’ exposures to stablecoins issued by regulated entities would generally be lower risk than those issued by unregulated entities, and should be subject to a capital treatment alternative to the one specified in terms of redemption and basis risk tests. The Committee proposes to calculate the capital charges for Group 1 crypto assets market risk according to three methodologies. Simplified they are Standardised Approach (SSA), Standard Approach (SA), and banks’ Internal Models.
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More refined guidelines
The capital charge for operational risk raised by crypto asset activities is calculated by following the SA – an income-based approach already in use for exposures to traditional assets. The Committee has updated the proposal relating to operational risk and resilience to provide a clearer delineation between risks that would be covered by the operational risk framework versus those that should be captured in credit and market risk frameworks. It has also ventured into proposing how banks’ risk management processes can address operational risks relating to crypto assets and how the supervisory review process can ensure that banks appropriately capture crypto asset risk.
The Committee has also elaborated the LCR and NSFR rules, making the approach more comprehensive and consistent, depending on whether crypto holdings are Group 1a (tokenised claim on banks), Group 1b (stablecoins), or Group 2 (other crypto assets). To a limited extent, Group 1a crypto assets may be considered as HQLA.
Conclusion
The BCBS has been working since 2019 to include banks’ crypto asset exposures in the Basel Framework, showing its belief in the ineluctability of crypto assets and considerable pragmatism in including in the evolving framework new forms of crypto assets such as DeFi assets and stablecoins. The result is a complex rulebook that has become more conservative over time. It is aimed to bring, to the maximum extent, crypto assets under the paradigm, and calculating approaches applicable to traditional assets. That to make the riskiness of crypto assets ultimately a function of the existence of a direct or indirect link of the crypto asset to traditional assets and related identifiable (central) issuer or intermediary and risk profile.
Once the BCBS fully appreciates that the value of the crypto assets – certainly for those "unbacked" crypto assets – derives from the value of the functionality or protocol they carry, in turn determining their demand or usage, it may have to revisit and amend the crypto asset exposures provision of the agreed Basel Framework, and also distinguish layer 1/layer 2 unbacked crypto assets from algorithmic stablecoins.
