STADLER VÖLKEL Rechtsanwälte GmbH

Consultation Document on the Prudential Treatment of Cryptoasset Exposures

24 June 2021
Consultation Document on the Prudential Treatment of Cryptoasset Exposures

Basel Committee on Banking Supervision Publishes Consultation Document on the Prudential Treatment of Cryptoasset Exposures

On 10 June 2021, the Basel Committee on Banking Supervision issued a public consultation on the prudential treatment of cryptoasset exposures. The 21-page consultative document follows a discussion paper published in December 2019, which generated 32 public comments from key industry participants. Recognizing the speed at which the cryptoasset class is evolving, the Committee expects to undergo multiple consultations on this topic. Stakeholders are invited to submit comments by 10 September 2021.

The consultation paper proposes minimum standards for the prudential treatment of banks' exposures to cryptoassets. The proposed standards are designed to be simple and technology neutral, and oftentimes are based on the prudential treatment of comparable traditional assets already regulated under the Basel Framework. The paper identifies potential operational, credit and market risks in connection with cryptoassets and proposes a new conservative prudential treatment for cryptoassets that generally are not linked to a regulated traditional asset (e.g., bitcoin).

The below table provides an overview of the Committee's proposals. The classification, risk-weighting and capital requirements of cryptoassets are explained in more detail in the following sections.

Table 1 – An overview of the prudential treatment of cryptoasset exposures.

Screening and classifying

As a first step, banks are tasked with classifying cryptoassets into two groups, Group 1 and Group 2. Group 1 cryptoassets consist of cryptoassets that meet all of the four of the "classification conditions" set out below. Group 1 is further broken down into two sub-groups: Group 1a consists of "tokenised traditional assets", while Group 1b consists of cryptoassets with effective stabilisation mechanisms (i.e., stablecoins). Group 2 cryptoassets include all cryptoassets that do not qualify for Group 1, for example bitcoin.

The four classification conditions for Group 1 are as follows:

1. The cryptoasset either is a tokenised traditional asset or has a stabilisation mechanism that is effective at all times in linking its value to an underlying traditional asset or a pool of traditional assets.
  • Tokenised traditional assets are digital representations of traditional assets using blockchain technology. Traditional assets are those assets that are captured within the current Basel Framework such as cash, bonds, commodities or equities.
  • As concerns stablecoins, a stabilization mechanism is deemed to be "effective at all times" if the difference in value between the cryptoasset and the underlying traditional asset does not exceed 10 basis points more than three times over a one-year period.
  • Stabilisation mechanisms that reference other cryptoassets as underlying assets (e.g., Dai) or that use protocols to adjust the supply of the cryptoasset (e.g., algorithmic stablecoins) are not considered to meet this condition.
2. All rights, obligations and interests arising from cryptoasset arrangements that meet the condition above are clearly defined and legally enforceable in jurisdictions where the asset is issued and redeemed. In addition, the applicable legal framework(s) ensure(s) settlement finality.
  • The explanatory remarks add a further condition that cryptoassets with stabilisation mechanisms must ensure full redeemability at all times.The rights, obligations and interests of the respective parties must be properly documented and the key financial risks must be identified. Where applicable, the cryptoasset arrangements must also be valid where the parties involved are not located in the same jurisdiction.
3. The functions of the cryptoasset and the network on which it operates, including the distributed ledger or similar technology on which it is based, are designed and operated to sufficiently mitigate and manage any material risks.
  • Material risks are those that could impair the transferability, settlement finality or redeemability of a cryptoasset. Traceability of all transactions and participants is identified as an important factor. Key aspects also include the network's operational structure, degree of access, the technical role of the nodes, and the validation and consensus mechanism of the network.
4. Entities that execute redemptions, transfers, or settlement finality of the cryptoasset are regulated and supervised.
  • The meaning of "regulated and supervised" is not provided. The relevant entities covered by this condition are operators of the transfer and settlement systems for the cryptoasset, stablecoin administrators, and custodians of a stablecoins' underlying assets.

A cryptoasset that fails to meet any of the above conditions is classified in Group 2.

Capital requirements for Group 1 cryptoassets

The consultation document proposes minimum risk-based capital requirements for cryptoassets classified into Group 1.

To address the operational risks associated with a bank's activities related to cryptoassets, the Committee proposes a Pillar 1 add-on operational risk charge for all Group 1 cryptoassets to which a bank is exposed. The Committee leaves open how this risk charge could be set, suggesting that a fixed or variable amount, or even an amount that decreases over time, could be used. However, the Committee notes that calibrating a gradually decreasing risk charge would pose a significant challenge.

Capital requirements for tokenised traditional assets (Group 1a)

In terms of credit and market risk, tokenised traditional assets falling into Group 1a generally may be treated as equivalent to a traditional asset for the purpose of calculating minimum capital requirements. The key condition is that the cryptoasset must confer the same level of legal rights as the comparable traditional asset. Banks should not assume this will always be the case. For example, the tokenised traditional asset may have different characteristics than its non-tokenised equivalent in terms of liquidity, market values and collateral recognition. In such a case, a bank would have to apply different risk weights to accommodate the additional risks.

Capital requirements for stablecoins (Group 1b)

Separate risk-weighted assets (RWA) calculations are provided for stablecoins falling under Group 1b. The Committee, acknowledging the myriad ways a stabilisation mechanism can be structured, provides two representative examples and applies the capital requirements in each case.

In "Illustrative example 1", an entity (the "redeemer") commits to exchange the stablecoin for the underlying traditional asset or for cash. The holders of the stablecoin have a direct contractual claim against the redeemer.

Illustrative example 1 – Case where cryptoasset holders transact directly with the redeemer

To calculate risk-weighted assets for this type of stablecoin, banks must include in RWA the sum of the following two amounts:

  • The risk weighted assets applicable to a direct holding of the underlying traditional asset.
  • The value of the cryptoasset holding multiplied by the risk weight applicable to an unsecured loan to the redeemer.

In "Illustrative example 2", the contractual claim for redemption is intermediated by a subgroup of "members" who sit between the redeemer and the other stablecoin holders.

Illustrative example 2 – Case where cryptoasset holders transact indirectly with the redeemer

The RWA calculation for members should be the same as the calculation set out in Illustrative example 1. In addition, if members are obligated to buy the stablecoin from holders, members must also include within credit risk-weighted assets an amount equal to:

  • The total current value of all existing cryptoassets that the bank could be obliged to purchase from non-member holders multiplied by the risk weight applicable to an unsecured loan to the redeemer.

For non-member holders, the RWA calculation depends on whether members have committed to buy the stablecoin in unlimited amounts. The consultation document lists various risks that should be included in each case.

Capital requirements for Group 2 cryptoassets

The Committee proposes newly prescribed capital requirements for cryptoassets classified into Group 2. The treatment is as follows:

  • A risk weight of 1250 % is applied to the greater of the absolute value of the aggregate long positions and the absolute value of the aggregate short positions to which the bank is exposed. That is:

RWA = RW x max .

  • The RWA will be calculated separately for each Group 2 cryptoasset to which the bank is exposed.

The above formula is designed to ensure that banks will hold risk-based capital at least equal in value to their Group 2 cryptoasset exposures. For example, an exposure of EUR 100 in cryptoassets would result in a minimum capital requirement of EUR 100. The rationale is that depositors and other senior creditors of a bank would not face a loss in the event of a full write-off of the cryptoasset exposures.

Stakeholders are invited to propose alternative approaches to the application of a 1250 % risk weight that are simple, conservative and easy to implement. Given that several consultations are envisioned, we expect the capital requirements for Group 2 cryptoassets to undergo multiple revisions and fine-tuning before they are finalized.

STADLER VÖLKEL Rechtsanwälte Logo