Clifford Chance

On 16 December 2022, the Basel Committee on Banking Supervision (BCBS) published a finalised prudential standard on banks' cryptoasset exposures (the Cryptoassets Standard) following two rounds of consultation. The Cryptoassets Standard aims to introduce a prudential framework for  banks to manage risks arising from exposures to cryptoassets by imposing capital charges depending on the type of asset and activity. The previous consultation, while welcomed by industry, was subject to widespread criticism that it went too far and would make most crypto exposures commercially unviable for banks. We look at what the final proposals say and the impact for market participants.

Publication of the Cryptoasset Standard is timely given the recent volatility in crypto markets following FTX's collapse in November. Its publication is the latest step in a lengthy consultative process following BCBS consultations in June 2021 and June 2022.

Key Definitions

The BCBS is the primary global standard setter for the prudential regulation of banks. It comprises 45 members from 28 jurisdictions, consisting of central banks and authorities with formal responsibility for the supervision of banking business.

Cryptoassets are defined for the Cryptoasset Standard as private digital assets that depend on cryptography and distributed ledger technologies (DLT) or similar technologies. Digital assets are a digital representation of value, which can be used for payment or investment purposes or to access a good or service.   The Cryptoasset Standard states that this definition includes dematerialised securities that are issued through DLT, but would exclude dematerialised securities that use electronic versions of traditional registers which are centrally administered, for example. Central bank digital currencies (CBDCs) are excluded and so do not fall within the Basel Framework, but BCBS will consider appropriate prudential treatment separately as they are issued.

The Cryptoassets Standard 

The Cryptoassets Standard divides cryptoassets into two main groups for prudential purposes, which are then further sub-divided as follows:

GROUP ONE

Group 1a: Tokenised traditional assets that meet the classification conditions, e.g. tokenised bonds, loans, commodities or cash held in custody.

• Risk Weighting: Subject to capital requirements based on the risk weights of underlying exposures as set out in the existing Basel Framework.

Group 1b: Cryptoassets with effective stabilisation mechanisms that meet the classification conditions, e.g. asset-backed stablecoins that have a pegged value. This does not include algorithmic stablecoins.

• Risk Weighting: Subject to capital requirements based on the risk weights of underlying exposures as set out in the existing Basel Framework.

GROUP TWO

Group 2a: Cryptoassets (including tokenised traditional assets, stablecoins and unbacked cryptoassets like Bitcoin) that fail to meet the classification conditions, but pass the Group 2a hedging recognition criteria.

• Risk Weighting: Adapted market risk rules apply with capital requirements set at 100% of the net position. 

Group 2b: All other cryptoassets (i.e. tokenised traditional assets, stablecoins and unbacked cryptoassets like Bitcoin) that fail to meet the classification conditions and fail the Group 2a hedging recognition criteria.

• Risk Weighting: Subject to conservative prudential treatment or 1250% risk weighting, where one-for-one capital charges will apply.

Key industry-driven changes

Following BCBS' June 2022 report which included a comprehensive draft Cryptoasset Standard for consultation, there were several outstanding issues for industry participants who were concerned that the BCBS had not recognised the diverse range of cryptoassets or provided for capital treatment that would appropriately reflect risk. While the final structure of the Cryptoasset Standard is broadly unchanged, some key modifications have been made to address these concerns.

Infrastructure risk add-on no longer automatically applied

BCBS has originally proposed that a 2.5% risk-weighted asset infrastructure add-on should apply to all Group 1 cryptoassets, which would have amounted to an effective 2.5% surcharge on the use of DLT for traditional assets. This provision has now been amended so that the add-on is no longer applied automatically. Instead, authorities would be empowered to activate such an add-on based on any observed weaknesses in the infrastructure on which particular cryptoassets are based.

This is an important change, as there had been concerns in the industry that an automatic infrastructure add-on would make it commercially unviable for banks (or other firms subject to Basel standards) to hold and trade even in Group 1 cryptoassets such as tokenised securities and fiat-backed stablecoins. It was noted that such an add-on “sets a precedent for applying capital penalties for the introduction of new technologies" and was characterised as a potential "tax on innovation" in this widely supported joint consultation response from the Global Financial Markets Association, the International Swaps and Derivatives Association, the International Securities Lending Association, the International Capital Markets Association and others.

Application to custodial assets clarified

The 1250% risk weighting for Group 2b cryptoassets remains, which means a dollar of capital has to be set aside for every dollar of exposure. However, it has been clarified that the risk weighting does not apply to such cryptoassets held in custody.

There was concern that the previous Cryptoasset Standard proposal would fully apply in relation to customer assets where a bank is acting as a custodian. The BCBS has confirmed that this is not the intention and clarified which elements of the standard are applicable to custodial services provided by banks, including that credit, market and liquidity risk requirements are not intended to apply to assets under custody.

Stablecoins: basis risk test removed, additional supervision requirement added

The Group 1 conditions in the second consultation included a requirement that stablecoins must pass a basis risk test which aims to ensure that the holder of a cryptoasset can sell it in the market for an amount that closely tracks its pegged "stable" value, in addition to a redemption risk test. This basis risk test will no longer apply.

Stablecoins will still be subject to a redemption risk test to ensure that the reserve assets are sufficient to enable the cryptoassets to always be redeemable at their pegged value, including during periods of extreme stress. For cryptoassets that are pegged to one or more currencies, the redemption risk test now also includes a requirement that the reserve assets must be comprised of assets with minimal market and credit risk. BCBS have also introduced a requirement for Group 1b stablecoins to be supervised and regulated by a supervisory authority that applies prudential capital and liquidity requirements.

Group 2 exposure limit adjusted

The BCBS had originally proposed that banks must keep their aggregate exposures to Group 2 cryptoassets below a threshold of 1% of their Tier 1 capital. This has been retained but exposures will now be measured as the higher of the gross long and gross short position in each cryptoasset, rather than the aggregate of absolute values of long and short exposures, to ensure that banks that are hedging exposures are not penalised. The BCBS has also adjusted the capital consequences of a breach of the limit so that any breach will mean that more conservative Group 2b cryptoasset capital treatment is applied to the amount exceeding the limit, rather than the full amount of exposure to Group 2 cryptoassets to avoid the "cliff" effect. However, a new overall limit of 2% will be introduced beyond which the whole of a banks' Group 2 exposures will be subject to the more conservative capital treatment.

Supervisory approval no longer pre-requirement for classification assessment

The BCBS has previously proposed that following an assessment of their cryptoassets against the classification conditions, banks would need to seek prior supervisory approval to finalise such classification. Recognising that this would cause delay, banks will now only be required to notify supervisors of their classification decisions and supervisors will have the power to override these decisions if they disagree with a bank’s assessment.

Do any unresolved issues remain?

The changes that have been made are generally very helpful for market participants and bring some much-needed clarifications for banks considering their approach to adopting novel technologies including cryptoassets, offering DLT-based financial products or crypto custody services, or participating in wider tokenisation projects. Removal of the automatic infrastructure risk add-on in particular is critical to ensure that meaningful bank participation in the crypto industry can continue, providing access to their customers, and bringing such activity within the regulated sector.

However, although the infrastructure risk add-on of 2.5% is no longer automatically applied, supervisory authorities will still have the discretion to apply it based on any observed weaknesses in the infrastructure that underlies specific cryptoassets. While this is clearly an improvement on a blanket additional cost, it does mean that market participants will face ongoing uncertainty as to what uses of DLT infrastructure might attract such an add on and the onus will be on banks to carefully diligence crypto projects to assess any potential vulnerabilities.

Following implementation of the Cryptoassets Standard, non-bank market participants who are not subject to Basel prudential standards may be put at a competitive advantage in relation to offering crypto products and services, particularly in relation to Group 2 cryptoassets. However, this must be weighed against the benefits introduced by the measures including financial stability and management of systemic risk. Wider (non-prudential) crypto regulation, for example under the Financial Stability Board (FSB)'s recently published proposed framework for the international regulation of crypto-asset activities and the EU's new Markets in Crypto-assets Regulation (MiCA) will generally be applicable to both banks and non-bank crypto services providers and will help to ensure there is a more level playing field in terms of conduct requirements at least.

Timing

The Cryptoassets Standard will form part of Chapter 60 of the Basel Accord with an implementation date of 1 January 2025. The BCBS' standards and the Basel Accord are not directly binding on any jurisdiction. As such, adoption and implementation into national regulatory frameworks is ultimately at the discretion of each jurisdiction.  

The Cryptoassets Standard sets out several areas that will be subject to further review and/or where additional requirements may be added in due course, likely ahead of the January 2025 implementation timeline. For example, in relation to stablecoins, the BCBS will further study the appropriate composition of reserve assets for the purpose of the redemption risk test to see if additional criteria are required and consider whether there are statistical tests that may be added that can reliably identify low-risk stablecoins. Permissionless blockchains, cryptoassets received as collateral, the degree of hedge recognition for Group 2 cryptoassets and calibration of the Group 2 exposure limit are also all subject to further review.