Crypto Exposure Standards Finalized By Basel Committee – Fin Tech

On December 16, 2022, the Basel Committee on Banking Supervision
(“Basel Committee” or “BCBS”) finalized a
standard for banks to monitor and manage their exposure to
cryptoassets (the “Crypto Standard”).¹ The Crypto Standard amends the Basel
Committee’s comprehensive framework for prudential regulation
to set out the prudential treatment of banks’ exposures to
cryptoassets.

The Crypto Standard is effective immediately, but given that it
does not have the force of law on its own, the Basel Committee has
requested that national regulators implement it by January 1, 2025.
In this Legal Update, we review the changes the Basel Committee
made to the drafts of the Crypto Standard and discuss what the
industry may expect next.

Background

The Basel Committee is a group of several dozen central banks
and bank supervisors that sets standards for the prudential
regulation of banks and provides a forum for regular cooperation on
banking supervisory matters. The Basel Committee standards do not
have the force of law but, rather, must be adopted or transposed by
its members (i.e., national regulators) into legal requirements
that apply within a specific jurisdiction. The Basel Committee has
promulgated and revised standards for capital and liquidity
requirements for banking organizations for many years (in addition
to other prudential standards), with the most recent major
revisions occurring in 2017.²

In June 2021, the Basel Committee published a public
consultation titled Prudential Treatment of Cryptoasset
Exposures that focused on the emergence of cryptoassets as a
new asset class that presents unique risks to banks.³ This proposal was modestly revised
through a subsequent consultation in June 2022.⁴

The proposal and final Crypto Standard separate cryptoassets
into two groups, each with two subgroups (i.e., Groups 1a and 1b
and 2a and 2b). Group 1 includes less volatile cryptoassets that
(a) are tokenized traditional assets or (b) have effective
stabilization mechanisms. Group 2 assets are also split into two
subgroups: (a) ones where a limited degree of hedging is permitted
and (b) ones where hedging is not recognized.

As discussed in our earlier Legal Update and the June
2022 proposal, the Crypto Standard also includes provisions
that address an infrastructure risk add-on; a redemption risk test
and a supervision/regulation requirement; an exposure limit on
Group 2 exposures; descriptions of how the operational risk,
liquidity, leverage ratio and large exposures requirements should
be applied to banks’ cryptoasset exposures; a supervisory
review process; and disclosure requirements.

Changes from the June 2021 Release

The Crypto Standard consists of a new chapter in the Basel
Committee’s framework for the prudential regulation of banks
that has over 130 sections and addresses the application of most
types of prudential standards to cryptoassets. The Crypto Standard
largely tracks the June 2021 proposal, as modified in June 2022,
with a handful of changes made during the finalization process.
These changes are:

1. Infrastructure risk add-on. In the June 2022
   proposal, the Basel Committee included a fixed add-on to
   risk-weighted assets that was set at 2.5 percent of the exposure
   value for all Group 1 cryptoassets. In the Crypto Standard, the
   Basel Committee replaced this with a more flexible approach that
   allows national regulators to initiate and increase an add-on based
   on any observed weaknesses in the infrastructure that underlies
   specific cryptoassets.




2. Basis risk test, redemption risk test and the
   supervision/regulation requirement. The June 2022 proposal
   included a requirement that cryptoassets with stabilization
   mechanisms pass a redemption risk test and a basis risk test. The
   objective of the redemption risk test is to ensure that the reserve
   assets are sufficient to enable the cryptoassets to be redeemable
   at all times, including during periods of extreme stress, for the
   amount to which the cryptoasset is pegged. The basis risk test,
   which was a quantitative test based on the market value of the
   cryptoasset, aimed to ensure that the holder of a cryptoasset could
   sell it in the market for an amount that closely tracks the peg
   value. In the Crypto Standard, the Basel Committee stated that the
   supervision/regulation requirement should apply in addition to the
   requirement to pass the redemption risk test. Further, 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 composed of assets with minimal market risk
   and credit risk. However, after reflecting on the merits of these
   different approaches, the Basel Committee decided not to implement
   the basis risk test in the Crypto Standard.




3. Group 2 exposure limit. The Crypto Standard
   retains the proposed requirement that banks keep their aggregate
   exposures to Group 2 cryptoassets below a threshold of 1 percent of
   their Tier 1 capital, subject to certain modifications. The first
   modification results in exposures being measured as the higher of
   the gross long and gross short position in each cryptoasset rather
   than the aggregate of the absolute values of long and short
   exposures, as proposed in the June 2022 proposal. The second
   modification relates to the capital consequences of a breach of a
   limit and is intended to reduce the cliff effects of breaches
   (e.g., apply punitive treatment only to the amount by which the 1
   percent limit is exceeded).




4. Responsibility for assessing the classification
   conditions. Under the June 2022 proposal, banks were
   required to assess their cryptoassets against the classification
   conditions and seek prior supervisory approval to finalize the
   classification. The Crypto Standard revises the process to remove
   the supervisory pre-approval element; instead, banks are required
   to notify their regulators of classification decisions, and
   national regulators will have the power to override these decisions
   if they disagree with a bank’s assessment.




5. Custodial assets. Respondents to the June 2022
   proposal raised concerns about the application of the standard in
   relation to customer assets where a bank is acting as a custodian.
   This apparently was not the intent of the Basel Committee, and,
   therefore, the Crypto Standard was revised to clarify which
   elements are applicable to custodial services provided by
   banks.

The Crypto Standard is a final standard, but indicates that some
issues remain under consideration by the Basel Committee. These
include the treatment of permissionless blockchains as Group 1
assets, appropriate statistical tests to reliably identify low-risk
stablecoins, and calibration of the Group 2 exposure limit.

Industry Impact

The Basel Committee indicated in the Crypto Standard that it
intends to closely monitor its implementation and will likely issue
additional refinements and clarifications over time. On one hand,
this can be viewed as a positive development, as some aspects of
the Crypto Standard are highly prescriptive and may change as
technology develops. On the other hand, constant change to
regulatory standards imposes a heavy burden on banks and should be
avoided where possible. On balance, this open-mindedness is
probably a good position for the Basel Committee to take because of
the evolving nature of cryptoassets and the risks presented.

As we have discussed in relation to the Basel
Committee’s climate risk management principles, the Crypto
Standard does not have the force of law in the United States. It is
unclear if the Crypto Standard will be included in the pending Basel Endgame rulemaking that US regulators
are considering (i.e., the process to incorporate the Basel
Committee’s 2017 revisions to the general capital requirements
into US regulation) and how the discovery of recent lapses in
controls at cryptocurrency companies will affect the regulation of
cryptoasset exposures of banks. Given the pressing need to adopt
Basel Endgame, we expect that US regulators will defer addressing
the Crypto Standard until after 2023.

Additional Author Dean A.
Corrado

Footnotes