Crypto Exposure Standards Finalized by Basel Committee ~ January 2, 2023

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Matthew Bisanz Jeffrey P. Taft Joseph A. Castelluccio Andrew Olmem

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.

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