Cryptocurrency risk framework in banking. The regulator’s latest stopper to protect banks’ dominance.

Why Basel Committee is so skeptical with cryptoassets?

In June 2021, a consultation paper on the prudential treatment of cryptoasset exposures was published by the Basel Committee on Banking Supervision. In order to meet the objectives of financial stability, consumer protection and market integrity established by the microprudential supervisory authorities, the document lays the foundations for the prudential treatment and, therefore, the quantification of the risks to which credit institutions are exposed. And why such a level of requirements for these entities? Because of the risk that their potential disruption would generate for financial stability, since in addition to channeling savings and investment by raising repayable funds from the public, they perform other critical economic functions, as defined in the European bank resolution regulation BRRD ([1]Article 31.2.a and b).

However, the Basel Committee’s position can be read in terms of caution, skepticism or disincentive to the crossover between banking and the crypto-asset world, since in the current context of such low returns (ROE, ROA) of credit institutions, the cost of capital for holding crypto-assets would increase significantly more, leading to a non-viable situation. And this prevents the interaction of banks, and therefore encourages their isolation, at a time when the traction of the decentralized financial industry DeFi is awaiting Layer 1 solutions (Ethereum Cardano, Binance, Solana, among others) sufficiently scalable to settle the rest of the protocols that already develop lending solutions, deposit, and in general, channeling savings and investment. The base, already created, has a defined roadmap to become the financial paradigm and leave the banks out of the picture, additionally cutting the financing of the entities via retail deposits. The only pending trade-off to be resolved is the one derived from the cost of compliance VS consumer or depositor protection via a depositor protection scheme and liquidity contributions through the liquidity of Central Banks Margin Lending Facilities (MLF).

Understanding banking fundamentals

As a preliminary explanation regarding the risk management approach that the banking regulator has maintained, it should be noted that the fundamental solvency ratio analyzes the level of equity that the institution maintains in relation to the assets it has on its balance sheet. This is the metric chosen by the regulator to determine mainly the viability of a credit institution. However, regarding the understanding of this ratio, which also forms part of the classic solvency analysis of companies, two points should be made:

  • Numerator: in the case of credit institutions, this includes both what is classified for accounting purposes as equity (defined as contributions made by shareholders with no obligation to repay, which allow them to participate in the entity’s shareholding structure) and those instruments which, although they cannot be computed as such, do have conditions in their clauses that guarantee a loss absorption ahead of the ordinary creditor. In other words, the absorption of losses occurs prior to the declaration of a bankruptcy proceeding (going concern), either through the non-remuneration of liabilities or clauses for conversion into equity instruments. Therefore, the numerator is not limited to the accounting equity, but to the computable equity.
  • Denominator: in the case of credit institutions, assets are not valued at book value, i.e. at the value at which the assets are recorded on the balance sheet. Assets are calculated on a risk basis, and to this end, the risks to which an entity is exposed are identified, and methodologies are developed for calibrating the weighti associated with each asset. Although this is a very complex chapter, because the modalities are very diverse, and each risk in turn has a matrix of sub-risks with its own methodologies, it serves to illustrate that the denominator is not calculated via total net assets, but via risk-weighted assets or RWAs.

In conclusion, the solvency formula for institutions is as shown below, requiring a minimum of 8% of equity computable by RWAs. These requirements increase significantly as a consequence of the regulatory obligations assumed (quantification of more microprudential risks, coverage of macroprudential risks, requirements to preserve the entity in case of non-viability, etc.), and generate a heavy compliance burden that puts banks’ profitability at risk.

Thus, the regulator, throughout the paper published for consultation, intends to determine the risk management framework applicable to credit institutions exposed to crypto-assets. However, despite the fact that the preservation of financial stability leads to cover the risks associated with crypto-assets, the regulator states that regulation is governed by the principle of technological neutrality. And what does this mean? It means that, regardless of the technology that structures the asset under analysis, only the risk and the activity are analyzed, so that the same activity, and the same risk arising from that activity, is treated in the same way.

The principle of technological neutrality, already enunciated in the European proposal for the MiCA Regulation[2], makes it possible to establish a series of categories of cryptoassets subject to regulation, and although the segmentation is different from that proposed by the Basel Committee, it pursues the same objective: to identify different risk matrices and associate a regulatory and supervisory regime to each one. On the one hand, MiCA establishes the general regulatory regime, through authorization, monitoring and ongoing supervision requirements, and on the other hand, the calculation of own funds is detailed for the first time in the Basel Committee’s paper.

Returning to the principle of technological neutrality, for the purposes of cryptoasset regulation, it can be defined as the regulator’s commitment not to position itself, either by incentivizing or penalizing, in determining the regulatory framework for financial instruments for formal reasons, i.e., for reasons relating to the architecture or data infrastructure that supports the recording of ownership and, consequently, the recording of transactions of said asset. Thus, only the objective identification of different risks because of the application of a structure can be a reason for articulating a different regulatory framework. This principle is symmetrical with the principle of prevalence of economic substance over legal form, enshrined in paragraph 2.12 of the Conceptual Framework for Financial Reporting, issued by the International Accounting Stability Board (IASB), which also reiterates the irrelevance of the formal structuring (in this case, application of distributed ledgers) of the instrument or transaction in relation to the economic impact it generates.

In this sense, all those tokens or cryptoassets that present similar characteristics to financial instruments, which are currently regulated under MiFID[3] (STO or Security Token Offering), must be classified under the general risk scheme foreseen in the European capital regulation CRR[4] . The reason, as I have already anticipated above, lies in the fact that the tokenization of an instrument does not generate additional or different risks to those already existing, but rather develops a form of registration of the ownership and transmission capacity of the same through a DLT architecture (distributed registries).

Basel Committee Proposal

The Basel Committee’s paper envisages a triple asset scheme:

  • Group 1A: tokenization of traditional financial assets.
  • Group 1B: stablecoins backed by assets, or by a pool of assets.
  • Group 2: exposures to crypto-assets not included under previous categories.

Before starting to break down each of these groups, it is important to note that any direct holdings of cryptocurrencies not identifiable as stablecoins (not including algorithmic stablecoins) are classified, for the purposes of international accounting standards for intangible assets IAS 38, as intangible assets. In such a case, the prudential treatment requires their deduction from shareholders’ equity, and specifically from the credit institution’s highest quality component, known as Core Equity Tier 1 or CET1. The degree of penalization for direct holdings of cryptocurrencies is maximum and seems to respond to a hyper-restrictive or prudential criterion rather than to a risk management scheme, so we understand that as the holding of cryptocurrencies settles in the trading book of the entities as a form of diversification, this can be discussed from a double point of view: either by questioning its classification as an intangible asset from the accounting point of view, or recalibrating the prudential deduction system for intangible assets.

Once the general framework of direct holding of cryptocurrencies has been set out, the classification of cryptoassets by groups is analyzed:

Level 1 assets: this category includes assets that meet a series of conditions, distinguishing between 1A as generic, and 1B as stablecoins backed by a traditional asset (including cash) or a pool of assets.

The regulator establishes that traditional character exists when the tokenized asset can be assimilated to bonds, loans, deposits or shares (in terms of cash flows, insolvency actions, among others), commodities or cash.

This classification, which for MiCA purposes includes STOs and EMTs (E — Money Tokens) and ARTs (Asset Referenced Tokens), also leaves out algorithmic stablecoins, such as Terra, which are gaining strength by using stabilization mechanisms on participants, incentivizing supply and demand.

The conditions are as follows:

  • Tokenization of a traditional asset.
  • The rights and obligations of the cryptoasset are clearly defined and legally binding in the jurisdictions in which the asset is issued and redeemed.
  • The functions of the cryptoasset and the network in which it operates are designed and operated to sufficiently mitigate and manage any material risks (risks relating to transferability of the asset and settlement capability of the token).
  • The entities executing the transfer and settlement of cryptoassets are regulated and supervised.

This last point closes the circle with MiCA, since the supervision exercised by the competent authorities establishes a level of requirements in terms of internal governance, risk management framework, investor and consumer protection that guarantees the existence of stability mechanisms, understood as the minimization of reputational impact due to non-compliance with obligations. The degree of disclosure of information required by the supervisor, not only to the supervisor itself but also to the market (the so-called Pillar III or market discipline pillar), guarantees the minimization of information asymmetries and the investor’s ability to decide with information audited and verified by third parties their potential investment in the issuing entity’s cryptoassets.

In this regard, it is important to note that the burden of proof to demonstrate that such assets comply with the conditions referred to above falls on the credit institution, so that, de facto, a dialogue must be established between cryptoasset issuers and holders to ensure traceability and transparency in compliance.

Level 2 Assets: includes all cryptoassets that do not meet these conditions. Specifically, they include:

  • Assets not deducted from CET1 due to their classification as intangible assets.
  • Indirect holdings — via fund or ETF — or synthetic — via derivatives — of cryptoassets already deducted (e.g. Bitcoin, Ethereum).

Thus, once the different groups have been analyzed, the requirements associated with each one are explained succinctly.

Level 1A Assets: risk scheme of traditional financial instruments for credit and market risk. It follows current credit and market risk framework.

Level 1B Assets: the scheme varies according to the type of stablecoin. In any case, the risk calculation depends on the change in value of the underlying or the issuer’s default risk.

  • If the token holder can settle against the issuer directly, the charge for risk-weighted assets is as follows:

RWA=RWA by collateral direct holding+(Cryptoasset Book Value * RW exposures to issuer).

  • If the token holder can only settle against the issuer indirectly, with only members issuing a formal binding promise to buy and sell cryptoassets on behalf of the holders, additional counterparty risk is created by potential default of the intermediary.

Level 2B Assets: only assets not included in the previous categories are included in this category.

  • Application of a risk weighting of 1,250% to the net of long and short positions, so as to ensure that the credit institution can assume a full write-off of the positions held without generating losses on depositors or other creditors.

Conclusions:

  • The prudential framework proposed by the Basel Committee, which is still in the consultation phase, establishes a triple framework under the principle of technological neutrality enshrined in MiCA, which also fits under the IASB’s Conceptual Framework.
  • The Basel Committee is preparing the potential entry of banks into the crypto world, with a very prudent and demanding approach that will de facto discourage any exposure of banks to this world. And it is precisely banking that is the most threatened player, because the potential of DeFi can shake the current dominance of banking in the channeling of savings and investment.
  • The prudential impact on banking is penalizing whatever the type of holding (direct, indirect or synthetic), because it focuses on the underlying and not on the form of registration. In this sense, all those cryptoassets classifiable as utility tokens or cryptocurrencies have a risk weighting surcharge assimilated to maximum risk.

[1] BRRD: Banking Recovery and Resolution Directive

[2] Market in Crypto Assets

[3] Market in Financial Instruments Directive: European directive that regulates the marketing of financial instruments and standardizes regulatory requirements for entities operating in Europe.

[4] Capital Requirement Regulation: European regulation that determines the calculation of capital requirements for institutions (credit institutions and investment services companies).