Saturday, October 8, 2022

Bringing Crypto Asset Activities Into the Regulatory Perimeter

Tech Innovation Meets Prudential Regulation

Author: David Schwartz J.D. CPA

A collection of the globe's most significant securities trade associations[1] joined forces to file a comprehensive response to the Basel Committee on Banking Supervision's (BCBS) second public consultation on the prudential treatment of banks' crypto-asset exposures. The September 30, 2022, letter voiced support for the design of the crypto-asset exposure framework proposed by BIS in its June 10, 2021, initial and follow-up June 30, 2022, consultations. However, the associations identified some elements of the proposal that they say "would  meaningfully  reduce banks' ability  to—and  in  some  cases  effectively  preclude banks  from—utilising the benefits of distributed ledger technology ("DLT") to perform certain  traditional  banking, financial  intermediation and  other  financial functions  more efficiently."


Aimed at addressing issues raised by respondents to the initial consultation, the BIS's second release retains the basic structure of the proposal in the first consultation, with crypto assets divided into two broad groups: 


  1. Group 1 includes those eligible for treatment under the existing Basel Framework with some modifications. [2]

  2. Group 2 includes unbacked crypto assets and stablecoins with ineffective stabilization mechanisms, subject to a new conservative prudential treatment.


The second consultation adds detail to the proposed groups and standards. It also includes new elements, such as an infrastructure risk add-on to cover distributed ledger technologies' latest and evolving risks, adjustments to increase risk sensitivity, and an overall gross limit on Group 2 crypto assets. It also proposes introducing an exposure limit that, if adopted, would initially limit a bank's total exposures to Group 2 crypto assets to 1% of Tier 1 capital.



The associations argue that recent volatility in crypto-asset markets has underscored that without prudential regulation, excess leverage, insufficient liquidity, and lack of capital make crypto unsuitable for banks and financial institutions. However, bringing crypto assets under a prudential regulatory rubric would free traditional financial institutions to use the technologies, employ crypto assets, and offer them and related services to their investors, customers, and clients. 


"Allowing appropriately risk-managed cryptoasset banking and other financial activities to take place within the regulatory perimeter should be a central goal of the final Basel Committee standards." 


 "A prudential framework that permits banks to support the growth of crypto assets benefits supervisors by providing better insight into the evolution and growth of these activities (e.g., by requiring the reporting of crypto asset exposures). At the same time, customers and investors will benefit from more transparent, trusted alternatives and the protections of fully regulated institutions providing services.


Leaving crypto asset markets and services outside of the prudential regulatory framework would cede these markets and services, they say, to the virtual "wild west" of unregulated and underregulated players, to the detriment of investors and market stability.


"Otherwise, un- and -lesser-regulated entities are likely to be predominant providers of cryptoasset-related services. The result would be an unlevel playing field and a lack of transparency in the build-up of leverage and risk in the financial system outside the regulatory perimeter. In that case, the absence of regulated financial institutions engaging in cryptoasset-related activities would be net worse than if banks were providing these services subject to an appropriately calibrated framework."


Adapting the Current Prudential Framework

The associations made three main recommendations to BIS to bring crypto assets into the prudential framework. 

  1. Keep the "same risk, same activity, same treatment" approach. Cryptoassets with equivalent economics and risks as traditional assets "should be subject to the same capital, liquidity and other requirements as the traditional asset;" 

  2. Take a "technology risk-neutral" approach (i.e., do not create infrastructure risk add-ons); and 

  3. Instead of pre-approving each particular crypto asset, supervisors should clearly define classification criteria for crypto assets for banks to apply. 


Some novel solutions and alterations to the current prudential framework would be necessary, say the associations, to accommodate the risk profiles of both Group 1 and Group 2 crypto assets. Financial institutions are eager to integrate not just crypto assets into their processes and offerings but also port over some of the technologies pioneered and tested in the crypto markets into their trading and clearing systems. Calibrating prudential standards and weighing risks associated with banks' use of crypto assets must take into consideration mitigating factors like the effects DLT, smart contracts, and blockchain databases would have, like reduced or instantaneous transaction times, wringing some risks associated with margins and counterparty credit risks out of the market by virtue of the technology alone. 


"Getting this right is critical to meet customer demand and harness the benefits of DLT and similar technologies. For example, the speed by and transparency with which transactions can be recorded using DLT, combined with the ability to swap and record assets and cash simultaneously, would help mitigate counterparty, liquidity and settlement risk, allow transactions to settle, and funds and assets to reach their intended recipient, faster and allow for efficiencies in collateral management."


As these technologies become more commonly employed, financial firms can apply tech-based risk-reduction to areas outside the crypto asset context. For example, as we have discussed, in the context of securities lending, regulatory bank capital charges are making it uneconomical for bank lending agents to provide borrower default indemnity to clients. However, we have also posited that if technologies like DLT could bring more transparency to securities lending, allowing lenders to screen better and monitor borrowers, the reductions to counterparty credit risk could be significant. 


"[f]intech advances in the application of SFTR datasets through distributed ledger technologies (DLT) may also bring more transparency to securities lending transactions. DLT opens the possibility that lending agents can give their concerned lenders the ability to a) screen their ultimate borrowers, b) limit their trades and c) give assurances that borrowed shares are not being used for purposes that are counter to the lender's own ESG principles. And, if the borrower is a broker-dealer, then non-directed and unvoted shares in the firm's depository account can be assigned to the ESG-compliant lenders, either for a fee or for preferential access to deep and desirable stock pools."


As with crypto assets, BIS may consider reevaluating the best way to set bank capital charges for borrower indemnity, given the reduced risk environment in a new technological landscape of rapid clearing and real-time data sharing and regulatory reporting. 


In fact, the associations included in their comment letter a request for assurances that securities finance transactions (SFT) would not be swept into the standardized approach for credit risk simply by virtue of employing blockchain or DLT. Rather, if the SFT, though transacted through a blockchain, consists solely of traditional assets, it should remain under the comprehensive approach and not be swept into the rubric of group classifications for crypto assets. 


 "[T]he Second  Consultation  states  that,  for  SFTs,  banks  should  apply the comprehensive  approach  formula  used in  the  standardised  approach  to  credit  risk. See SCO60.98. The Associations seek confirmation from the Basel Committee that an SFT or margin loan relating solely to traditional assets, even if the SFT is executed on a platform that  uses  the  blockchain,  would  be  eligible  for  the  comprehensive  approach  to  the  same extent  as  any  other  SFT or  margin  loan involving  traditional  assets,  including  the recognition of eligible collateral. An SFT or margin loan that relates partially or wholly to Group  1a,  Group  1b,  and  Group  2a  cryptoassets  would  similarly  qualify  for  the comprehensive  approach  to  the  same  extent  as  any  other  SFT or  margin  loan involving traditional  assets,  subject  of  course  to  any  limitations  on  the  recognition  of  the  relevant cryptoassets as eligible collateral."




Given the changes made from the first consultation to the second, it seems that BIS is paying close attention to the feedback received. This latest input from the world's most influential securities trade association contains cogent suggestions that, if taken seriously, could help to (i) promote the adoption and benefits of DLT use, (ii) facilitate regulated banks' engagement in the crypto asset markets and (iii) improve investor protection by leveling the global regulatory "playing field." 



[1] The comment letter consortium consisted of The Global Financial Markets Association, 1the Futures Industry Association, the Institute of  International  Finance,  the  International  Swaps and  Derivatives  Association,  the International Securities Lending Association, the Bank Policy Institute, the International Capital Markets  Association,  and the  Financial  Services  Forum.


[2] Following the framework's overarching principle that prudential regulation of crypto assets should be technology neutral and based upon the risks and functions of crypto assets. In essence: "Same risk, same activity, same treatment."  "A crypto asset that provides equivalent economic functions and poses the same risks as a 'traditional asset' should be subject to the  same  capital,  liquidity  and  other  requirements  as  the  traditional  asset." Computers and money: the work of the Basel Committee on crypto assets