Outreach Blog

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."

 

 

Conclusion

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

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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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