BCBS Addresses Capital Requirements for “Crypto-Assets”

The BCBS consultation will likely give an indication of the banking industry’s mindset towards holding cryptoassets in the future, says Douglas Cheung at Wolters Kluwer.

Earlier this year the Basel Committee on Banking Supervision (BCBS) had released a paper discussing the topic of central bank issued digital currencies (CBDCs). Adoption of CBDCs could lead to market developments not so different to those observed in the non-deliverable currency markets for Taiwan, China, and South Korea currencies.

This includes the CBDC’s own forward market, followed by the development of term structures and interest rate swaps (IRS) markets. Potential basis between the traditional fiat currency and the CBDC could arise, with the basis representing favouritism for either CBDC or fiat.

On 12 Dec 2019, the BCBS began early steps by consulting on the prudential treatment for financial institutions holding cryptocurrencies. Specifically, it is looking to form an opinion as to whether the BCBS will issue a global prudential standard which addresses the capital and liquidity requirements for banks holding material positions. In the BCBS’s view, cryptocurrencies are not “currencies” but rather “assets” as they:

“ …do not reliably provide the standard functions of money and are unsafe to rely on as a medium of exchange or store of value. Crypto-assets are not legal tender, and are not backed by any government or public authority.

Development of the prudential framework

In the development of the potential framework, the BCBS highlights three key principles:

  1. “Same risk, same activity, same treatment”: Cryptoassets that exhibit the same risks and functions as traditional assets are to be treated similarly for prudential purposes.
  2. “Simplicity”: Complex internal models for calculating capital requirements are discouraged at this stage, and where possible the re-use of current frameworks should take place.
  3. “Minimum standards”: Note that in the absence of BCBS proposals, the Swiss Financial Market Supervisory Authority (FINMA) had advised financial institutions to apply a flat risk weight of 800% to cryptoassets to cover market and credit risks regardless of whether the position sits in the banking or trading book.

The discussion paper also provides an example of capital and liquidity requirements to a particular scenario. While not stating what exact cryptoasset is being illustrated, it alludes to the holding of a “store of value” type asset such as Bitcoin. The prudential treatment applied in the example reveals no surprises, with full deduction from Common Equity Tier 1 capital (CET1), and full 100% risk weighting on delta, vega and curvature risk, with no diversification benefits permitted. Cryptoassets are not allowable as high quality liquid assets (HQLA) in the calculation of the liquidity coverage ratio (LCR), and are not eligible as collateral for credit risk mitigation.

Sources of value

The paper details a variety of sources of value, including perceptions of value, expectations of future cash flows and price rises, and technology. Digital asset valuation is a relatively new area, and responses to the paper may propose a broad range of valuation models. These varying models will also impact the approach to calculating the capital charge, as proposals requiring sensitivity measures, stress testing or simulations can depend on several different valuation inputs.

There may also be submissions mainly focused on Bitcoin, with altcoin valuations including correlation coefficients to Bitcoin. Market participants are aware of Bitcoin’s influence on overall cryptoasset prices, and while its market capitalisation dominance has declined due to the emergence of the altcoin market, overall price fluctuations continue to be heavily correlated to Bitcoin. This essentially has made fundamental analysis less relevant, and some investors who have bought into cryptoassets for strong fundamentals would find these assets often underperforming.

What can we expect from submissions

I expect a very wide range of risk weightings to be proposed, as well as a broad variety of cryptoasset types and scenarios discussed. It will be hardly surprising if the majority of the responses include highly punitive risk weightings, and I expect that no financial institution will propose an advancedinternal model based approach though some academics in the field may propose advanced modelling for cryptoasset valuation, particularly in relation to Bitcoin.

Should the BCBS decide that it will set a global standard, it will most likely partition the cryptoassets into different groups based on risk exposures, and further consultations can be expected for more complex cryptoassets as the committee firstly addresses Bitcoin. It will also be interesting to see how much attention the BCBS will place on valuation methods that treat cryptoassets as currencies, since the committee has clearly stated that cryptoassets are not currencies under their definition.

The BCBS invites all interested stakeholders to respond to the discussion paper, which includes banks, central banks, technology companies and the general public. In this regard, I’m paying particular attention to which banks will respond to the consultation as well as their opinions, as this may give an indication of the banking industry’s mindset towards holding this new asset class in the future.

Submissions to the BCBS close on 13 March 2020. The discussion paper can be found here.

Douglas Cheung is Lead Technology Product Manager for Wolters Kluwer Finance, Risk & Reporting.

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