Basel Crypto Guidelines: 21 Largest Banks May Have $20 Billion Combined Exposures – Ledger Insights

The second consultation on crypto assets of the Basel Committee on Banking Supervision closed at the end of September and published the comments received. One of the proposed rules caps the amount of bank exposures to crypto to 1% of bank Tier 1 capital. Some of the comments concluded that means most of the world’s largest banks may have a combined exposure of $20,000. million to crypto assets.

The four most restrictive proposed Basel rules

There are many details in the proposed Basel rules, but the four biggest problems are:

1. Cryptocurrency exposures require a dollar-for-dollar reserve of Tier 1 capital by banks
2. Total cryptocurrency exposures are capped at 1% of Tier 1 capital
3. The use of DLT for traditional assets attracts a surcharge of 2.5%
4. Cryptocurrency custody also has a dollar-for-dollar capital requirement.

Earlier we summarized the joint comments from the major trade associations.

Cryptocurrency exposure limit

The combined Tier 1 capital of 21 of the 30 global systemically important banks (G-SIBs), excluding nine banks in China, Japan and Switzerland, totals $2 trillion, limiting their combined crypto asset exposure ( cryptocurrencies) from Group 2 to $20 billion. The crypto market is currently worth more than $950 billion. So, together, the banks could have a maximum exposure of 2% to the entire cryptocurrency market.

The CME made a similar calculation and concluded that all of its CME clearing bank member firms could have a combined exposure of $20 billion.

Group 2 crypto assets have a 1,250% risk weight, which means banks must set aside one dollar of capital for every dollar of crypto exposure. Although some hedging is now accounted for (up to 65%), in the absence of a cap, this would already discourage bank exposures.

Societe Generale observed that this “risks cementing control of these markets to non-bank players through overly onerous requirements”.

The World Federation of Exchanges and the Deutsche Börse had similar sentiments. “The proposed methodology is unprecedented in financial market regulation when compared to other economically more volatile and less predictable asset classes (such as other complex financial instruments),” Deutsche Börse wrote. “To our knowledge, exposure limits on individual asset classes for banks were not even proposed during the 2008 global financial crisis.”

Some large cryptocurrency exchanges have also responded and also opposed the limit, even though banks could be competition. Institutional adoption is seen by many as a critical path for crypto assets to become mainstream.

Same activity, same risk, same treatment?

Just as the Tier 1 cap for cryptocurrencies was universally scheduled, so was the 2.5% infrastructure risk add-on for Group 1 assets, which covers traditional tokenized assets and extremely conservative stablecoins.

“It is contradictory to the general principle of ‘same activity, same risk, same treatment,’ recognized by the BCBS, especially for assets belonging to group 1a (tokenized traditional assets),” wrote BNP Paribas.

Societe Generale characterized it as “excessively conservative and lacks evidence-based justification. The use of DLT could reduce the level of operational risks in institutions.”

Speaking about the 2.5% surcharge on the tokenization of conventional assets, the German Banking Industry Committee wrote: “There is a risk that this activity could shift from the regulated financial sector to less regulated or completely unregulated sectors. This cannot be claimed by the Basel Committee”.

The 2.5% top-up “sets a precedent for capital punishment for the introduction of new technologies,” the CME wrote, characterizing it as a tax. “The stated goal of the FSB, the International Organization of Securities Commissions (IOSCO), and the BCBS is to achieve a technology-neutral approach to the regulation of crypto assets.”

Deutsche Börse also pointed out the lack of technological neutrality regarding whether the blockchain infrastructure is permissioned or not, because the Basel rules strongly favor permissioned DLT.

Additional charges on activities that are already regulated

Different types of regulated institutions complained that they are already subject to prudential regulation and therefore should not be subject to additional burdens.

For example, both the CME and the CBOE stated that centrally cleared derivatives should be excluded from the 1% Tier 1 capital exposure limits.

Fnality, the DLT-based payment infrastructure, believes that the 2.5% DLT add-on for tokenized conventional assets should not apply as it complies with the Principles of Financial Market Infrastructures.

The World Federation of Exchanges has requested that crypto assets traded on regulated exchanges be given the same treatment as their traditional counterparts. This especially relates to the 2.5% DLT add-on, “particularly where the DLT is managed by an authorized exchange/CCP, which should and should take such risks into account.”

Crypto custody on balance sheet

In April, the SEC imposed a new accounting rule that requires custodians of crypto assets to include the assets they hold on their balance sheet. Normally, assets owned by bank customers do not touch the balance sheet. The rule means that for every dollar of cryptocurrency in custody, a bank must set aside a dollar of capital, which is not a viable business model. State Street described the rule as “crazy”. Major custodians have opposed the rule.

As an example, at the end of June 2022, BNY Mellon, the world’s largest conventional custodian, had assets under custody of $43 trillion with $21.8 billion of Tier 1 capital.

Thus, such a rule essentially prevents conventional custodians from engaging in cryptocurrency custody beyond a small scale.

The first Basel proposal did not take into account assets in custody. But the second proposal published in June stated that exposures to crypto assets also apply to “activities, such as non-fiduciary custody services, that can only give rise to operational risk.”

The Association of Global Custodians wrote: “Our members do not believe it is appropriate for the Committee to use the Second Consultation to redefine the current understanding of the term ‘exposure’ to include assets in custody.” The American Bankers Association agreed.

Three of the world’s largest conventional custodians, BNY Mellon, State Street and Northern Trust, wrote a combined letter objecting to this, as well as the 2.5% DLT add-on for conventional assets and the 1% Tier 1 cap.

Stablecoins and basis risk

There was a fair amount of talk about stablecoins.

Our reading of the proposal is that tokenized bank deposits are considered traditional Group 1a assets rather than 1b stablecoins. Stablecoin issuer Circle seemed to think the same, but BNP Paribas asked for explicit clarification.

The proposed Basel rules include some pretty onerous tests on stablecoins, so current stablecoins are unlikely to be considered Group 1. Otherwise, they become Group 2 with their 1250% risk weight. or dollar-for-dollar capital requirement.

The first test relates to a user’s ability to redeem a stablecoin, and the second is for basis risk. That considers how often a stablecoin has recently lost parity using a conservative 20 basis points.

Since banks are already prudentially regulated, BNP Paribas believes that these tests should not apply to bank-issued stablecoins. The Basel proposals already state that to qualify as Group 1b, a stablecoin must have a supervisor imposing prudential capital and liquidity requirements. The proposals state that the Basel Committee is considering replacing the two tests with this monitoring requirement.

FTX US made the logical point that if a stablecoin passes the redemption test, then the basic test is irrelevant because a user can redeem the stablecoin if the peg is lost. The redemption risk test is meant to work even in a crisis situation. However, regulators would likely argue that they are intentionally being cautious.

Stablecoin issuer Circle argued that its stablecoin is fully backed by cash and cash equivalents and therefore “holds reserves that are safer than tokenized deposits, which the BCBS classifies as Group 1a.” He wants securely backed stablecoins to be treated the same as tokenized deposits.

In general, the comments were more or less consistent in calling for more relaxed rules. The second round of proposals was somewhat more accommodating but considerably more restrictive in other significant respects.

Shortly before the second round of consultations began, the Chairman of the Basel Committee, Pablo Hernández de Cos, said that “diluting bank capital requirements for fear of crypto-asset activities migrating out of the regulated banking system is not an argument. convincing”.