An influential group of central bankers from across the world’s largest economies has opened a consultation designed to draw up the next major cross-border rules on cryptoassets.
The Basel Committee is comprised of the 45 heads of central banks in countries such as Australia, Brazil, China, the UK, South Africa and the United States.
It is the major intergovernmental body that looks at global risks to banking stability and aims to come up with policy to help the banking system to remain in good health.
Its latest industry-wide discussion paper looks at potential new rules on the treatment of cryptoassets.
The paper opened its call for comment from industry participants on 12 December 2019 and will run until 13 March 2020.
what could change
It has been clear for some time that piecemeal, country-level regulation is not sufficient to adequately deal with banks’ rapidly-expanding interest in holding cryptoassets. Those normally conservative, slow-moving organisations like the Basel Committee are coming to recognise this fact.
Banks underpin the entire system. Without the correct capital requirements in place, they could suffer another meltdown akin to the 2007-2008 credit crisis, which is something the Basel Committee desperately wants to avoid.
The Committee’s major point is of principle is that they want to institute a “prudent treatment of bank exposure to cryptoassets”.
too big to fail
The Basel Committee’s most widely-recognised reform for the banking sector came in the wake of the 2007-2008 credit crisis.
The Basel III Accord, as it is known, placed requirements on banks to maintain sensible leverage and debt-to-asset ratios. While technically voluntary, such is the power and influence of these global banking chiefs that any institution that refused to comply would simply be shut out of opportunities to grow within the wider financial framework.
The fallout from the financial crisis informed regulators that too many banks had too little available capital to remain solvent in periods of financial anxiety. As we have mentioned, banks underpin the entire financial system. The Basel Committee came to the conclusion that these systemically important institutions – that are too big to fail – were funded with too much debt and could not remain liquid in the face of large capital losses.
The main outcome of the Accord was that banks had to display they had adequate Tier 1 capital, a measure of their financial stability and strength. This was instituted in 2010.
cryptoassets and tier 1
According to the discussion paper, the same kind of process as the Tier 1 reforms could be put into place for cryptoassets.
Under the section: “Capital and liquidity requirements for high-risk cryptoassets and liabilities”, the Committee explains that “direct holdings of cryptoassets would be allocated to the banking book, and indirect exposures (eg net short positions or derivatives) would be assigned to the trading book”.
Given the “high degree of uncertainty about the realisable value of cryptoassets in times of stress,” bank exposure to cryptoassets would be directly deducted from Tier 1 capital. That means holding cryptoassets would directly affect the calculation that banks have to show regulators that they are financially stable.
risk in times of stress
Because equity markets have — albeit with some notable exceptions — been on a decade-long bull run with valuation rises across the board, “the behaviour of cryptoassets during periods of financial stress has yet to be fully tested,” the paper says.
As such, banks face legitimate series of substantial risk from holding cryptoassets, including liquidity risk — not being able to convert crypto back to fiat currency “at little or no loss of value in private markets” and credit risk — for cryptoassets that constitute a legal obligation between an issuer and a holder, banks holding such cryptoassets may be subject to a credit risk.
The non-financial risks to banks of holding cryptoassets also include cybersecurity risks — in the face of many retail cryptoexchanges suffering hacks with the loss of customer assets, reputational risks from promoting loss-making crypto coins, and legal risks from “misconduct related to anti-money laundering…securities and commodities regulations and cross-border legal framework differences.”
Adding another element of complexity are the differing types of cryptoasset, the Committee says.
The Basel Committee appears to want to follow the UK’s market regulator, the Financial Conduct Authority, in discerning three main types of cryptoasset and to treat each differently. Incidentally, the FCA settled upon security tokens, utility tokens, and exchange tokens in its July 2019 policy paper.
Firstly there are the volatile coins intended to be used as speculative investment vehicles, so-called “high-risk cryptoassets” in the Committee’s view, like Bitcoin, Litecoin and Bitcoin Cash.
Secondly there are security tokens, those cyrptoassets that “represent a claim on an underlying asset” and would have to be subject to “regular external audits“ to derive the true value of any underlying asset.
Lastly, there are stablecoins, which this paper notes are considered to be of lower risk to banks, given that they tend to be backed by reserves of fiat currency or a commodity like gold.
All of the above, from categorisation, to potential bank capital requirements for holding cryptoassets, is now under discussion.
Given the power, reach and influence of the Basel Banking Committee, the crypto world will be watching their conclusions closely come the end of March.