Banks and cryptoassets – the first introduction of a regulatory framework.

Welcome to Finance and Fury. This episode we will continue looking at the crypto markets. In particular, we focus on the regulatory frameworks that have been released by the Bank for international settlements, BIS for short.

1. One division of the BIS - the Basel Committee on Banking Supervision - released a consultation paper this month to provide a framework to every nation's regulator of financial institutions on how to treat cryptocurrencies -
   1. Now – the Basel Committee on Banking Supervision is the world's most powerful regulator of banking standards and rules – it gets to decide what capital adequacy banks should focus on, as well as what assets should be classified as capital – if you have been listening for a while, you would have heard me mention this group – they are who APRA, who regulates superfunds and banks in Aus take their directions from
   2. So this recent release is meant to provide the framework for banks on how to treat different forms of cryptocurrency on their balance sheets - if they wish to start purchasing crypto
2. The big question of this episode is if this is a major win for cryptocurrencies, as it was initially treated as purely based around market price reactions, or is this something that could actually damage the crypto markets through a financial system takeover?
3. Firstly, it is important to note that this paper does not refer to crypto as a currency – such as the name cryptocurrency would imply – instead, they call them cryptoassets – implying that these are assets for banks or for the financial system to hold or trade these as assets – this off the bat could be viewed as an implied intent, where in the BIS's view, existing cryptos will never be treated as a currency in the mainstream – but I wanted to mention this as I will be using the term cryptoasset throughout most of this episode when it is in relation to this prudential paper – please forgive me in advance as cryptoassets will be mentioned a lot
   1. Another important point is that this report specifically states that central bank digital currencies will not fall under this legislative framework – which also implies that this is a serious option that they are looking at and will fall under a different legislative framework – as an actual currency, not a crypto asset – which we will come back to next week

Start with the introduction to the BIS report –

1. The BIS have noted that over the past few years, they have seen rapid growth in cryptoassets – with market capitalisation of these assets rising – sitting at an estimated $1.5 trillion
   1. But while the cryptoasset market remains small relative to the size of the global financial system – there continues to be rapid developments, with increased attention from a broad range of stakeholders – these stakeholders are some investment banks, since banks like JPM, Goldman and Citi have already launched their own crypto-focused businesses – I find it hard to believe that the BIS would view individuals as stakeholders
2. In this report the BIS brings up the normal rage of concerns with Cryptoassets – including consumer protection, money laundering and terrorist financing, as well as their carbon footprint from the electricity usage
   1. But the big point of concern they focus on is that, quote: "The Committee is of the view that the growth of cryptoassets and related services has the potential to raise financial stability concerns and increase risks faced by banks."
   2. In other words, crypto can be destabilising on the financial system – anything that provides some potential competition is destabilising if you are used to monopoly controls – this happens in all aspects of commerce – if you have a monopoly business operating who can fix prices and provide poor services, then a competitor appears, this is destabilising for your business practices, you will lose customers – so what to do? In most cases they simply buy out the competitor or have them shut down
   3. If banks were to start trading crypto using derivatives, then this could also pose a risk to the financial system
3. The report also mentions that certain cryptoassets have exhibited a high degree of volatility, and could present risks for banks as exposures increases – these risks include liquidity risk; credit risk; market risk; operational risk (which include fraud and cyber risks); money laundering / terrorist financing risk; and legal and reputation risks – this basically ticks all the risk boxes beyond political/legislative risk – but to the BIS this isn't a concern, as they impose these risks on the market
   1. To that end, the BIS Committee has taken steps to address these risks through producing this legislative framework – and they first started looking at this over two years ago, back in March 2019 – where the Committee published an article on the risks associated with cryptoassets – then in December 2019, the Committee published a discussion paper seeking views of stakeholders on a range of issues related to the prudential treatment of cryptoassets – remember stakeholders are entities with direct connections to the BIS – i.e. Central Banks and megabanks
   2. It is important to note that mega banks like JPM, Goldman and Citi group are very interest in securitising crypto – anything that can be securities to make a profit off is a bonus in their eyes – remember in the mid-2000s they were creating synthetic contracts off collateral debt obligations – i.e. peoples mortgages to try and made more money than simply what the interest payments could provide to a commercial bank

How does this legislative framework treat cryptocurrencies – or cryptoassets as the BIS refers to them – I won't be covering the minute details for the sake of time, as this report is 20 something pages long – but if you are interested the links will be in the show notes at financeandfury.com – or you can look up Prudential treatment of cryptoasset exposures – but I will be covering the higher level implications of this framework

1. Cryptoassets are defined as private digital assets that depend primarily on cryptography and distributed ledger or similar technology – these digital assets are a digital representation of value, which can be used for payment or investment purposes
2. The prudential treatment of cryptoassets has been guided by three general principles:
   1. Same risk, same activity, same treatment: a cryptoasset that provides equivalent economic functions and poses the same risks compared with a "traditional asset" should be subject to the same capital, liquidity and other requirements as the traditional asset. The prudential treatment should, however, account for any additional risks arising from cryptoasset exposures relative to traditional assets.
   2. Simplicity: The design of the prudential treatment of cryptoassets should be simple. Cryptoassets are currently a relatively small asset class for banks. As the market, technologies and related services of cryptoassets are still evolving, there is merit in starting with a simple and cautious treatment that could, in principle, be revisited in the future depending on the evolution of cryptoassets.
   3. Minimum standards: Any Committee-specified prudential treatment of cryptoassets would constitute a minimum standard for internationally active banks. Jurisdictions would be free to apply additional and/or more conservative measures if warranted. As such, jurisdictions that prohibit their banks from having any exposures to cryptoassets would be deemed compliant with a global prudential standard
      1. This is an important point – as the framework is the minimum standards that need to be applied – if a regulator wishes to go above and beyond, or even ban banks for holding crypto, that is well within their rights and would be deemed compliant

In essence – what these principles do – assuming a bank is allowed to trade crypto - is break it down into groups of assets – Group 1 (broken down into A and B) and then Group 2

1. Group 1 cryptoassets – these fulfil a set of classification conditions and as such are eligible for treatment under the existing Basel Framework (with some modifications and additional guidance). These include certain tokenised traditional assets and stablecoins
   1. Group 1 cryptoassets will be subject to at least equivalent risk-based capital requirements based on the risk weights of underlying exposures as set out in the existing Basel capital framework.
   2. The cryptoasset either is a tokenised traditional asset or has a stabilisation mechanism that is effective at all times in linking its value to an underlying traditional asset or a pool of traditional assets. In the case of underlying physical assets, they must verify that these assets are stored and managed appropriately
   3. All cryptoasset arrangements must ensure full transferability and settlement finality at all times. In addition, cryptoassets with stabilisation mechanisms must ensure full redeemability (ie the ability to exchange cryptoassets for cash, bonds, commodities, equities or other traditional assets) at all times.
2. Group 2 cryptoassets – are those, such as bitcoin, that do not fulfil the classification conditions. Since these pose additional and higher risks, they would be subject to a new conservative prudential treatment
   1. These coins are the ones that people would be more familiar with – such as BTC, ETH, ripple, really any coin that isn't a stable coin or a tokenized version of an asset like a share, bond, commodity or currency
3. Each of these groups therefore have different Capital requirements for each banks reserve requirement - Similar to activities related to traditional assets that the banks hold, such as loans, bank activity related to cryptoassets will increase the operational risk charge to a bank within the Basel framework – due to cryptoassets being new and rapidly evolving, there is potentially an increased likelihood that they pose unanticipated operational risks in most cases to the banking system – this is basically saying that they don't know the true risks to the financial system if banks start trading crypto
   1. Group 1 cryptoassets will be subject to the requirements set out in the Basel Framework for a normal asset that the banks hold – group 1 is broken up into two categories depending on the classification of the asset
      1. Group 1a cryptoassets: tokenised traditional assets – i.e Tokenised traditional assets use an alternative way of recording ownership of traditional assets through the use of cryptography - may be treated as equivalent to a traditional asset for the purpose of calculating minimum capital requirements for credit and market risk - In practice this means that a tokenised cryptoasset is treated the same as - Bonds, loans, commodities, deposits and equities in regards to capital adequacy requirements
         1. This is because this form of cryptoasset must confer the same level of legal rights as ownership of these traditional forms of financing, eg rights to cash flows, claims in insolvency etc.
         2. For example, a tokenised corporate bond held in the banking book will be subject to the same risk weight as the non-tokenised corporate bond held in the banking book. Similarly, if a bank holds a derivative on a tokenised asset, it will be reflected in the market risk charge in the same way as a derivative on the non-tokenised asset – so in the banks eyes there is no difference in holding a bond or a tokenised version of the bond
         3. so – a tokenised cyptoasset can be recognised as collateral for the purposes of credit risk mitigation if it falls within the framework
      2. Group 1b cryptoassets: cryptoassets with stabilisation mechanisms that seek to link the value of a cryptoasset to the value of a traditional asset or a pool of traditional assets through a stabilisation mechanism.
         1. Cryptoassets under this category must be redeemable for underlying traditional asset(s) (eg cash, bonds, commodities, equities) – things like a stablecoin – so whilst not a tokenised version of the asset, its value is linked to the underlying asset, therefore it is treated relatively similar – however
      3. Group 2 cryptoassets – are those that pose unique risks compared with Group 1 - as such are subject to the newly prescribed capital requirement – these are coins like BTC and ETH – anything that doesn't have a tether to the value
         1. A risk weight of 1250% is applied to the greater of the absolute value of the aggregate long positions and the absolute value of the aggregate short positions to which the bank is exposed.
            4. A 1250 percent risk-weight is the equivalent in banking terminology to a 100% capital requirement
         2. So for bitcoin and Ethereum - this would require banks to hold $1 dollar for every $1 in "exposure" to those assets

• This is in line with the toughest standards for banks' exposures on riskier assets, such as illiquid shares or junk bonds - So if the bank has a $100 exposure in bitcoin this would result in a minimum capital requirement of $100

1. This also applies to cryptoasset derivatives positions with the potential maximum loss value under a RWA formula – This can be a bit of an issue for the derivative markets – as the RWA is often not the total loss based around the value of the trade, but the cost of the derivative contract – which is often many times smaller – as you are paying for a premium

4. So in summary – if the assets are a tokenised version of an asset, or use an asset as an anchor for their value, then the banks can hold these and it can be treated as part of their capital requirements under the existing Basel III requirements – so banks can use this as part of CAR to against their RWA – under Basel III – you need to hold 8% of your RWA – which in Aus is calculated as 35% of your loans

My take on all of this

1. This could be good news for crypto markets, as they now may see greater recognition by the most powerful financial institution on earth when it comes to providing direction on regulatory frameworks
2. Or, it could be that the financial system sees another way to make some money – so why not take the plunge?
   1. There is nothing inheritably wrong with making money – but the way that banks do this, especially in the US is different from you or I purchasing crypto
3. The issue with this is the structure of the financial system – as these banks are TBTF
   1. If you buy one BTC for $50k and it drops down to $10k, you have lost $40k which sucks – you will likely feel bad – but you can hold onto this and hope the price recovers
   2. But the way a bank like JPM or Goldmans make these trading positions is normally though the use of derivatives on these assets – they only put up a fraction of the funds and cannot simply hold if the prices decline – because of counter party risk – as each bank tries to get out of a position at one point of time – this can create major issues -financial system collapse –
   3. If you go bankrupt – then too bad – if a bank goes bankrupt – this becomes your problem – as banks will get bailed out – remember, they are Too big to fail
4. The BIS notes that the extreme price volatility of some of these assets – particularly those in group 2 – have unproven track record of liquidity will make it challenging to hedge positions when providing derivative instruments or when manufacturing investment products that reference crypto assets
5. There are any number of ways that this can explode in the future – here are just three I can think of off the top of my head
   1. One – Requirements for additional dollars or bonds to be printed to absorb the increase in the RWA for any bank holding category 2 of the crypto assets – Say BTC does go to $500k - Banks need to increase cash they hold if prices rise – banks don't hold much cash relative to their overall asset and liability position – the balance sheet of banks is basically neutral – they have the same amount of liabilities as assets – so if the price of cryptos increases massively, then banks would need to have central banks expand the money supply further for them to maintain their CAR requirements
      1. Reminds me a little bit of the Mississippi bubble – the price of assets increases to the point that people want to cash out – but not for a worthless form of conversion such as the paper money being issued – if cash like the USD continues to be expanded at its current pace – people could request alternative assets destabilising the financial system - could create a major issue down the road
   2. Two – asset bubble through bank speculation and derivative practices – The GFC period was bad enough when you have banks speculating on newly created assets – whilst mortgages have been around for hundreds of years, the CDOs were relatively new –
      1. Through entering into crypto – banks are entering into a new territory of pure speculation – the buying and selling of cryptoassets by itself isn't the issue – but the speculative practice of derivates and who knows what else they come up with in the years to come could become a major issue for the stability of the financial system – could both collapse crypto markets as well as shares and bonds if economic confidence gets hit
   3. Three – Additional risks, such as AML issues – if the banks do not act in good faith, because to be honest they do not have a good history of this – there could be a call by regulators for additional crack downs on crypto

So in summary – this legislation Creates a two tiered system for Cryptos – and opens the door for the largest financial entities to begin speculating on what is already a volatile asset

1. For the two tiers - one is seen as good as the assets underlying it - The other – is seen as a very risky asset class
   1. So we may also see the rise of tokenised assets and a new wave of how the economy works
2. In addition – it means that you will now be competing with the most sophisticated traders on earth – complex computer algorithms dictating market prices could see larger swings in volatility
3. It goes without say that governments are increasingly focused on issues surrounding cryptocurrencies – especially with some central banks exploring digital currencies – this even came up in the recent G7 meetings this month
4. So we will finish off the crypto series next episode looking at China's Central bank digital currency

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https://www.bis.org/bcbs/publ/d519.pdf