Capital Treatment of Cryptoassets – a heavy price to pay?
Executive Summary
In December 2022 the BCBS published its final prudential standards for the treatment of cryptoassets. This is to be implemented by regulators by 1st January 2025. This framework is applicable to firms who hold cryptoasset exposures on their balance sheet or trading book and will be subject to local regulatory implementation.
The updated standards include some welcomed moderation of the proposed rules in some areas, including the infrastructural risk add-on, basis risk test and exposure limits. However, the final standards still contain a prohibitive 1250% risk weighting for a large group of riskier digital assets (effectively those not backed by traditional assets). In addition to these updates, the BCBS has outlined a number of areas which will be subject to ongoing monitoring and review, all of which we will cover in this blog.
Before launching a cryptoasset business banks must ensure that they have a cryptoasset specific extensive risk management framework in place which acknowledges the distinct risk profile of the asset class across all risk types, liquidity management and reporting. The prohibitive risk-weighting for Group 2b assets would require banks seeking to run a profitable digital assets business to shape a digital asset portfolio which excludes Group 2b classified assets. Banks will need effective product approval and ongoing product governance processes in order to ensure assets are categorised in the right way. This will require expertise, judgement and legal interpretation. In this blog we have set out our initial analysis of three popular stablecoins in order to show how the BCBS classifications is likely to be applied in practice.
BCBS Prudential Treatment Blog
The structure of the standards remains largely consistent with the June 2022 publication:
Group 1 cryptoassets (those which meet in full the classification conditions) and are either tokenised traditional assets, which mirror the credit and market risk of traditional assets but are hosted on DLT (digitised bonds as an example), or stablecoins which meet classifications conditions.
Group 2 (those that fail to meet the classification conditions) are assets such as algorithmic stablecoins, cryptocurrencies and NFTs. The hedge recognition criteria remain in place and act to divide cryptoassets into Group 2a (those where a limited degree of hedging is recognised) and Group 2b (those where it is not recognised)
In order to enhance the standards we would welcome a consistent taxonomy or mapping from the BCBS outlining which assets fall within each category of the framework.
The collaboration of industry participants has been key to providing the BCBS with a holistic view of the Digital Assets landscape. Their responses has most likely been pivotal in the updates we see reflected in the final standards, with the three key areas outlined below:
Infrastructure risk add-on: The first area to receive an update since the consultation is the proposed infrastructural risk add-on for Group 1 cryptoassets. Previously this was set as a fixed RWA add-on of 2.5% of the exposure value. This has been replaced by an approach which allows for the regulator to implement a more nuanced add-on based on observed weaknesses. The BCBS has set the infrastructure risk add-on at 0% initially. This is a welcome approach which recognises the effectiveness of the technology underpinning some of the more mature digital assets infrastructure.
Basis risk test: Secondly, the BCBS considered responses pertaining to the quantitative test based on market value of a cryptoasset, the basis risk test. Ultimately, the BCBS has committed to continuing the pursuit of a statistical test and should this be successful it will be considered as an add-on requirement for Group 1b cryptoassets. However, for now, the requirements are focused on redemption risk tests as a measure of the riskiness of stablecoins. Later in the blog we will explore stablecoins in more detail and the key question banks will have around which of these will meet the BCBS’ redemption risk tests.
Group 2 exposure limit: The final major update to the prudential standards was an updated approach to the Group 2 exposure limit. Banks are advised to retain an exposure to Group 2 cryptoassets below 1% of tier 1 capital. However, the cliff edge has been removed so that exposures up to 2% will be permitted. The decision will allow banks to treat exposures between 0% – 1% with the Group 2a treatment and 1%-2% with the Group 2b treatment. However, once the 2% barrier has been breached all Group 2 assets must be treated with the 2b standardised conservative prudential treatment.
Ongoing Regulatory Monitoring
The BCBS outlined a further set of issues that they would be monitoring on an ongoing basis, the first of which being a topic we’ve touched on: the basis risk test. Further areas include permissionless blockchains, Group 1b cryptoassets received as collateral, the Group 2a criteria and the degree of hedge recognition, and finally the calibration of the Group 2 exposure limit. We expect the regulators and the BCBS to revisit these elements of the rules in future subject to market developments. Banks’ approach to implementing the rules should allow for future changes in these areas particularly.
Deloitte Cryptoasset Decision Tree
The available capital approaches outlined within the BCBS vary significantly depending on the classification of the cryptoasset. Group 1 exposures have banking and trading book options for calculating Credit and Market risk available to firms. For these assets, the full remit of Simplified Standardised Approach (SSA), Standardised Approach (M-SA) and Internal Model Approach (IMA) is available for Market Risk. Similarly for Credit Risk the Standardised Approach (C-SA) and Internal Ratings Based Approach (IRB) are available.
Group 2 assets have fewer approaches available due to the greater uncertainty around their value/liquidity. For Group 2a, the Market Risk Simplified Standardised Approach and Market Risk Standardised Approach are the two options firms have. For Group 2b (effectively unbacked stablecoins and cryptocurrencies and NFTs), all assets are to follow the Standardised Conservative Prudential Treatment which is outlined within the BCBS paper and includes a 1250% risk-weight. Other risk categories and approaches are outlined in the diagram above.
Group 2b Assets and Deloitte Stablecoin Analysis
Stablecoins are cryptoassets with a stabilisation mechanism which helps minimise fluctuations in the market value of the cryptoasset. This allows stablecoins to be used for day-to-day private and business transactions. To ensure stability, stablecoins are pegged to a reference asset such as a fiat currency, commodity, or other cryptoassets (algorithmic stablecoins). Given the updated regulatory approach proposed, removing the infrastructure risk add-on and the basis risk test and redemption risk updates, we have focused on stablecoins specifically however future iterations of our blog series will include analysis of all cryptoassets.
Cryptoassets with effective stabilization mechanisms that meet the classification conditions on an ongoing basis can be placed into Group 1b. An “effective stabilization mechanism” will need to minimize fluctuations (as stated above), ensure the stablecoin is redeemable for a predefined amount of the reference asset and will need to pass the redemption risk test. The stabilization mechanism will also need to be designed to enable risk management similar to the risk management of traditional assets as well as having transparency around the ownership rights of the reserve assets backing the stablecoin.
The objective of the redemption risk test is to ensure that the reserve assets backing the stablecoin are sufficient to enable the stablecoin to be redeemable at all times for the peg value (including periods of extreme stress). This requires the value of the reserve assets to be equal or greater than the aggregate peg value of all outstanding cryptoassets. Additionally, the portfolio of reserve assets must hold minimal market and credit risk. For example, the majority of reserve assets must be High Quality Liquid Assets (HQLA) and denominated in the currency which the stablecoin is pegged to. Finally, there should be transparency around the value and composition of reserve assets. This measure includes regular public disclosures of the value and composition of reserve assets as well as independent external audits of the reserves at least once annually.
Deloitte has conducted analysis of the three largest stablecoins (based on publicly available data which is externally audited) by market cap (as of 1st February 2023) against the above criteria:
Value of reserves: Our analysis from December 2022 composition reports shows that all the stablecoins have sufficient reserves backing the stablecoin in terms of value. All the stable coins are 100% backed by reserves at a 1:1 ratio.
Quality of reserves: Reserves for most of the stablecoins are composed of cash reserves and cash equivalent reserves denominated in US Dollars (the reference asset for all three stablecoins) which can be seen as HQLA. USD Coin has the largest amount of cash reserves out of all three stablecoins (23.69%), this is greater than both Tether (7.93%) and Binance USD (3.42%). However, the reserves for Tether (largest stablecoin by market capitalisation) are also composed of “other investments” which may not be seen as HQLA. The breakdown of reserves for the three largest stablecoins by market capitalisation can be seen in the graph below.
Transparency and valuation: Focusing on transparency, although all three are externally audited at least once a year, there are irregularities in the public disclosures of the value and composition of reserve assets. More specifically the composition of reserves are not disclosed weekly for all three stablecoins. The requirement of disclosing the value of reserves daily is only met by Tether and USDC out of all three stablecoins.
This analysis suggests that currently there are potential barriers to these stablecoins meeting the strict requirements to avoid being counted as Group 2b assets. However, transparency of stablecoin reserves is increasing - new regulatory requirements around fiat-backed stablecoins are imminent in the UK and EU, and the publication of the BCBS standards may act as a catalyst for stablecoin operators to increase the transparency and quality of their reserves.
A placement in Group 1b for a stablecoin would mean capital treatment generally based on the existing Basel framework. However, there may also be additional capital costs for assets which avoid Group 2b: add-ons may be levied for any infrastructure weaknesses; and stablecoins which do not meet the ongoing classification conditions will be subject to more prudent capital requirements of Group 2a (if the hedging criteria is met) or Group 2b (if the hedging criteria is not met). It also must be noted that algorithmic stablecoins do not qualify for Group 1b.
Conclusion
Ultimately, while the proposed regime remains stringent, it is not as tough as that consulted upon. The direction of travel appears to be towards a regime which will allow banks to conduct cryptoasset business but which will require high standards of risk management tailored to the risks of individual cryptoassets. A robust consultation period which supports local implementation and enhancement of the existing standards will allow firms to enter the marketplace with more certainty, currently there are more questions than answers.
On a positive note, even if the high requirements for Group 2 will continue to contribute to banks’ hesitance to engage with some asset classes, the use of the technology per se to facilitate operational efficiency is not punished (i.e. tokenised traditional instruments) and this will incentivise innovation. On a parallel note, there’s the complexity of a lack of homogenised taxonomy which could lead to confusion within the Financial Industry, and whilst this publication provides clarity on capital obligations, there’s no certainty that every institution will interpret a particular asset class in equal measure. Overall, all progress is welcome, and the more regulatory guidance received, the more comfortable institutions be exploring both the technology itself and the different asset classes it brings.
[i] Data has been accumulated from the following sources: Tether Assurance Consolidated Reserves (Dec 2022); USDC Attestation report (Dec 2022); Binance USD Attestation Report (Dec 2022)
