Basel crypto rules: 21 biggest banks could have $20bn combined exposure – Ledger Insights

The second consultation on cryptoassets by the Basel Committee on Banking Supervision concluded at the end of September, and it published the feedback received. One of the proposed rules limits the amount of bank exposures to cryptocurrency to 1% of bank capital. Some of the feedback concluded that most of the world’s largest banks may have a combined exposure of $20 billion to crypto assets.

The four most restrictive proposed Basel rules

There are many details in the proposed Basel rules, but the four main issues are:

1. Exposures to cryptocurrency require a dollar-for-dollar set aside of Tier 1 capital by banks
2. Total cryptocurrency exposure is limited to 1% of Tier 1 capital
3. DLT use for traditional assets attracts a surcharge of 2.5%
4. Cryptocurrency custody also has a dollar-for-dollar capital requirement.

We have previously summarized the joint feedback from large industry organisations.

Cryptocurrency exposure limit

The combined Common Equity Tier 1 capital of 21 of the 30 Globally Systemically Important Banks (G-SIBs) – excluding nine banks in China, Japan and Switzerland – totals $2 trillion, limiting their combined Tier 2 cryptoasset (cryptocurrencies) exposure to $20 billion . The crypto market is currently worth more than $950 billion. So, in total, the banks can have a maximum exposure of 2% to the entire cryptocurrency market.

CME did a similar calculation, concluding that all of the CME Clearing bank member firms could have a combined exposure of $20 billion.

Group 2 crypto-assets have a risk weight of 1250%, meaning banks must set aside a dollar of capital for every dollar of cryptocurrency exposure. Although some hedging has now been accounted for (up to 65%), this will already, in the absence of a ceiling, disincentivize bank exposures.

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

The World Federation of Exchanges and Deutsche Börse had similar sentiments. “The proposed methodology has no precedent 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. “Individual asset class exposure limits for banks have not, to our knowledge, even been proposed during the 2008 global financial crisis.”

A few major crypto exchanges also responded, and they also objected to the fee, despite banks potentially being competitive. Institutional adoption is seen by many as a critical path to cryptoassets becoming mainstream.

Same activity, same risk, same treatment?

As much as the Tier 1 cap on cryptocurrencies was universally calculated, so was the 2.5% infrastructure risk surcharge for Tier 1 assets, which covers tokenized traditional assets and extremely conservative stablecoins.

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

Societe Generale characterized it as “excessively conservative and lacking evidence-based justification. The use of DLT can lower the level of operational risk in institutions.”

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

The 2.5% surcharge “sets a precedent for using capital punishment for the introduction of new technologies,” wrote CME, which characterized it as a tax. “The stated aim of the FSB, the International Organization of Securities Commissions (IOSCO) and the BCBS is to achieve a technology-neutral approach to the regulation of cryptoassets.”

Deutsche Börse also pointed to the lack of technology neutrality regarding whether the blockchain infrastructure is permissioned or permissionless, because the Basel rules strongly favor permissioned DLT.

Additional burdens on activities that are already regulated

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

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

Fnality, the DLT-based payment infrastructure, believes that the 2.5% DLT surcharge for tokenized conventional assets should not apply since it already complies with the Financial Market Infrastructure Principles.

The World Federation of Exchanges called for cryptoassets traded on regulated exchanges to be treated the same as their traditional counterparts. This applies in particular to the 2.5% DLT surcharge, “especially when DLT is managed by an authorized exchange/CCP, which must and does take such risks into account.”

Crypto depository on the balance sheet

In April, the SEC introduced a new accounting rule, which requires custodians of crypto assets to place the assets they hold on their balance sheets. Normally, assets owned by the banks’ customers do not affect 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 “madness”. The major administrators have all objected to the rule.

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

Therefore, such a rule essentially blocks conventional custodians from participating in cryptocurrency custody beyond a small scale.

The first Basel proposal did not consider held assets. But the second proposal published in June stated that exposures to cryptoassets also apply to “activities, such as non-regulatory custody services, which 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 held in custody.” The American Bankers Association agreed.

Three of the world’s largest conventional managers, BNY Mellon, State Street and Northern Trust, wrote a joint letter objecting to it, as well as the 2.5% DLT surcharge for conventional assets and the 1% Tier 1 cap.

Stablecoins and basis risk

There was a lot of feedback about stablecoins.

Our reading of the proposal is that tokenized bank deposits are considered group 1a traditional assets as opposed to 1b stablecoins. Stablecoin issuer Circle seemed to agree, but BNP Paribas asked for explicit clarification.

The proposed Basel rules include some fairly onerous tests on stablecoins, so it is unlikely that any current stablecoins will be considered Group 1. If this is not possible, they will become Group 2 with 1250% risk weighting or dollar-for-dollar capital requirements.

The first test is related to a user’s ability to redeem a stablecoin, and the second is for basis risk. It takes into account how often a stablecoin has lost its peg recently using a conservative 20 basis points.

Given that the 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 supervisory authority that imposes capital and liquidity requirements. The proposals state that the Basel Committee is considering replacing the two tests with this supervisory requirement.

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

Stablecoin issuer Circle claimed that its stablecoin is fully backed by cash and cash equivalents and therefore “has reserve holdings that are safer than tokenized deposits, which the BCBS classifies as Group 1a”. It wants to see securely backed stablecoins treated in the same way as tokenized deposits.

In general, the feedback was more or less consistent when it came to asking for more relaxed rules. The second round of proposals was in some ways more accommodating, but significantly more restrictive in other significant aspects.

Just before the start of the second round of consultations, the head of the Basel Committee Pablo Hernández de Cos said, “dilution of the bank’s capital requirements due to fears that crypto-asset activities will migrate outside the regulated banking system is not a convincing argument.”