On November 9, 2021, the Basel Committee on Banking Supervision (the “BCBS”) issued a press release that, among other things, reiterated its commitment to developing a “conservative risk-based global minimum standard” to address potential risks to the banking system arising from crypto-assets. This announcement followed a June 10, 2021 public consultation, a December 12, 2019 discussion paper and a March 13, 2019 newsletter, the sequence of which evidence steady progress by the BCBS in developing a more precise and risk-sensitive taxonomy for cryptoassets, but also reveal that there is significant work to be done to address concerns raised by industry commenters. As a part of the press release, the BCBS announced that it had reviewed comments to the Consultation and specified that it would issue a further consultation by mid-2022.

In this Debevoise Update, we summarize the BCBS’s progress to date in developing a prudential framework for crypto-assets, and highlight the evolution of key themes.

March 13, 2019 – Newsletter. On March 13, 2019, the BCBS published a newsletter on the risks associated with crypto-assets styled as a “Statement on crypto-assets” (the “Newsletter”). Although the Newsletter did not formally define the term “crypto-assets,” it explicitly carved out from its scope any central bank digital currencies (“CBDCs”), described the common association with the term “cryptocurrencies,” and set forth the BCBS’s view that cryptocurrencies did not “reliably provide the standard functions of money and are unsafe to rely on as a medium of exchange or store of value.”  The Newsletter went on to identify key risks arising from the asset class that it regarded as having a “high degree of volatility” and “an immature asset class given the lack of standardization and constant evolution.”  The Newsletter cautioned that if a bank decided to acquire crypto-asset exposures or provide related services, the bank should:

  • Conduct due diligence of identified risks prior to acquiring any crypto-asset exposures or providing related services;
  • Have a clear and robust risk management framework appropriate for the risks of its crypto-asset exposures and related services;
  • Disclose material crypto-asset exposures or related services as a part of its regular financial disclosures (including by specifying the accounting treatment); and
  • Inform its supervisor of any actual and planned crypto-asset exposure or activity.

December 12, 2019 – Discussion Paper. On December 12, 2019, the BCBS published a discussion paper (the “Discussion Paper”) that sought to obtain views of relevant stakeholders on a range of issues related to the regulatory treatment of crypto-assets, including the features and risks of crypto-assets that should inform the design of a prudential framework for a banks’ crypto-asset exposures as well as general principles and considerations that should guide the design of such a prudential framework. Key features of the Discussion Paper are discussed below.

  • Evolving Taxonomy. The Discussion Paper reiterated the Newsletter’s position that crypto-assets were an “immature asset class” but, in contrast to the Newsletter, clarified that only certain crypto-assets “have exhibited a high degree of volatility, and present risks for banks,” and included a nod to initiatives in the crypto-asset space to reduce volatility by anchoring crypto-assets to one or more reference assets (e., stablecoins).
    • Although the Discussion Paper did not define “crypto-asset,” and acknowledged that there was “no single or generally-recognised definition,” it tried to identify certain technological and design features of the asset class, including its digital and virtual nature, reliance on cryptography and use of distributed ledger technology.
    • The Discussion Paper also tried to identify certain economic functions and sources of value of crypto-assets, and sought to identify additional factors that could affect the risk profile of crypto-assets, including arising from the creation of the crypto-asset, users of crypto-assets, validators of crypto-assets and the applicable legal regime and transparency related to crypto-asset market data.
  • Principles That Guide Framework. The Discussion Paper set out three general principles intended to guide the design of a potential prudential framework for crypto-asset exposures, as follows:
    • Neutral – a crypto-asset and a “traditional” asset that are otherwise equivalent in their economic functions and risks should be treated the same for prudential purposes, e., the prudential framework should be technology-neutral. The BCBS refers to this as the “same risk, same activity, same treatment” principle.
    • Simple – The design of the prudential framework should be simple and flexible in nature, given that the asset class is relatively small.
    • Minimal– any framework should be a minimum standard; individual jurisdictions should be free to apply additional or more conservative measures if warranted.
  • Treatment of Cryptocurrencies and “High-Risk” Crypto-Assets. The Discussion Paper also reiterated the BCBS’s belief that cryptocurrencies, as a subset of the larger crypto-asset class, do not “reliably provide the standard functions of money and are unsafe to rely on as a medium of exchange or store of value.” The paper went on to recommend a conservative prudential treatment for such exposures.
    • The Discussion Paper defined “high-risk” crypto-assets as having certain features, including that: (1) they are digital assets that are recorded on a distributed ledger technology platform and are secured cryptographically; (2) they are not issued by a jurisdictional authority or another identified issuer; (3) they have no intrinsic value and are not explicitly and directly linked to, or backed by, assets with intrinsic values; and (4) holdings of the assets do not give rise to a contract between the holder and another identified issuer.
    • The Discussion Paper went on to provide an “illustrative example” of how capital and liquidity requirements would be implemented. This example provided extremely punitive deduction, or deduction-equivalent treatment for purposes of banking book and trading book risk-based capital requirements, prohibited crypto-assets from being eligible to serve as “financial collateral” for purposes of the credit risk mitigation framework or as “high-quality liquid assets” for purposes of the Liquidity Coverage Ratio (“LCR”) and net stable funding ratio (“NSFR”) frameworks, and subject to the most stringent inflow/outflow and required/available stable funding requirements under the LCR and NSFR.

June 10, 2021 – Consultation. On June 10, 2021, the BCBS issued a public consultation (the “Consultation”), which set out guiding principles for the prudential treatment of crypto-assets exposure, proposed taxonomy for crypto-assets, and set forth certain regulatory, supervisory and disclosure requirements for banks engaged in crypto-asset activities.

  • Further Evolving Taxonomy. The Consultation built on the Newsletter and Discussion Paper by adopting the more precise definition of crypto-asset used by the Financial Stability Board—a “private digital asset that depends primarily on cryptography and distributed ledger or similar technology.” Excluded from the scope of the Consultation were “dematerialized securities” recorded on electronic versions of traditional registers and databases (distinct from those recorded with distributed ledger technology), central bank digital currencies and traditional assets already covered by the BCBS capital framework.
  • Guiding Principles. The Consultation’s classification framework for crypto-assets was based on the three principles set out earlier in the Discussion Paper: (1) same risk, same activity, same treatment; (2) simplicity; and (3) minimum standards.
  • Classification Framework. The Consultation divided crypto-assets into three broad categories for purposes of prudential treatment:
    • Group 1a included crypto-assets that are tokenized versions of traditional assets. These generally would be subject to the same capital requirements as the underlying traditional asset (subject to add-on operational risk charges based on any new risk resulting from the tokenization),[1] consistent with the “same risk, same activity, same treatment” principle.
    • Group 1b included crypto-assets that have a stabilization mechanism that ‘is effective at all times in linking its value to an underlying traditional asset or pool of traditional assets.” Such crypto-assets would be subject to the same capital requirements as the underlying pool of assets (subject to add-on operational risk charges based on any new risk resulting from the tokenization and/or the stabilization mechanism).
    • In order to be classified as a Group 1a or Group 1b crypto-asset, certain additional conditions must be met, including that: (1) all rights, obligations and interests arising from crypto-asset arrangements that meet the condition above are clearly defined and legally enforceable in jurisdictions where the asset is issued and redeemed; (2) the applicable legal framework(s) ensure(s) settlement finality; (3) the functions of the crypto-asset and the network on which it operates, including the distributed ledger or similar technology on which it is based, are designed and operated to sufficiently mitigate and manage any material risks; and (4) entities that execute redemptions, transfers or settlement finality of the crypto-asset are regulated and supervised. The Consultation did not distinguish between trading book and banking book treatment.
    • Group 2 included all other crypto-assets, including Bitcoin. The Consultation proposed a risk weight of 1250% (calculated separately for each crypto-asset in Group 2) “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.” This treatment seems to align with the Discussion Paper’s “illustrative” treatment for certain “high-risk” crypto-assets.
  • Interaction with Other Prudential Frameworks. The Consultation clarified that its proposals did not seek to deviate from existing leverage ratio, large exposures framework or liquidity ratio requirements.
    • The proposed LCR and NSFR treatment would be the same as the Discussion Paper’s “illustrative” treatment for high-risk crypto-assets.
  • Supervisory Review and Disclosure Requirements. The Consultation recommended that banks engage in risk management, including by addressing (1) the heightened operational and cyber risk of crypto-assets exposure; (2) risks attributable to the underlying technology; and (3) AML and financing of terrorism risks. As to disclosure, in line with general BCBS principles, the Consultation recommended that banks’ disclosure of their crypto-asset holdings should be clear, comprehensive, meaningful to users, consistent over time and comparable across banks.
  • Industry Response. Industry response to the Consultation was mixed.  Criticisms include those with respect to the Group 1a and 1b classification prerequisites, the lack of risk-sensitivity within Group 2 and collateral eligibility, among other issues.

The authors would like to thank Debevoise Summer Law Clerk Tejas Dave for his contribution to this article.

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[1]       With respect to recognition as collateral under the credit risk mitigation framework, the Consultation suggested that banks only recognize those crypto-assets where volatility in values and holding periods under distressed market conditions either can be confirmed to not be materially increased compared with the traditional asset pool or traditional assets or where any material increase can be reflected by prudent increases to the parameters applied for the traditional asset.

Author

Satish Kini is a corporate partner and Chair of Debevoise’s Banking Group and a member of its Financial Institutions Group. He can be reached at smkini@debevoise.com.

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Gregory Lyons is a corporate partner and Co-Chair of Debevoise’s Financial Institutions Group. Mr. Lyons is also Chair of the New York City Bar Association Committee on Banking Law. He can be reached at gjlyons@debevoise.com.

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Alison M. Hashmall is a counsel in the firm’s New York office and a member of Debevoise's Banking Group. Ms. Hashmall’s practice focuses on advising domestic and non-U.S. banking organizations and other financial institutions on a wide range of bank regulatory, policy, and transactional matters and cryptocurrency-related issues. She can be reached at ahashmall@debevoise.com.

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Caroline Swett is a corporate counsel and a member of Debevoise’s Financial Institutions and Banking Groups. She can be reached at cnswett@debevoise.com.

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Chen Xu is a counsel of the Banking Group and is resident in the New York office. His practice focuses on advising banking clients on a wide range of bank regulatory, policy and transactional matters and cryptocurrency-related issues, including in the areas of regulatory capital, liquidity and stress testing. Mr. Xu is recognized as an “associate to watch” by Chambers USA (2021), where clients say that he is “a tremendous resource” who is “just exceptional at working through the real technical nuances of capital rules and the other quantitative aspects of technical regulations.” Mr. Xu received his J.D. from Columbia Law School in 2013 and his B.A. from University of California, Berkeley in 2010. He can be reached at cxu@debevoise.com

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Taylor Richards is a corporate associate and a member of Debevoise's Banking Group. She can be reached at tmrichards@debevoise.com.

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Amy Aixi Zhang is a corporate associate and a member of Debevoise's Banking and Financial Institutions Groups. She graduated from Harvard Law School in 2020. During her time in law school, Ms. Zhang was President and Co-Founder of the Harvard Law School Blockchain and FinTech Initiative. She authored “Regulating Crypto Assets: Securities and Commodities,” a case study published in FinTech Law: The Case Studies by Harvard University Press in July 2020 and was a fellow at a mortgage servicing fintech company before joining Debevoise in 2020. She can be reached at aazhang@debevoise.com.

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