The Potential Impacts of Banking Regulators’ Proposal to Classify Crypto as Risky Assets

What is on the mind of the Basel Committee on Banking Supervision in regard to cryptocurrencies positions and the allocation of capital? The organization recently published a consultation paper that establishes collateral rules for various crypto holdings. In this article, Greg Bunn, Chief Strategy Officer at CrossTower, and Martin Gaspar, a Research Analyst at CrossTower, review the Basel Committee's paper and offer their analysis.

On June 10, 2021, the Basel Committee on Banking Supervision, which sets minimum standards for international banks, published a public consultation paper on how banks will be required to allocate capital on cryptocurrency positions, loans, and other exposures. The paper is notable as the proposed treatment of crypto is very punitive on what is categorized as Group 2 cryptos, which would effectively include all cryptocurrencies that are not stablecoins. While such treatment of crypto would be quite conservative, we are not surprised by this as the Committee has been hinting for some time that this would be the likely outcome.

The proposal provides substantially more details on stablecoins than we have seen before and the rules could pose real challenges for banks wishing to participate in crypto activities. As part of the proposal, cryptocurrencies will be divided into Group 1(a) – Tokenized assets, Group 1(b) – Crypto with stabilization mechanisms, and Group 2 – All other crypto. Group 1(a) assets will be treated as a look through to the underlying assets (ex: a tokenized loan will carry the same risk weighting as the equivalent loan), with add-ons for operational risk, such as security interests and legal challenges.

Group 1(b) assets will be treated as a look through to the underlying asset with a credit risk add-on for unsecured counterparty credit exposure to the asset redeemer. Where a Group 1(b) asset is re-pledged to a lending pool, the treatment is as above with an additional credit risk add-on for unsecured exposure to the pool operator. There is a plethora of obligations on banks if they classify something as Group 1, including legal, monitoring, and documentation. There are also operational risk add-ons for all of the above.

One notable detail in the proposed rules is that if the difference between the value of a Group 1 asset exceeds that of the asset to which it is tied by more than 10 bps three times over a one-year period, it is reclassified as Group 2. Such parameters raise the question of whether any crypto can be considered a stablecoin. For example, during the May 2021 selloff, the popular stablecoin USDT was trading at least 70 bps or more from its $1.00 target.

Group 2 assets are risk weighted at 1,250%. This means that a bank with an 8% Tier 1 capital ratio effectively has a 100% capital deduction. If the bank held $100 of BTC, it would need to hold $100 of capital against it. Consequently, Group 2 assets will have no collateral value for lending.

It is important to note that the paper asks for comments on which activities, such as transfer agents and asset servicing, should be out of scope. The proposed rules do not necessarily stop banks from participating in crypto deposits, clearing, settlement, and custody, but it does discourage them from holding crypto on their balance sheet and from lending against crypto collateral. Therefore, such activities are likely to reside with firms that are not regulated as banks with respect to risk-based capital, leverage, and liquidity.

Another consequence of making it expensive for international banks to hold certain stablecoins and other crypto on their balance sheets could involve delayed crypto adoption. Stablecoins have especially been touted as a way to bank the unbanked and provide people in developing nations access to stable currencies, such as USD. But by limiting the services banks can provide in crypto, especially with regards to “stablecoins”, it will likely become more difficult for stablecoins to proliferate.

The proposed rules also seem to penalize any so-called stablecoin that is not a central bank digital currency (CBDC), which are out of scope for these rules. The market price of most stablecoins often fluctuates more than 10 bps from the target peg based on market volatility. This could mean that most, if not all, stablecoins today would be disqualified from the more favorable Group 1(b) status, relative to their Group 2 peers. As a result, it is unlikely that affected banks would choose to hold these kinds of stablecoins, assuming CBDCs are available and require less capital to hold. This could encourage the eventual phase out of these stablecoins from popular crypto platforms entirely.

It could also limit the potential market outside of crypto for DeFi-native stablecoins such as DAI if major banks find it costly to work with such coins in the future. Specifically, the proposed rules state that stablecoins which involve stabilization mechanisms that “reference other crypto assets as the underlying asset” or “use protocols to increase or decrease the supply of the crypto asset” are ineligible to be in Group 1 and are Group 2 instead.

Moreover, another criterion that is difficult for algorithmic stablecoins to meet is full redeemability for “cash, bonds, commodities, equities or other traditional assets” at all times. In addition, the proposed rules require that entities that execute redemptions of the crypto asset be regulated and supervised, a criterion that nearly all algorithmic stablecoins currently do not meet.

Thus, it is possible that algorithmic stablecoins like DAI may be limited to the crypto space, where there is demand for a decentralized stablecoin, in part from its unique minting mechanism (DAI is minted upon demand, the Maker protocol does not need to maintain a balance of DAI to lend out).

Notably, the rules do not provide much clarity regarding the 10 bp deviation of the stablecoin. Is this the market price and on which exchanges? Or does it pertain to the stabilization mechanism itself? The stabilization mechanism that many stablecoins use today involves redeeming the stablecoin with the issuer for the underlying asset. Thus, as long as the issuer is solvent, the stablecoin in question would be able to remain 1:1 with the underlying, in theory. However, if the 10 bp deviation refers to its market price, it is unlikely any stablecoins would be able to maintain Group 1 status, based on historical moves.

Photo Credit: by Karolina Grabowska from Pexels

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The authors of this article are Greg Bunn, Chief Strategy Officer at CrossTower, and Martin Gaspar, a Research Analyst at CrossTower.

Greg Bunn is the Chief Strategy Officer at CrossTower. Greg is an expert in structuring, financing, and building businesses with over 20 years of experience. Most recently, Greg served as Global Head of Counterparty Strategy & Central Funding at Citadel. Previously, Greg was Global Co-Head of Prime Finance at Deutsche Bank running the securities financing businesses across prime brokerage, delta-one derivatives, securities lending, listed derivatives, and clearing. Greg is a Chartered Accountant, CFA Charterholder and holds a BS (Honors) from University of South Africa.

Martin Gaspar is a research analyst at CrossTower. Martin has several years of experience in conducting deep fundamental research and cryptocurrency analysis. Prior to joining CrossTower, Martin was a fixed income research analyst at Wells Fargo Securities, where he helped support traders, salespeople, and buy-side clients through his actionable investment recommendations. He has a passion for crypto and has followed the space extensively since 2012. Martin holds a BA from Colorado College, where he graduated with Distinction in Economics.

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