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Proposed prudential treatment of cryptoassets offers certainty

Out-Law News | 19 Dec 2019 | 1:18 pm | 3 min. read

Banks might welcome the certainty that will follow from the way an international financial watchdog plans to recognise the risk of cryptoassets they might acquire, an expert in financial services regulation has said.

The Basel Committee on Banking Supervision has opened a consultation on the "prudential treatment" of cryptoassets in which it has said that in most cases cryptoassets will be deemed to be so low in quality, and high risk, that they will not be considered to contribute to banks' books when those banks acquire them.

Rory Copeland of Pinsent Masons, the law firm behind Out-Law, said this determination has the potential to alter the way financial regulators view banks' ability to overcome a financial crisis.

Copeland said: "Prudential regulators have to determine the ‘quality’ of assets that banks hold on their books, based on the stability of their value and how easily they can be converted into cash in a stress situation. So cash is the highest quality, along with US government treasuries etc. Shares in high risk new ventures are the lowest quality, because in times of stress these companies are most likely to go bust. Banks and others have to hold a mixture of asset qualities in different proportions."

"The Committee’s starting point is that cryptoassets are to be regarded as so low quality, or high risk, that they don’t contribute to a bank’s assets in any way. The proposals will give the banks certainty about how they must recognise them from a prudential perspective. At the same time the proposals could have a significant impact for those already holding cryptoassets and may concern some who are looking to get exposure to this developing asset class," he said.

The proposals outlined by the Basel Committee form part of potential new regulatory safeguards that could be introduced to take account of the risks banks could be exposed when buying or offering services associated with cryptoassets.

The Committee has asked financial institutions and other stakeholders to help shape the "prudential treatment" that should be applied in such cases.

"If banks are authorised, and decide, to acquire cryptoassets or provide related services, the Committee is of the view that banks should apply a conservative prudential treatment to such exposures, especially for high-risk cryptoassets," the Committee said in a discussion paper.

"To that end, the Committee is publishing this discussion paper to seek the views of stakeholders on a range of issues related to the prudential regulatory treatment of cryptoassets, including: the features and risk characteristics of cryptoassets that should inform the design of a prudential treatment for banks’ cryptoasset exposures; and general principles and considerations to guide the design of a prudential treatment of banks’ exposures to cryptoassets, including an illustrative example of potential capital and liquidity requirements for exposures to high-risk cryptoassets," it said.

"Cryptoassets are an immature asset class given the lack of standardisation and constant evolution," the Committee said. "Certain cryptoassets have exhibited a high degree of volatility, and present risks for banks, including liquidity risk; credit risk; market risk; operational risk (including fraud and cyber risks); money laundering and terrorist financing risk; and legal and reputation risks."

"While certain types of crypto-assets are at times referred to as 'cryptocurrencies', the Committee is of the view that such assets do not reliably provide the standard functions of money and can be unsafe to rely on as a medium of exchange or store of value. These types of cryptoassets are not legal tender, and are not backed by any government or public authority," it said.

Lauren McCarthy of Pinsent Masons said: "As noted by the Committee, cryptoassets are a relatively new asset class and the potential impact on banks’ stability is yet to be seen. Increasing capital to match crypto exposures will be a costly exercise for banks. However, given the range of risks at this stage, we’d expect the industry to welcome further guidance on how these assets should be treated from a prudential perspective."

The Committee said it has determined that some form of regulation is needed because of the increased risks to banks and concerns over the impact on financial stability that it said are associated with the growth of cryptoassets and related services.

The publication of its discussion paper follows on from the Commission's statement on cryptoassets issued in March. Then, the watchdog said there were "minimum" measures banks should adopt if they decide to "acquire cryptoasset exposures or provide related services". The Committee urged due diligence, a framework of appropriate governance and risk management, public disclosure and dialogue with regulators.

The Committee's discussion paper is open to consultation until 13 March. The Committee brings together regulators from around 30 countries to coordinate rules for their banks. Its members include the Bank of England, US Federal Reserve, European Central Bank and the China Banking Regulatory Commission.