Cryptoassets – Basel Regulatory Capital and Prudential Treatment

2. Background

By way of background, the Basel Committee on Banking Supervision (“Basel Committee”) is a committee consisting of senior representatives from banking regulators and central banks in major jurisdictions, which sets regulatory capital and other prudential standards for banks. While the prudential standards published by the Basel Committee do not have the force of law, they are generally transposed into national laws and regulations by Basel Committee member jurisdictions, subject to certain local variations.

The Basel Cryptoasset Standards were published in December 2022 following two rounds of public consultations. The standards are aimed at providing a minimum global framework for banks’ cryptoasset exposures which promotes responsible innovation while maintaining financial stability. The Basel Committee will soon publish a consolidated version of the Basel prudential standards which will embed the new Basel Cryptoasset Standards.

3. Key terms used in the Basel Cryptoasset Standards

The Basel Cryptoasset Standards broadly define “cryptoassets” as private “digital assets” that depend primarily on cryptography and distributed ledger technologies (“DLT”) or similar technology. The term “digital asset” is in turn defined as a digital representation of value which can be used for payment or investment purposes or to access a good or service.

Dematerialised securities (i.e., securities that have been moved from physical certificates to electronic book-keeping) that are issued through DLT or similar technologies are within the scope of the Basel Cryptoasset Standards and are referred to as “tokenised traditional assets.” On the other hand, dematerialised securities that use electronic versions of traditional registers and databases which are centrally administered are outside the scope of the Basel Cryptoasset Standards.

Central bank digital currencies (“CBDCs”) are also not covered by the Basel Cryptoasset Standards, although the Basel Committee will give further consideration to the prudential treatment of CBDCs as and when they are issued. In this respect, we note that the Hong Kong Monetary Authority (“HKMA”) is exploring issuing its own CBDC known as e-HKD, while the People’s Bank of China (“PBOC”) has been actively driving the usage of its CBDC known as e-CNY.

The Basel Cryptoasset Standards set out rules for determining the regulatory capital and other prudential treatment of a bank’s “exposures” to cryptoassets. The term “exposure” broadly includes both on- and off-balance sheet amounts that give rise to credit, market, operational and/or liquidity risks in respect of cryptoassets.

4. High-level overview of the Basel Crypto Standards

Under the Basel Cryptoasset Standards, the prudential treatment of a bank’s cryptoasset exposures varies depending on whether the cryptoasset falls into the following categories:

Group 1 cryptoassets, which consist of:

Group 1a cryptoassets, being tokenised traditional assets that meet a stringent set of classification conditions set out in the Basel Cryptoasset Standards. In this context, the term “traditional assets” is defined as non-cryptoassets that are already captured under the existing Basel prudential framework, such as bonds, loans, commodities and equity interests.
Group 1b cryptoassets, being stablecoins with effective stabilisation mechanisms that meet the stringent classification conditions set out in the Basel Cryptoasset Standards. In this context, the term “stablecoin” is defined as a cryptoasset that aims to maintain a stable value relative to a specified asset or a pool of assets. The Basel Committee notes that algorithm-based stablecoins or those stablecoins that use protocols to maintain their value are not eligible for Group 1 categorisation.

Group 2 cryptoassets, which consist of:

Group 2a cryptoassets, being cryptoassets (including tokenised traditional assets, stablecoins and unbacked cryptoassets such as Bitcoin) that do not meet the classification conditions for Group 1 cryptoassets, but that do satisfy the Group 2a hedging recognition criteria set out in the Basel Cryptoasset Standards, which include various thresholds relating to market capitalisation, trading volume and price observations for the relevant cryptoassets (“Hedging Recognition Criteria”).
Group 2b cryptoassets, being cryptoassets (including tokenised traditional assets, stablecoins and unbacked cryptoassets such as Bitcoin) that do not meet the classification conditions for Group 1 cryptoassets and also do not satisfy the Hedging Recognition Criteria.

Documenting categorisation decisions and regulatory reporting

Under the Basel Cryptoasset Standards, banks must fully document the information used in determining compliance with the classification conditions and make this available to regulators upon request. In terms of cryptoassets to which a bank is already exposed on the implementation date of the Basel Cryptoasset Standards, the bank must inform its regulator of its classification decisions for each cryptoasset. According to the Basel Cryptoasset Standards, this information should ideally be sent well before the 1 January 2025 implementation date. In light of the complexity of the classification conditions and the documentation requirement, there is much for banks to do before the implementation date.

In terms of cryptoassets that a bank proposes to acquire after the implementation date, the bank must inform its regulator of its classification decisions before the acquisition. According to the Basel Cryptoasset Standards, this must occur with sufficient time for the regulator to review and, if necessary, override the classification decision reached prior to the bank’s acquisition of the cryptoasset.

Regulatory capital treatment of cryptoassets: At a high-level, the regulatory capital treatment of Group 1 cryptoassets (i.e., qualifying tokenised traditional assets and qualifying stablecoins) is generally based on the existing Basel capital rules.

The regulatory capital treatment for Group 2a cryptoassets is based on modified versions of the Basel market risk capital rules taking into account netting and subject to a 100% capital charge. In contrast, Group 2a cryptoassets are subject to a very conservative capital treatment that involves applying a 1,250% risk weight. A risk weight of 1250% is actually the reciprocal of the 8% minimum total capital ratio that banks must maintain under the Basel capital rules and, for this reason, it is often described as a “dollar-for-dollar” capital charge. In reality, however, many banks maintain regulatory capital ratios that are well in excess of the minimum requirements.

Group 2 Exposure Limit: Besides imposing regulatory capital requirements, the Basel Cryptoasset Standard also limit the amount of a bank’s exposure to Group 2 cryptoassets. Specifically, a bank’s total exposure to Group 2 cryptoassets must not exceed 2% of the bank’s Tier 1 capital and should generally be lower than 1%. These exposure limits are collectively referred to as the “Group 2 Exposure Limit”. Banks breaching the 1% limit will apply the more conservative Group 2b capital treatment to the amount by which the limit is exceeded. In contrast, breaching the 2% limit will result in all Group 2 exposures (including exposures under the limit) being subject to the very conservative Group 2b capital treatment (application of the 1,250% risk weight).

Other key aspects of the Basel Cryptoasset Standards: Besides the foregoing, other key elements of the Basel Cryptoasset Standards include rules on how the Basel Committee’s operational risk, liquidity, leverage ratio and large exposures requirements should be applied to a bank’s cryptoasset exposures. The standards also set specific risk management and disclosure requirements in respect of a bank’s cryptoasset exposures.

5. Key changes compared to the Basel Committee’s Second Consultation

For readers who have been closely following the development of the Basel Cryptoasset Standards, this section of the article sets out some of the key differences between the final Basel Cryptoasset Standards and the second consultation published by the Basel Committee in June 2022 (“Second Consultation”).

Infrastructure risk add-on: The Second Consultation included an add-on for infrastructure risk, which was proposed as a fixed add-on to a bank’s risk-weighted assets (“RWAs”) set at 2.5% of the exposure value of all Group 1 cryptoassets. In the final Basel Cryptoasset Standards, this fixed add-on has been replaced with a more flexible approach that allows regulators to introduce and increase an add-on based on any observed weaknesses in the infrastructure underlying specific cryptoassets.
Basis risk test, redemption risk test and the supervision/regulation requirement: The Group 1 classification conditions in the Second Consultation included a requirement that cryptoassets with stabilisation mechanisms must satisfy both a redemption risk test and a basis risk test. The purpose of the redemption risk test is to ensure that the reserve assets are sufficient to enable the relevant cryptoassets to be redeemable at all times for the amount to which the cryptoasset is pegged. The basis risk test, being a quantitative test based on the market value of the cryptoasset, is designed to ensure that the holder of a cryptoasset can sell it on the market for an amount that closely tracks the peg value. The Basel Committee has decided not to implement the basis risk test at this time, but will further study whether there are statistical tests that can reliably identify low-risk stablecoins for inclusion as an additional criterion for Group 1b cryptoassets. Further, the final Basel Cryptoasset Standards require that the issuer of the stablecoin be supervised and regulated by a supervisor that applies prudential capital and liquidity requirements to the issuer.
Group 2 Exposure Limit: For purposes of the Group 2 Exposure Limit, the final Basel Cryptoasset Standards provide that exposures would be measured as the higher of the gross long and gross short position in each cryptoasset, instead of the aggregate of the absolute values of long and short exposures, as proposed in the Second Consultation. This change is designed to ensure that banks are not penalised for hedging their cryptoasset exposures. To reduce so-called “cliff effects”, the final Basel Cryptoasset Standards provide that breaching the 1% limit means that the very conservative Group 2b capital treatment will apply only to the amount by which the limit is exceeded, rather than to all Group 2 exposures. However, the final Basel Cryptoasset Standards introduce a new 2% limit, breach of which will result in all Group 2 exposures being subject to the Group 2b capital treatment.
Responsibility for categorising cryptoasset exposures: Under the Second Consultation, banks were required to seek prior regulatory approval for their categorisation of their cryptoasset exposures. In contrast, under the final Basel Cryptoasset Standards, a bank is only required to notify its regulator of its categorisation decisions, although the regulator will have the power to override these decisions if it disagrees with the bank’s assessment.
Custodial assets: Compared to the Second Consultation, the final Basel Cryptoasset Standards clarify which aspects of the standards are applicable to cryptoasset-related custodial services provided by banks.

6. Taking a closer look at key aspects of Basel Cryptoasset Standards

We have prepared a detailed summary of the Basel Cryptoasset Standards, which is available upon request. The summary begins by considering the classification conditions used to categorise a bank’s cryptoasset exposures into Group 1 and Group 2. Next, it describes the treatment of a bank’s Group 1 and Group 2 cryptoasset exposures under the Basel Committee’s credit risk, market risk, operational risk, leverage ratio, liquidity, large exposures, risk management and disclosure rules.

Specifically, the following topics are covered in the detailed summary:

Classification conditions for Group 1 cryptoassets (qualifying tokenised traditional assets and qualifying stablecoins)
Classification conditions for Group 2 cryptoassets
Documenting categorisation decisions and regulatory reporting
Minimum regulatory capital requirements for Group 1 cryptoassets
Minimum capital requirements for Group 2 cryptoassets
Minimum capital requirements for operational risk
Leverage ratio requirements
Minimum liquidity risk requirements
Large exposures requirements
Risk management requirements
Disclosure requirements

7. Next steps: on-going monitoring and review by the Basel Committee

As the cryptoasset market is fast-evolving, the Basel Committee will closely monitor the implementation and impact of the Basel Cryptoasset Standards, and may make additional refinements and clarifications from time to time. Among other things, the Basel Committee stated that it will monitor and review the following aspects of the Basel Cryptoasset Standards:

Statistical tests and redemption risk test: The Basel Committee will further study whether there are statistical tests that can reliably identify low-risk stablecoins for inclusion as an additional criterion for Group 1b cryptoassets.
Permissionless blockchains: The Basel Committee will continue to consider whether risks posed by cryptoassets that use public/permissionless blockchains can be sufficiently mitigated to allow for their inclusion in Group 1 and, if so, on what conditions.
Group 1b cryptoassets as collateral: Under the Basel Cryptoasset Standards, Group 1b cryptoassets are currently not permitted to be recognised as eligible collateral for the purposes of calculating a bank’s regulatory capital requirements. The Basel Committee will continue to assess this position.
Hedging Recognition Criteria: The Hedging Recognition Criteria are relevant for determining whether a cryptoasset will be classified as a Group 2a or Group 2b cryptoasset. The Basel Committee will monitor and assess the thresholds used in the Hedging Recognition Criteria and the extent of hedge recognition in respect of Group 2a cryptoassets.
Level of the Group 2 Exposure Limit: As the cryptoassets market evolves, the Basel Committee will reassess the appropriateness of the 1% and 2% Group 2 Exposure Limits in the Basel Cryptoasset Standards.

8. Implementation of the Basel Cryptoasset Standards in Hong Kong

On 20 December 2022 – just a few days after the Basel Cryptoasset Standards were published – the HKMA issued a circular to all Authorized Institutions (“AIs”) stating its intention to implement the Basel Cryptoasset Standards in Hong Kong in accordance with the globally agreed timetable. The HKMA stated that the Hong Kong banking industry will be consulted on the specific local implementation proposal in due course. In the meantime, the HKMA noted that AIs with plans to conduct cryptoasset-related business activities are recommended to familiarise themselves with the Basel Cryptoasset Standards and consider their implications.

9. Potential future implications for Mainland China?

In September 2021, the PBOC together with nine other PRC ministries, commissions and judicial bodies, jointly issued the Notice on Further Preventing and Resolving the Risks of Virtual Currency Trading and Speculation (“PBOC Notice”), which states that business activities related to crypto currencies are illegal financial activities and services provided by an overseas crypto currency exchange to PRC residents via the Internet are also illegal financial activities. Specifically, the PBOC Notice provides that:

“Exchanging legal tender for virtual currencies or vice versa, exchanging one virtual currency for another, buying and selling virtual currencies as a central counterparty, providing information and pricing services for the trading of virtual currencies, issuing tokens to raise funds, trading virtual currency derivatives, and engaging in other virtual currency-related activities are potentially instances of illegal issuance of coupons as substitutes for the legal tender, unauthorized public offering of securities, illegal conduct of futures business, or illegal fundraising. Such activities are unlawful and strictly prohibited by law, and shall be forcibly banned in accordance with the law. Any person that has committed such illegal financial activities that constitute a crime will be prosecuted for criminal liabilities. . . . Provision of services by overseas virtual currency exchanges to residents in China via the internet is also considered to be an illegal financial activity.”

Notwithstanding the ban on virtual currency related activities described in the PBOC Notice, Mr Huang Yiping (a former member of the Monetary Policy Committee of the PBOC who is currently Chairman of China Finance 40 Academic Committee and Director of the Institute of Digital Finance at Peking University) has, in a public speech in December 2022, urged the PRC government to consider whether such policies are sustainable in the long run and remarked that a permanent “no” to crypto-related products could result in missed opportunities in technologies such as blockchain, which are “very valuable” to regulated financial systems. Please also refer to this Chinese language article written by Mr Huang based on his public speech.

As the world’s second largest economy and an important member of the Basel Committee, to the extent that a bank established in Mainland China has, or will have, cryptoasset exposures which fall outside the scope of the general prohibition in Mainland China, the bank may wish to consider the potential impact of the Basel Cryptoasset Standards, which Mainland Chinese financial regulators may consider implementing in the future.

We closely follow crypto-related legal and regulatory developments in Mainland China and would be pleased to share our insights with you.

10. Where can I learn more about the Basel Cryptoasset Standards and their impact on my business?

The core cross-border financial regulatory and structured finance team at KWM has extensive experience advising international and PRC-based financial institutions on the Basel regulatory capital and prudential standards, including designing structured products and derivatives that comply with such standards.

Our team of fully bilingual partners and lawyers are familiar with the Basel capital and prudential standards as implemented in Hong Kong and Mainland China. We also regularly advise established financial institutions as well as emerging fintech companies on licensing, compliance and legal documentation issues relating to virtual currencies, cryptoassets and related derivatives products in Hong Kong and Mainland China. We are familiar with the unique and nuanced commercial and legal issues faced by Mainland Chinese companies and their counterparties in China’s fast-evolving cryptoassets and fintech landscape.

We would be pleased to share our insights with you. Please feel free to contact our core team members.

In this article:

“Hong Kong” or “Hong Kong SAR” shall be construed as a reference to “Hong Kong Special Administrative Region of the People’s Republic of China”.
The Mainland of China is described as “China Mainland”; Hong Kong SAR is described as “Hong Kong”; Macau SAR is described as “Macau”.
Save as used in the US Legislation, “the PRC” connotes China Mainland, Hong Kong SAR and Macau SAR.