Prudent supervision of crypto assets: the framework and logic of the Basel Committee

  In recent years, encrypted assets have developed rapidly. Although the market size of encrypted assets is still small compared with traditional financial markets, and the risk exposure of encrypted assets held by formal financial institutions is also very limited, this emerging field has attracted great attention from international regulators such as the Basel Committee.
  In March 2019, the Basel Committee issued a communication document on the risks of encrypted assets, putting forward brief minimum regulatory expectations for banks authorized to purchase encrypted assets or provide related services. In December 2019, the Basel Committee issued a discussion paper that put forward preliminary considerations on the prudent handling of encrypted assets in order to solicit opinions from stakeholders. On this basis, the Basel Committee issued a consultation document in June 2021, proposing more comprehensive recommendations for the prudent handling of encrypted assets, and continuing to solicit public opinions. Although it has not yet been finalized, the Basel Committee’s regulatory framework for crypto assets has begun to take shape.
Definition and classification of crypto assets

  The Basel Committee followed the definition of the Financial Stability Board (FSB) and defined encrypted assets as private digital assets that mainly rely on cryptography and distributed ledgers or similar technologies. Digital assets are digital representations of value, which can be used for payment or investment purposes, or to obtain goods or services. The Basel Committee believes that encrypted assets can be divided into two categories: the value of the first type of encrypted assets is related to traditional assets or asset pools, and the other types of encrypted assets are the second type of encrypted assets, such as Bitcoin. Obviously, the latter type of encrypted assets has the characteristics of being native on the chain.
  The effective value connection between the first type of encrypted assets and traditional assets or asset pools is based on a series of guarantees.
  The first is legal protection. All rights, obligations and benefits related to crypto assets must be clearly defined and legally enforced in the jurisdictions where the assets are issued and redeemed. For example, for digital bonds, digital loans, digital deposits, and digital stocks, the same legal rights as the ownership of these traditional forms of financing must be granted, including the right to obtain cash flow, the right to bankruptcy claims, etc.; The legal rights of the same level of ownership of the physical goods based on the account; for the digital cash in custody, the same level of legal rights as the traditional cash in custody must be granted. At the same time, it is also necessary to ensure the legal finality of the settlement of encrypted assets.
  The second is technical guarantee. The functions of encrypted assets (such as issuance, verification, redemption and transfer) and the network on which they operate, including the distributed ledger or similar technology on which they are based, must fully mitigate and manage any transferability and settlement finality that may damage encrypted assets Or a significant risk of redeemability. To this end, entities that perform activities related to these functions must follow strong risk governance and risk control policies and practices.
  Finally, there is regulatory protection. Entities that perform the redemption, transfer or settlement of encrypted assets are subject to supervision and supervision.
  The first type of encrypted assets can be divided into two types: one is tokenized traditional assets. It is a digital representation of traditional assets. Traditional assets often record asset ownership in a custodian or central securities depository (CSD) account, while tokenized traditional assets use cryptography, distributed ledger technology (DLT) or similar technologies to record ownership. For example, traditional dematerialised securities (dematerialised securities) registered in the electronic account book of the Central Securities Depository (CSD) will become digital securities if they are registered in the distributed ledger.
  The second is cryptoassets with effective stabilisation mechanisms. What is an effective stability mechanism? The Basel Committee proposes a quantitative indicator: in a year, the difference in value between encrypted assets and basic traditional assets must not exceed 10bp of the value of the underlying traditional assets, and must not exceed three times. Otherwise, it will be regarded as not an effective stabilization mechanism. Afterwards, only when the bank proves to the regulator that the reason for the value difference breaking through the threshold has been resolved and will not happen again, can the encrypted asset be reassessed as having an effective stabilization mechanism. The Basel Committee emphasized that the use of other encrypted assets as basic assets (including the use of other traditional asset-based encrypted assets) or the use of agreements to increase or decrease the supply of encrypted assets (such as algorithmic stablecoins) are not considered effective. The stabilization mechanism. In other words, stablecoins like DAI are not classified as encrypted assets with an effective stability mechanism, and belong to the second category of encrypted assets.

  The main difference between the above two first types of encrypted assets is whether they need to be redeemed or converted into traditional assets before obtaining the same legal rights as directly owning traditional assets. Tokenized traditional assets do not need, for example, digital stocks and digital bonds are equity and debt. They do not need to be redeemed or converted into traditional stocks and bonds to have these rights. Encrypted assets with effective stability mechanisms need to be, for example, stable tokens anchored in bank deposits need to be redeemed or converted to bank deposits before they can have corresponding rights.
Cautious handling of risk exposure of encrypted assets
(1) The first pillar

  1. The first type of encryption assets
  (1) the same risk, same event, the same treatment
  if two exposures given the same degree of legal rights (cash flow, bankruptcy claims, asset ownership, etc.), as well as to all time The possibility of paying the due amount is the same, so they may have very similar values ​​and pose a similar risk of loss. In terms of supervision, it is natural to give the same treatment. Therefore, the Basel Committee proposed that, compared with traditional assets, crypto assets that provide the same economic function and pose the same risk should be subject to the same capital, liquidity and other regulatory requirements as traditional assets, but should be considered when handling them prudently. Any additional risks arising from the risk of traditional assets in encrypted assets. According to this principle, tokenized traditional assets are equivalent to traditional assets in the legal sense, so they should be given the same regulatory treatment as traditional assets, but additional risks must be considered.
  For encrypted assets with effective stability mechanisms, they may not be given the same level of legal rights as traditional asset ownership, but the value of encrypted assets can be sought to link the value of encrypted assets with the value of traditional assets or traditional asset pools through the stability mechanism. The risks arising from changes in the value of assets or potential defaults also constitute key risks that need to be considered when handling prudently.

  (2) Operational Risk
  Basel Committee believes that, in view of the assets and is based on the encryption technology is very new and is in constant iterative development, increase the likelihood of operational risks they may bring unexpected. This risk can be resolved by adding operational risk capital requirements to the first pillar. The accrual method can be different, for example, accrual based on a unified percentage of the amount of risk exposure, or gradually reduce the operational risk capital accrual as the technology maturity and system robustness improve.
  (3) liquidity risk
  potential investor groups hold tokens asset may be associated with non tokens of different assets, and therefore asset tokens may have a traditional (non tokens of) different liquidity characteristics of assets, leading to The market value of the same tokenized assets and non-tokenized assets are different. In addition, due to the short history of tokenized assets, there may not be enough data to simulate the impact of these different liquidity characteristics on the market value, which will preclude the use of model-based methods to calculate market risk.
  Credit risk (4) Redemption of
  encryption assets with an effective stability mechanism are often required to redeem or convert legacy assets to ensure their effective contact with the traditional asset values, and therefore the risk of changes in the value of traditional assets or potential breach of contract, in addition, Encrypted asset holders also face the risk of potential default by the redeeming counterparty. This is similar to the risks faced by banks when lending securities: in addition to the risk of losses from changes in the value of the securities they lent and potential defaults, banks also face the risk of default by the securities borrower (that is, non-return of securities). In response, the Basel Committee requires banks to calculate risk-weighted assets (RWA) for these two risks.
  The Basel Committee also considered a more complicated redemption scenario: not everyone can directly trade with the redemption counterparty, and only “member” holders are allowed to directly trade with the redemption counterparty to convert encrypted assets into a base. Assets, other non-“member” holders who cannot directly trade rely on “member” holders to maintain the conversion between encrypted assets and underlying assets.
  If a bank is a “member” holder, it must consider whether it promises to purchase crypto assets from non-“member” holders. If such a legally binding commitment is included, the bank will face the risk that once the redeemer defaults, it will have to purchase encrypted assets from non-“member” holders to fulfill its contractual obligations. The Basel Committee believes that banks that make such commitments must consider this additional “purchase commitment” risk in credit risk-weighted assets, and even if the bank has no legal obligation to purchase crypto assets from non-“member” holders, Banks and regulators should also consider whether member banks are obliged to intervene and purchase these assets in practice to meet the expectations of non-“member” holders and protect the bank’s reputation. If there is such an intervention risk, the bank should consider it in the risk-weighted assets. An exception can be made only if it is clear that there is no risk of such intervention. When a bank is a non-“member” holder, the risk it faces depends on whether the “member” promises to purchase an unlimited amount of encrypted assets from the non-“member” holder. If “members” do not promise to purchase unlimited amounts of encrypted assets, then the bank will face three risks: risks arising from changes in the value of the underlying assets or potential default, the risk of default by the redeemer, and the risk of default by all “members”. And if “members” promise to purchase an unlimited amount of encrypted assets, then the bank faces two risks: the risk of changes in the value of the underlying assets or potential defaults, and the risk of default by all “members”.
  2. The second type of encrypted assets    The
  Basel Committee believes that the second type of encrypted assets are high-risk assets, so the prudent handling of them is simple and conservative.
  The RWA calculation formula for the second type of encrypted assets is: RWA=RW×max[abs (long), abs (short)].
  Among them, the risk weight RW is 1250%. The risk weight of 1250% ensures that the risk capital held by the bank is at least equal to the value of its risk exposure in the second category of encrypted assets. In other words, facing the risk exposure of the second type of encrypted assets of one dollar, the bank must hold one dollar of risk capital. It can be seen from the formula that the Basel Committee does not allow the netting of long positions and short positions, and the risk exposure shall be the larger of long positions and total short positions. Moreover, the Basel Committee requires that the RWA be calculated separately for each second type of encrypted asset.
  For derivatives that are based on the second type of encrypted assets or are priced in units of the second type of encrypted assets, the corresponding counterparty credit risk exposure must also be calculated. The risk exposure is replacement cost (RC) plus potential future risk (PFE). Among them, PFE is calculated at 50% of the total nominal amount. When calculating RC, netting within the eligible and executable netting group is allowed, but netting between different encrypted assets is not allowed.
  For securities financing transactions (SFT) and margin loans involving the second type of encrypted assets, banks should use the comprehensive method formula specified in the credit risk mitigation part of the credit risk standardization method to calculate the credit risk exposure of their counterparties. The Basel Committee believes that the second category of encrypted assets is not a qualified collateral in the comprehensive approach. Therefore, like all non-eligible collateral, when banks receive the second category of encrypted assets as part of the SFT, they must use the same The same deduction rate for stocks that are not traded on a recognized exchange (ie, a 25% deduction).
  For simplicity, the above formula also applies a 1250% risk weight to short positions, the same as long positions. But in theory, short positions may cause unlimited losses, so in some cases, the capital required by the above formula may not be enough to cover potential future losses. The Basel Committee proposed that if banks have significant risk exposures in short positions in the second category of encrypted assets or derivatives, they may lose more than 1250% of the capital required by the risk weight. In this regard, regulators must consider the first pillar Additional form of additional capital is collected. Where applicable, the capital addition will be calculated and calibrated under the Committee’s revised market risk framework (100% risk weighting for delta, vega and curve) and the basic CVA risk framework (BA-CVA). If the result is higher than Based on the capital requirement of 1250% risk weight, this amount is used.
(2) The second pillar

  The Basel Committee proposed that banks that have direct or indirect risk exposure to any form of encrypted assets must accept the supervisory review procedures stipulated in the Basel framework. Supervisors should review whether the bank’s policies and procedures for identifying and assessing risks not covered by the minimum capital requirements are appropriate and whether the results of their assessments are adequate. Supervisors should have the right to require banks to remedy any deficiencies in the process of identifying or assessing these risks. Although specific regulatory actions may vary from situation to situation, there are several types of response measures that regulators can consider:
  First, stress testing and scenario analysis. Supervisors can decide to require banks to include any specific risks that are not fully identified and assessed in their risk management framework into their stress testing framework or scenario analysis. The second is provision. Supervisors may require banks to consider taking some measures, such as provision for crypto asset risks that are not fully identified and assessed in their risk assessment framework. The third is additional capital costs. Regulators may impose additional capital charges on individual banks for crypto asset risks that are not fully identified and assessed in their management framework, and calibrate them based on the assumptions of pressure events that drive losses to these risks. The fourth is regulatory restrictions or other mitigation measures. Supervisors can impose some mitigation measures on banks, such as applying internal limits set by supervisors to control the risks of encrypted assets that are not fully identified or evaluated in their risk management framework. This approach will ensure that banks are not exposed to excessive risks of encrypted assets.

(3) The third pillar

  Banks’ disclosure requirements for risk exposures or related activities of encrypted assets should follow the general guidelines for the disclosure of the third pillar of banks in the Basel framework. In addition to quantitative information, banks must provide qualitative information that outlines the bank’s activities related to crypto assets and the main risks related to crypto asset risk exposures. The description includes: business activities related to crypto assets and how these business activities are transformed into The composition of the bank’s risk profile; the bank’s risk management policy related to the risk of encrypted assets; the scope and main content of the bank’s report related to encrypted assets; the most important current and emerging risks related to encrypted assets and how to manage these risks.
  According to general guidelines, banks must regularly disclose information about any major type 1 and type 2 encrypted asset risks, including each specific type of encrypted asset risk information: the amount of direct and indirect risk exposure (including net risk exposure) The total long and total short portion of the mouth); capital requirements; and accounting classification.
  In addition to the above-mentioned separate disclosure requirements that apply to all Type 1 and Type 2 encrypted assets, banks must incorporate the risk exposure of Type 1 encrypted assets into relevant existing disclosure templates applicable to traditional assets (such as credit risk, market risk) .
The concept of prudential supervision of encrypted assets
(1) Technology-neutral concept

  The Basel Committee believes that as a starting point, the prudential framework for encrypted assets should adopt the concept of “technology neutrality”, and its design should not explicitly advocate or discourage the use of specific technologies related to encrypted assets. It can be said that the Basel Committee’s prudent handling of encrypted assets fully embodies the principle of supervision that substance is more important than form. Although new technologies may bring new risks, the key lies in whether the risk nature of the asset has changed. If compared with traditional assets, encrypted assets have the same functions, same rights, and the same risks, it means that such encrypted assets are essentially no different from traditional assets, and therefore should be subject to the same regulatory requirements as traditional assets. It can’t be low, and there can be regulatory arbitrage when it is low, and it can’t be high. If it is high, there will be regulatory discrimination and inhibit technological innovation.
(2) Risk matching concept

  The Basel Committee’s prudent handling of encrypted assets upholds its consistent principle of risk matching. Low risk and low requirements, high risk and high requirements. The value of the first type of encrypted assets has an effective connection with traditional assets, while the second type of encrypted assets does not. Therefore, the Basel Committee regards the second type of encrypted assets as high-risk encrypted assets, using the highest risk weight of 1250%. Compared with traditional assets, encrypted assets may cause additional risks due to the application of new technologies, such as additional operational and network risks for the DLT platform. These risks may include, but are not limited to: theft of encryption keys, destruction of login credentials, and distribution Denial of Service (DDoS) attacks. In this regard, the Basel Committee requires banks to ensure continuous assessment, management and appropriate mitigation of risks not covered in the Basel framework, such as risks attributable to operational risks and cyber risks, risks attributable to basic technology, money laundering and funding The risk of terrorism, etc.
(3) Concise and prudent concept

  The Basel Committee believes that crypto assets are currently a relatively small asset class for banks. Since the market, technology, and related services of encrypted assets are still developing, simple and prudent handling is beneficial as a starting point. Therefore, the Basel Committee is relatively conservative and cautious in its prudent handling of crypto assets. Any prudent handling of encrypted assets prescribed by the committee will constitute the minimum standard for international banks. If necessary, jurisdictions are free to apply additional and/or more conservative measures. Accordingly, jurisdictions that prohibit banks from holding any risk exposure to crypto assets are also considered to meet global prudential standards.
  At this stage, the Basel Committee believes that crypto assets do not meet the qualifications of qualified high-quality liquid assets (HQLA), including the first category of crypto assets, and it is not recommended for leverage, large risk exposure frameworks, or liquidity ratio requirements The following provides for any new regulatory treatment for encrypted assets. In terms of large risk exposures, the handling of encrypted assets must follow the same principles as other risk exposures. Regarding the requirements for liquidity coverage ratio (LCR) and net stable funding ratio (NSFR), any type 1 crypto assets on the bank’s balance sheet must follow the risk treatment methods that take into account the LCR and NSFR standards. The second type of encrypted assets must be subject to the 0% inflow of LCR and 100% NSFR coefficient, and the crypto assets and liabilities must be subject to 100% outflow and 0% NSFR coefficient.
(4) Long-term development concept

  Although the Basel Committee’s current prudential handling of crypto assets is relatively conservative and cautious, it is not static. The Basel Committee proposed that, in principle, it can be re-examined in the future based on the development of encrypted assets. For example, investigating whether the encrypted assets in the first category of encrypted assets that are equivalent to the traditional assets that are eligible to be included in HQLA can be confirmed as HQLA; the corresponding operational risk capital provision can be adjusted according to the development of technology.
Summary and inspiration

  Although the Basel Committee emphasized in the March 2020 document that the discussion paper should not be interpreted as the Basel Committee’s endorsement or support of any specific existing or planned crypto assets, it has repeatedly pointed out that banks are prohibited from holding any risks in crypto assets. Exposed jurisdictions are also regarded as meeting global prudential standards, but there is no doubt that the aforementioned prudential supervision measures against encrypted asset risks proposed by the Basel Committee provide useful regulatory guidance for global formal financial institutions to participate in the encrypted asset market.
  In particular, its definition, classification, regulatory principles, and regulatory concepts of encrypted assets fully embodies the pragmatic, scientific, dialectical, and harmonious regulatory philosophy, which is worthy of reference by all countries. One is the characterization of encrypted assets. It is not a “one size fits all”, but penetrates the bottom layer of encrypted assets, and handles different risks in a prudent manner and is scientifically rigorous. The second is a technology-neutral concept. It neither clearly advocates nor encourages the use of specific technologies, and maintains regulatory neutrality. The third is the unification of short-term risk response and long-term regulatory evolution. Regarding new asset risks, starting with simplicity and caution, constantly reviewing, gradual adjustments, and continuous improvement, it not only avoids regulatory suppression, but also avoids regulatory gaps and regulatory arbitrage, and achieves a balance between financial innovation and risk prevention.

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