Basel banking proposals on ‘crypto’ assets spell bad news for BTC bag holders—part 2

This is a three-part editorial series. Check out Part 1 here and Part 3 here.

In the wake of the 2008 global financial crisis, the rules and regulations that were drafted in response by the Basel Committee for Banking Supervision (BCBS) and subsequently mandated for banks around the world were implemented in an effort to protect both the financial system—as well as the public at large—from enduring the worst economic conditions since the Great Depression. The systemic threat that the sub-prime loan crisis represented to the American—and subsequently—the global economy, together with the uninhibited risk-taking of many (some now former) major banks and institutions, was swiftly regulated away—although, not before it was far too late. With the ‘crypto’ asset economy, Basel is attempting to stamp out any prospect of something similar occurring before it even gets off the ground.

“The Committee believes that the growth of crypto assets and related services has the potential to raise financial stability concerns and increase risks faced by banks,” explained the BCBS when announcing the opening of the 2021 public consultation phase of the crypto asset exposure regulatory development.

“Certain crypto assets have exhibited a high degree of volatility, and could present risks for banks as exposures increase, including liquidity risk; credit risk; market risk; operational risk (including fraud and cyber risks); money laundering/terrorist financing risk; and legal and reputation risks.”

To mitigate against these perceived risks, Basel has proposed a comprehensive set of regulations for banks wishing to gain exposure to and offer digital currency products to their customers. These proposals started with a 2019 discussion paper, followed by a 2021 public consultation document and now the 2022 public consultation document, which will likely be the final opportunity for any change of course, as the Committee has indicated that it intends to have the regulations finalized and ready for ratification by the end of this year.

Since the release of the initial discussion paper in 2019, the fundamental stance of Basel has remained largely the same, with a risk-averse approach that treats the vast majority of the digital asset ecosystem with a great deal of skepticism. And despite calls from a vocal minority in the ‘crypto’ sphere with bark much louder than bite, the public input to date has only led to further restrictions and more onerous conditions being imposed—particularly around digital assets with no intrinsic value like BTC.

Central to the proposals to emerge from Basel is the creation of a two-group classification system for crypto assets, which—depending on how they are classified—prescribes how banks are required to treat these assets, including limits for how many are able to be held on their balance sheets, the requisite liquidity provisions around these assets and the risk mitigation factors required for their carrying.

Assets which fall into the Group 1 crypto asset classifications and meet the stringent requirements for either of the two sub-groups are (with some modifications) eligible for treatment under existing Basel frameworks, resulting in a more clear and relatively familiar pathway for participation by banks. By default, any crypto assets that fail to meet any of these classification conditions for Group 1 are lumped in as Group 2 crypto assets, which come with an even stricter set of rules and requirements which dictate how banks must treat them.

The proposed regulations feature a clear and detailed framework defining how digital assets are to be classified—and for BTC bag holders hoping for a wave of banks swooping up swathes of the speculative asset to relive the nostalgia of the last bull run and the absurd prices that came with it, the proposals will come as a less than welcome rebuke.

Group 1 crypto assets

Group 1 crypto assets—which the Committee has determined to be of a lower risk relative to their Group 2 counterparts—are broken down into a pair of narrow sub-groups under the two-group framework: Group 1a assets can be described as tokenized traditional assets and Group 1b assets can be classified as stable coins with effective stabilization methods. To be classified as a Group 1 crypto asset, all of the classification conditions to be defined as either a Group 1a or Group 1b crypto asset must be met in full—partial compliance counts for naught, it’s an all or nothing deal.

Interestingly, the Committee made specific note that crypto assets that are underpinned by permissionless blockchains, which encompasses most if not all public blockchains (though arguments could be made that the highly-centralized nature of developer-controlled blockchains like BTC and Ethereum are in fact not permissionless), will be unlikely to be able to meet the classification criteria for Group 1 crypto assets under either sub-group. This is an area, though, that Basel is specifically seeking feedback on as part of the public consultation process, meaning that if appropriate criteria for inclusion can be formulated, there is the potential for this to change in the future.

In addition, the revised 2022 proposals include an “infrastructure risk add-on” of 2.5% for all recognized Group 1 crypto assets, to cover any additional risk posed by the nascence of blockchain and distributed ledger technology, which may yet carry unforeseen and unaccounted for risks.

Group 1a crypto assets consist solely of tokenized traditional assets, which use blockchain technology as an alternative method for recording ownership (as opposed to a centralized securities depository or custodian). In practice, this will encompass bonds, loans, deposits and equities; commodities; and cash held in custody—each of which is then subject to additional conditions, which include strict legal enforceability and certainty of settlement at any time without restriction or transfer. They must also confer the full legal rights of the underlying assets without the need for conversion, such as rights to cash flows or claims in insolvency. Crypto assets that require redemption or conversion to the traditional asset in order to benefit from these legal rights do not qualify for Group 1a crypto asset status.

Assets which meet these criteria will be subject to at least equivalent capital requirements, meaning that the minimum standard required will be that contained within the existing Basel Capital Framework to insulate against both market and operational risk for the underlying asset. In effect, this gives Group 1a crypto assets largely the same benefits and properties for banks as if their traditional equivalent was held—at least as far as Basel is concerned.

Perhaps most importantly, Group 1a crypto assets are the only crypto assets under the proposed frameworks that are eligible for recognition as collateral for risk mitigation purposes. This means that when banks are calculating their credit risk exposure and the subsequent requirements to mitigate against these under existing Basel frameworks (and by definition, applicable domestic and international laws which adopt these principles), only Group 1a crypto assets have the potential to be included. These assets must still meet market depth and liquidity requirements comparable to the traditional counterpart in order to satisfy the proposals, effectively ensuring that they can readily be redeemed for their full value in a liquidation event.

Group 1b crypto assets consist solely of so-called stable coins—which are defined as crypto assets with “effective stabilization mechanisms.” To be classified as a stable coin with effective stabilization methods under the proposals, the crypto asset must meet two tests: the redemption risk test and the basis risk test.

The redemption risk test—the objective of which is to ensure that the reserve assets are sufficient to enable the asset to be redeemable at all times, including (though in light of recent events, perhaps ‘particularly’ would be more appropriate) during periods of extreme stress, for the peg value. This means that to fulfill the requirements of the test, a U.S. Dollar stable coin would need to be redeemable for a U.S. Dollar at all times. The test has additional requirements relating to the composition and value of the reserve assets which underpin the stable coin, but the crux of the test is that it is at all times redeemable.

The basis risk test—the objective of which is to ensure that the crypto asset is able to be sold on the market for an amount that “closely tracks the peg value”—is more complex and comprises three “sub-tests” that dictate whether a crypto asset has passed or failed the test, and subsequently, how it is classified under the proposed framework. The proposals state:

Test 1: If the peg-to-market value difference does not exceed 10 basis points more than 3 times over the prior 12 months, the crypto asset has “fully passed” the basis risk test.

Test 2: If the peg-to-market value difference exceeds 20 basis points more than 10 times over the prior 12 months, the crypto asset has “failed” the basis risk test.

Test 3: If the crypto asset has neither “fully passed” nor “failed” the basis risk test, it is considered to have “narrowly passed” the basis risk test. Crypto assets that meet all the classification conditions for inclusion in Group 1b, but only narrowly pass the basis risk test, will be subject to an add-on to risk-weighted assets.

In simple English, to fulfill the requirements of the basis risk rest (as a full pass) and be classed as a Group 1 crypto asset, the market price of a stable coin must not fluctuate more than 0.1% more than 3 times in a 12-month period. Stable coins that fail to meet this highwater mark, but that have not fluctuated more than 0.2% more than 10 times over the past 12 months are deemed to have narrowly passed the test, but are subject to additional requirements in order to be held under a Group 1b classification.

This is a marked difference from the first consultation document released by Basel in 2019, which initially proposed a quantitative test which required banks to monitor the difference between the market and pegged value of a stablecoin.

The fallacy of so-called “stable” coins

Should these taxonomies for Group 1 crypto assets and the prescribed tests to classify them be implemented—as they are largely expected to—the chances of any of the most popular stable coins currently in use being held by major banks is effectively zero.

Take Tether (USDT) for example—a “stable” coin that at the time of writing boasted the third highest market cap of all digital assets—which has already come under intense scrutiny from authorities (including the New York State Attorney General’s Office) for its laughable “audits” of the reserve assets underpinning the coin, which even the most prominent members of the crypto crime cartel would admit that in no way, shape or form would satisfy the Basel proposals. But even suspending belief for a moment and pretending that Tether’s audits were entirely above board and its reserve assets constituted those which would satisfy the redemption risk test, the complete inability of the “stable” coin to maintain its peg—which in May plunged by 545 basis points to $0.9455—would exclude it from being included on the balance sheet of any bank (though it’s hard to imagine any reputable banking institution would consider using Tether given its history, even in the absence of rules specifically prohibiting it).

Similarly, over the past week alone, each of the top five stable coins by market cap—Tether, USD Coin (USDC), Binance USD (BUSD), Dai (DAI) and TrueUSD (TUSD)—have failed to maintain an adequate peg as required by the proposed basis risk test, relegating each of them to Group 2 crypto asset status before even considering the composition of their reserve assets under the redemption risk test.

However, despite the systemic risks to customers and institutions alike that the current generation of highly-fluctuating so-called “stable” coins represent, together with the shady-at-best collateral backing underpinning them, it hasn’t stopped members of the crypto crime cartel acting purely out of self-interest and trying to distort the narrative for their own benefit.

In response to the initial proposal document and call for comment last June, the Bitcoin Association of Switzerland, not to be confused with the Bitcoin Associate for BSV, was all too happy to extoll the virtues of Tether (in all likelihood because of the role it plays in artificially sustaining the price of the BTC Ponzi scheme which they continue to benefit from).

“[T]he Group 1 criterion of 10 [bps] fluctuation is way too restrictive and also the wrong metric to look at. To give a concrete example: a stable coin like the Tether (USDT) would have a good chance to qualify as [a] “Group 1 crypto asset” as it enjoys a very high degree of liquidity and is traded at a tight spread versus the US dollar,’ they wrote.

“However, at the same time, there is a non-negligible risk of a regulator freezing the accounts of the issuer in the name of combating money-laundering, thereby causing a sudden drop in the market value of the Tether.”

Yikes.

Unfortunately for Tether backers though, the unchallenged echo chamber in which they are accustomed to operating within—and the distinct lack of evidence required to make their baseless claims—doesn’t hold water with experienced power players from traditional financial markets.

“To ensure a level playing field, non-bank issuers of stable coins such as Tether, for which the stable coins are only allegedly 100% collateralized by USD or other fiat currencies, or whose collateralization is not made fully transparent by the issuer, should be treated as strictly as corresponding issues or constructs by banks,” said the German Banking Industry Committee in its submission.

“As Tether is the main liquidity provider in the BTC market, although the stable coin Tether is largely “collateralized” by commercial paper, financial stability and liquidity risks should also be taken into consideration. The regulatory arrangements should therefore pay appropriate attention to the actual collateralization of stable coins, and the measurement of capital requirements should depend on the type of stable coin under consideration.”

Of course, within the law-abiding BSV ecosystem, the expectation that stable coins be backed 100% by the assets that they serve as a digital proxy for has well since been established. Back in 2019, Bitcoin Association Founding President Jimmy Nguyen penned an op-ed for CoinGeek that detailed the regulation-friendly principles and commitment to honesty that underpins BSV:

“If you issue a stable coin (on BSV or any other platform), the backing assets should be verifiable and auditable to ensure that each dollar worth of stable coin is truly backed by an equivalent dollar of real funds or liquid assets,” said Nguyen.

“Many observers believe Tether coins have been used to artificially pump up BTC’s value—including during BTC’s crazy 2017 bull run—and unduly influence the BTC market. That in turn triggers artificial rises and falls of other cryptocurrencies, which historically coupled to BTC’s price trends. We do not want magically-minted digital coins to distort financial markets.”

So, while none of the ideas proposed by Basel as they pertain to Group 1 crypto assets represent a significant departure from the ideals which should underpin any honest blockchain ecosystem and digital currency, the response from some corners of the digital asset industry to the proposals demonstrates that there is still a lot of work to be done to clean up the sector.

Of note, Basel reached no decisive conclusion as to how Central Bank Digital Currencies (CBDCs) would be classified—an issue which they said would be subject to further consideration as and when they are issued. However, reading between the lines, there appears to be the potential for effectively designed CBDCs with appropriate controls to be implemented in the future and subjected to far more favorable carrying conditions for banks—more akin to how cash and reserve accounts are currently treated—which, under the currently proposed frameworks, would effectively monopolize this market for banks.

But why, given the already rather onerous conditions imposed on Group 1 crypto assets under the Basel proposals, are the less-than-honest corners of the crypto world clamoring to relax the taxonomies and have “assets” such as Tether included? In the final part of this series, we explore what is in store for all other crypto assets—those classed within Group 2—and detail why this spells bad news in particular for BTC bag holders hoping for a bank-fueled price pump.

Read Part 1 of this three-part editorial series, “Basel banking proposals on crypto assets spell bad news for BTC bag holders,” here.