Basel banking proposals on ‘crypto’ assets spell bad news for BTC bag holders—part 3

This is a three-part editorial series. Check out Part 1 here and Part 2 here.

The hallmark of the proposals from the Basel Committee on Banking Supervision (BCBS) for the regulation and prudential treatment of ‘crypto’ assets is a two-group taxonomy. Group 1 crypto assets are strictly limited to tokenized versions of real-world assets and stablecoins, with strict criteria that would likely preclude any popular stablecoins currently in use today. These assets are subject to a tough, albeit relatively familiar set of carrying requirements for banks, with the primary points of emphasis found in existing frameworks from Basel.

Digital assets which fail to meet the stringent requirements for Group 1 crypto assets automatically become Group 2 assets, which have an even more restrictive set of requirements—as well as limitations—than their Group 1 counterparts. Crypto assets which fall into the Group 2 classification cover essentially every popular crypto asset on the market today, from BSV and Ethereum, through to BTC and Tether—a reality which has drawn the ire of many prominent institutions in the ‘crypto’ sphere.

So why has this classification from Basel prompted such harsh criticism from many corners of the crypto world—particularly from members of the crypto crime cartel—and what does it mean for banks looking to onboard these assets onto their balance sheets?

Group 2 crypto assets

Crypto assets classified in the Group 2 taxonomy are those which Basel considers pose a higher risk than their Group 1 counterparts and as such, are subject to a “newly prescribed conservative capital treatment.”

The most important component of the rules and regulations which apply to Group 2 crypto assets is a total exposure limit for banks, which is capped at 1% of Tier 1 capital. Tier 1 capital is a bank’s main funding source and is primarily comprised of disclosed reserves and equity—and generally represents the total accumulated funds of the bank. This limit for Group 2 crypto assets is calculated based on the aggregate number of gross exposures, with no netting or recognition of diversification benefits.

Although the committee has indicated that this 1% limit is provisional and would be reviewed periodically, to be clear, this is not to be viewed as tacit permission from Basel for banks to begin dabbling in BTC and other ‘crypto’ assets. Rather, this is a clear and obvious restriction on banks considering such a step, despite some of the propaganda on the contrary emanating from ill-informed members of the crypto media. Because, in addition to the gross restriction on the amount of Group 2 crypto assets that are permitted to be held, they are also subject to an extremely high risk-weighting, which translates to a significant opportunity cost for banks investing in this class of asset.

The risk-weighting of assets is used to determine the capital requirements for banks to hold different types and classes of assets, in order to cover unexpected losses arising from the underlying assets. A bank’s capital ratio is calculated by dividing the amount of Tier 1 capital a bank possesses by the total of risk-weighted assets (RWA) held. Under the second Basel accord—more commonly referred to as Basel II – Tier 1 capital must account for at least 8% of a bank’s capital ratio (this will rise to 10.5% with the implementation of Basel III, which is required by January 1, 2023). That means that for every $1 million of risk-weighted assets held, at least $80,000 of Tier 1 capital must be held to retain a sufficient capital ratio (rising to $105,000 with Basel III). This makes the amount of Tier 1 capital held not just important for the financial health of a bank, but also in dictating both the structure and composition of its investments.

The quality and the riskiness of an asset determines the risk-weighting which must be applied. U.S. Treasury bonds or gold bullion, for example, carry a risk-weighting of 0%—meaning that they are effectively the equivalent of holding cash and have no impact on a bank’s capital ratio. Retail residential mortgages attract a risk-weighting upwards of 35%, while publicly traded equities will typically carry a risk-weighting between 80% and 150%. Under the proposed framework from Basel, Group 2 crypto assets will attract an effective risk weighting of 1,250%—essentially requiring a dollar-for-dollar write-down of these assets against Tier 1 capital. When banks have limited Tier 1 capital at their disposal, the opportunity cost of holding Group 2 crypto assets compared to other asset classes is enormous.

Like with Group 1, Group 2 crypto assets are also divided into two groups—Group 2a and 2b—which is used to determine the risk-weighting required for these assets. The classification of these assets is determined entirely on the basis of whether or not they meet the prescribed hedge recognition criteria to mitigate against counterparty credit risk, which includes requirements around the availability of regulated derivatives or an exchange-traded fund (ETF) or note (ETN), sufficient capitalization and liquidity, in addition to a history of real (non-manipulated) and reliable data.

This is a change from the initial 2021 proposals, under which all Group 2 assets would have been subjected to the same high regulatory cost of holding, with a 1,250% risk-weighting applied to the maximum of long and short exposure for all crypto assets that fall under this taxonomy. That 1,250% risk-weighting will now technically only apply to Group 2b crypto assets. Group 2a crypto assets will instead be accounted for using a 100% capital charge, which in effect retains the 1,250% risk-weighting, but facilitates the potential for reduction via limited recognition of hedging.

Despite the clear chilling effect that the Basel proposals will have on the attractiveness of crypto assets to banks, it would be remiss not to note that 1% of the Tier 1 capital of a major bank still represents a not insignificant potential cash injection into the crypto asset landscape. Take JPMorgan Chase & Co. for example, which is the largest U.S. bank by total assets—coming in at a cool $3.38 trillion—assets which are underpinned by $263.1 billion of Tier 1 capital. Taking an extremely oversimplified approach to calculating potential exposure, JPMorgan could add roughly $2.6 billion worth of Group 2 crypto assets to its balance sheet while remaining compliant with the proposed Basel frameworks. That is roughly the same amount of BTC that Michael Saylor purchased (albeit at a significantly higher price compared to the current market value) while still at the helm of MicroStrategy—a company with a market cap that is less than 1% of that of JPMorgan.

So, given the high regulatory costs of carrying digital assets—both direct and indirect—as well as, to major banks, what will be considered seriously limited potential upside (particularly in the context of the vast array of alternative asset classes which are subject to much less onerous restrictions) and the opportunity cost of carrying crypto assets on their balance sheets, the question becomes, why would they even bother?

For context, at the time of writing, 38 banks worldwide reported total assets on their balance sheets exceeding the entire market capitalization of all crypto assets (stats per S&P Global Market Intelligence and CoinMarketCap), a list which includes household names like Bank of America, Goldman Sachs and Barclays, in addition to lesser-known institutions such as the China Minsheng Bank, Japan’s Mizuho Financial Group and Italy’s Intesa Sanpaolo SpA. For the vast majority of these financial monoliths, it’s unlikely that the juice is going to be worth the squeeze.

Bad news for BTC bag holders

All of this means that for crypto bag holders hoping to ride out the storm of recent market conditions, the proposals from Basel will come—to put it lightly—as less than welcome news. The initial proposals from Basel released in 2021 for public consultation—which in many respects, were more relaxed than the current iteration—drew sharp criticism, with some prominent industry bodies failing to even retain an illusion of professionalism in their comments.

“We would love to be proven wrong, but we cannot shake off the impression that your reasoning is guided by politics and not by the constructive and neutral application of principles,” wrote the Bitcoin Association of Switzerland (not to be confused with the Bitcoin Association for BSV, also based out of Switzerland), adding, “It is even conceivable that the proposal in its current form could be legally challenged in various countries due to not being reconcilable with constitutional principles such as proportionality and economic freedom.”

“For currencies, it should also not matter who the issuer is or whether an issuer exists at all. All the major world currencies have ceased to be redeemable for anything real a long time ago. Like Bitcoin, the USD and the EUR do not represent a claim towards an issuer. They only have value because people have some faith in the systems they represent. So why not just classify Bitcoin as an extraordinarily volatile currency? You should note that the volatility of Bitcoin has been decreasing for years, and by 2030, its price might have become as stable as that of gold or the South African Rand.”

But still, ‘crypto-maxis’ wonder why the traditional financial system and political institutions often fail to take the digital asset industry seriously? Well, the vaguely-threatening, nonsensical, anarchistic ramblings from a leading trade association certainly offers some insight. And with the revised proposals released for public comment this year being even more restrictive than what was initially mooted, the submissions received from the crypto crime cartel are sure to be even more unprofessional than the last batch. Perhaps during the next public consultation, we’ll see suggestions for more relaxed treatment citing comparisons to the Zimbabwean Dollar or Venezuelan Bolivar—both stalwarts of stability—arguments that the committee will no doubt find highly compelling and persuasive, I’m sure.

But the real question is why, when crypto is supposedly designed to usurp the legacy financial system and trigger a monetary revolution outside the bounds of control of traditional power structures, would some of its biggest proponents be so insistent on effectively integrating the two—or at least bringing those two supposed disparate worlds that much closer together.

The answer, as it turns out, requires no educated guesswork nor inference drawing. Rather, it’s spelled out in black and white by one of the very institutions that stands to gain the most from an uninhibited free-for-all for banks and crypto assets: Coinbase (NASDAQ: COIN).

“In the same way that the internet democratized the exchange of information and transformed how we are connected to the rest of the world, crypto assets are unlocking new and more efficient methods of transferring value and financial assets that will revolutionize how we save, spend, and pay for goods and services.,” wrote Coinbase Chief Policy Officer Faryar Shirzad in his company’s submission to the Committee.

“Banks provide a critical role in responding to this strong customer demand. We support their increasing involvement in the development of crypto asset markets with their well-established risk management practices and financial services experience. Their participation, coupled with an appropriately tailored prudential framework, will bring additional efficiency, security, and credibility to the crypto asset ecosystem.”

The key word in that statement from Coinbase: credibility.

Despite being submitted a full year ago, the words from Coinbase’s Shirzad not only still ring true today, but in hindsight, were eerily prophetic. Since that time, we have of course seen a complete crash of the crypto asset market, with the downfall of Terra-Luna and Three Arrows Capital (3AC), as well as the contagion effects seen on broader crypto markets in their wake, undoubtedly reminding many experienced financial players of the Lehmann Brothers and Bear Stearns collapses which stand out as hallmarks of the 2008 Global Financial Crisis. With major crypto companies proving they were built on a platform of little more than bluster and bravado, not to mention the number of intentional “rug-pulls” designed to defraud customers of their hard-earned capital, the crypto industry needs credibility—and getting major banks on board would go a long way to re-building trust with the public.

But in the case of Coinbase, that need for credibility goes beyond just the largely useless speculative assets that litter its exchange and trading platform, but extends to the business itself and its ability to remain a going concern. The entrance of banks—which Coinbase would no doubt look to partner with—would assuredly help to rescue the company’s plummeting stock price, which has plunged 80% since listing in April 2021, amidst rumors of bankruptcy, cost-cutting, a staff exodus and even the prospect of a distressed acquisition (one has to think that FTX and Sam Bankman-Fried would be licking their lips at the prospect of buying up their biggest competitor at a bargain basement price to largely monopolize the great con of the crypto crime cartel for the U.S. market).

But the bottom line from Basel for these less than reputable institutions hoping to latch their wagon to big banks in search of credibility and even more ill-gotten gains from the public is a resounding rejection.

A Basel-driven boon for utility?

Yet despite a grim outlook for the speculative Ponzi tokens which dominate the current crypto landscape, the prospect for digital assets with genuine utility could prove to be an entirely different proposition.

Consider BSV in the context of the Basel proposals: as it neither directly qualifies as a tokenized real-world asset nor a stable coin (though assets built atop the underlying BSV protocol, be they stable coins or tokenized assets, may have the potential to qualify under either taxonomy in the future if appropriate frameworks allowing permissionless blockchains are introduced), BSV would join the vast majority of contemporary digital assets in Group 2 and be subject to the same restrictions and requirements. However, as a digital asset designed to actually be used (as opposed to HODLing it away in digital vaults to continue to perpetuate the Ponzi), banks would only need to hold sufficient working capital of BSV to fund the transactions that they intend to write to the ledger.

Doing some very basic maths courtesy of the blockchain cost calculator provided by the BSV blockchain and mintBlue, a bank posting one billion transactions to the BSV blockchain each month would require working capital equivalent to US$6 million—a number which for any global bank processing that magnitude of transactions constitutes little more than a rounding error. That number, too, fails to account for the prospect of efficiency gains, batching transactions and bulk fee rates from transaction processors, meaning that the reality is that US$6 million is in all likelihood an exceptionally high estimate. But more importantly, the regulatory carrying charge and opportunity cost of holding such an amount of BSV under the proposed Basel frameworks would be trivial, offering a genuine incentive compared with competing blockchain ecosystems for the banking world to onboard to BSV.

But, given the reactions from the rest of the crypto world to the Basel proposals, which have ranged from anger and surprise to shock and even threats of legal action, who could have possibly predicted what was in store?

Why, the man who invented the technology, Satoshi Nakamoto aka Dr. Craig Wright, of course.

“We have a vision of systems that are built on the Bitcoin blockchain, which maintains a global, open ledger. It is the vision of a single ledger, so that banks, governments, and corporations cannot fudge the numbers,” explained Dr. Wright in a 2019 blog post, aptly titled Bitcoin is not against banks.

“Forget the lies you have been told about Bitcoin. Bitcoin doesn’t stop banking, it doesn’t even stop central banks. In fact, central banks were born using a gold standard. The first central banks actually had a one-to-one reserve requirement. It didn’t last long, and they realized that they could do a four-units-to-1 gold standard in the British central bank. The fact of the matter is: there is little difference between bitcoin held with Coinbase and the modern banking system.”

Similarly, in a 2021 blog post titled Banking old wine in new bottles, Dr. Wright built on this argument, once again hitting the nail on the head while the rest of the crypto world either buried their heads in the sand, feigned ignorance or even tried their hand at bullying Basel.

“What we see in the BTC environment presents a regression to a gold-based bank. In fact, it is a free banking system where government regulations have not taken hold, and the bank gets to play with your money outside of controls,” wrote Dr. Wright.

“In the United States, Fort Knox was famous for holding gold. Such is the paradigm that many in the BTC or cryptocurrency industry want to create. They don’t want to see Bitcoin; they don’t like my invention. Rather, they want to regress to a system of digital gold, analogous to the early system that exchanged notes between trusted intermediaries.”

Thankfully though, despite the rhetoric from corners of the crypto crime cartel which seems to dominate headlines within the world of digital assets, it certainly appears that it is Dr. Wright’s narrative which is proving convincing to those that really matter in this arena: The Basel Committee on Banking Supervision. That fact can only spell bad news for BTC bag holders hawking digital gold for big banks to hold in their vaults. On the other hand, such sentiment will ring a resoundingly positive note with supporters of the original vision for Bitcoin, as digital cash designed to actually be used and the backbone of an enterprise data system.

With the public consultation phase on the Basel proposals set to conclude on September 30—and with no major changes expected to be made—we could be just months away from seeing these principles confirmed and subsequently adopted in the domestic law of the most powerful economies on the planet. But that’s not all there is to look forward to. With all submissions received as part of the public consultation released and freely available, the uninhibited ignominy from the crypto crime cartel in their submissions when they fail to get their way should provide ample fodder for entertainment.

Read Part 2 of this three-part editorial series, “Basel banking proposals on crypto assets spell bad news for BTC bag holders,” here.