Rising risks of crypto assets to banks call for robust regulation

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Global banking regulators are seriously evaluating the risks and rewards associated with banks’ exposure to fast growing crypto asset class. Image Credit: Ramachandra Babu/©Gulf News

Dubai: Global banking regulators are seriously evaluating the risks and rewards associated with banks’ exposure to fast growing crypto asset class.

The recent consultation on the prudential treatment of banks’ crypto asset exposures from the Basel Committee on Banking Supervision (BCBS) provide a much needed regulatory framework as banks globally are exploring the potential risks and rewards from their exposure in this rapidly evolving asset class, according to Fitch Ratings.

The BCBS proposal recommends a differentiation in the prudential treatment of crypto assets. Tokenised traditional assets would be eligible for the same capital requirements as the underlying assets if they confer similar legal rights.

The prudential treatment of fully reserved crypto assets with stabilisation mechanisms such as stablecoin would aim to capture the risks of the underlying assets and of the unsecured commitment of the entity that exchanges the crypto asset for its underlying assets or cash.

Higher risk weightage

Crypto assets that cannot be classified as tokenised traditional assets or that have no stabilization mechanism would attract a much higher risk-weight of 1,250 per cent to reflect their significantly higher risks to banks, owing to their volatility and opacity. This treatment would be applied to cryptocurrencies such as bitcoin and Ethereum, which would also not be considered as redeemable within 30 days for the calculation of the regulatory liquidity coverage ratio.

To avoid higher capital requirements, banks holding stablecoin would be required to monitor daily the difference in value to the underlying pool of assets and to perform a detailed assessment of the stabilization mechanism, which would exclude newly established crypto assets.

What is a stablecoin?

A stablecoin is a new class of cryptocurrencies that attempts to offer price stability and are backed by a reserve assets.

Stablecoins have gained traction as they attempt to offer the best of both worlds—the instant processing and security or privacy of payments of cryptocurrencies, and the volatility-free stable valuations of fiat currencies.

In short, stablecoins are cryptocurrencies that attempt to peg their market value to some external reference. Stablecoins may be pegged to a currency like the US dollar or to a commodity’s price such as gold. The key here is the value of stablecoins are collateralised.

Banks would also be required to verify ownership rights of the underlying pool of traditional assets, with classification requiring formal approval from supervisors. The associated regulatory burdens of this exposure are likely to discourage banks from holding stablecoins, especially those issued by third parties as the bank has little control over the underlying reserve pool and stabilisation mechanism.

Low exposure levels

Currently banks’ exposure to crypto assets remains small according to the BCBS. However, the rapid development of the asset class and the fast growth of crypto currencies that are not stabilized increases material risks for banks with cryptocurrency exposure.

The extreme price volatility of some of these assets and an unproven track record of liquidity will make it challenging to hedge positions when providing derivative instruments to institutional clients or when manufacturing investment products that reference crypto assets. Allowing less sophisticated retail and private customers access to this asset class also entails substantial reputation and legal risk.

The higher capital and operational requirements related to cryptocurrency could hinder wide-scale adoption by banks, which would most likely hold these assets as custodians and not on balance sheets. The punitive treatment of cryptocurrencies and their derivatives will likely discourage trading of cryptocurrency, or at least restrict banks to client transactions where exposure is kept neutral.

The recent notable exception is El Salvador, the first country to introduce bitcoin as legal tender. In a communique following the G7 meeting earlier this month, finance ministers and central bank governors stressed that global stablecoins should adhere to strict standards and should not begin operation until relevant legal, regulatory and oversight requirements are adequately addressed.

A new era of central bank digital currencies

Governments around the world are increasingly focused on issues surrounding cryptocurrencies, with some central banks exploring central bank digital currencies CBDCs.

The BCBS’s proposals exclude treatment of central bank digital currencies, which, if introduced, would likely have similar risk profiles to central bank cash.

A number of countries have begun to experiment with a general-purpose central bank digital currency (CBDC), with others likely to launch pilot schemes in the next two years. The authorities will face trade-offs between the risks and benefits associated with a widely used CBDC as they take this work forward.

“The deployment of CBDCs will create opportunities to strengthen financial system inclusion, innovation, resilience and efficiency, but may also give rise to new risks,” said Monsur Hussain, an analyst at Fitch Ratings.

Fitch sees the advantages of CBDCs lie in their potential to enhance cashless payments backed by an authority, with innovations in step with the wider digitalisation of day-to-day lives.

For central banks in some emerging markets (EMs), a key driver for researching CBDCs is the opportunity to bring underbanked communities into the financial system, and improve the cost, speed and resilience of payments.

While the rise of digital payment systems, which have strong network effects have the risk of creating oligopolies in the payment space, Fitch expects widespread use of CBDCs could erode private providers’ monopoly over payments-related data and improve the central banks’ capacity to track and trace financial transaction data for money laundering and prevention of financial crime.

Key risks

Introduction of CBDCs will come with the risks of decline in the role of banks in day-to-day financial transactions and significant loss of privacy.

“We believe the introduction of CBDCs will inevitably involve households and businesses converting some of their commercial bank deposits into CBDCs. All other things being equal, this would require banks to shrink their balance sheets – a process known as disintermediation,” said

Such risks would be likely to rise if CBDC wallets were managed directly by central banks, rather than being administered by authorised financial institutions. Even in the latter case, funds may still flow from deposit accounts into CBDC wallets if fears rise over financial instability.

Another challenge faced by CBDCs is how to replicate the anonymity of cash. Users may be reluctant to accept a digital cash substitute if it does not grant a sufficient degree of privacy.