Prudential Treatment of Crypto Asset Exposures – New BCBS Rules Proposed
On December 16, 2022, the Basel Committee on Banking Supervision (BCBS) published its final report on the prudential treatment of banks’ exposure to crypto assets (the BCBS Report). The BCBS Report is the result of two consultation rounds initiated by the BCBS in June 2021 and June 2022, respectively, and introduces international standards for the treatment of crypto assets under the capital requirements set out under the Basel Framework (the BCBS Standard).
This bulletin aims to provide an overview of the new BCBS Report and its potential implications on Swiss banks. It first outlines the current capital requirements applicable to crypto assets held by Swiss banks and subsequently provides an overview of the new capital requirements introduced by the BCBS Standard. It closes with an outlook on the expected further developments of the Swiss capital requirements in light of the new BCBS Report.
Current Capital Requirements of Crypto Assets in Switzerland
Switzerland implemented the Basel Framework in the Capital Adequacy Ordinance (CAO) and certain implementing FINMA Circulars. Under the CAO, a non-systemically important bank must generally have a minimum capital of 8.0% of its total risk-weighted assets as well as a capital buffer of 2.5% of its risk-weighted assets.
To calculate the bank’s risk-weighted assets the bank’s assets will be weighted, depending on their specific characteristics and how they are held by the bank, against their credit risk, non-counterparty-related risks, market risks, operational risks, risks under guarantees for central counterparties and value adjustment risks in connection with derivative counterparty credit risks, as applicable.
2. Specific Capital Requirements for Crypto Assets
Until today, FINMA has not published generally applicable standards on the treatment of crypto assets for purposes of capital requirements. According to the currently prevailing practice, crypto assets are attributed a risk weighting of 800%. This 800% requirement is deemed to serve as a general risk weight indicator that covers both credit and market risks and applies to any type of crypto assets. Therefore, a bank must add 800% of the crypto assets it holds to its risk-weighted assets, irrespective of (i) whether the assets are held in the bank’s trading or banking book and (ii) their individual characteristics and risk profile.
In addition to the 800% risk weighting requirement for crypto assets, FINMA’s practice is reported to include a requirement for banks to notify FINMA if the amount of crypto assets held on their trading book exceeds 4% of their total capital. Also, since August 1, 2021, article 4sexies of the Swiss Banking Act enables FINMA to impose on an individual bank a specific maximum amount for crypto-based assets held in custody for clients.
3. Activities Triggering Capital Requirements
Given the strict capital requirements for crypto assets, it is important to determine whether an activity of a Swiss bank triggers these capital requirements or not. As a general rule, the capital requirements are applicable to crypto assets if they must be included on the bank’s balance sheet. That said, the capital treatment typically depends on a variety of factors, some of which are outlined below:
- Trading and custody of crypto assets for clients: If a Swiss bank holds crypto assets for its clients – be it for trading or mere custody purposes – it depends on the individual form of custody whether FINMA’s 800% risk weighting requirement must be applied to them or not. Generally, client assets do not need to be included on a bank’s balance sheet and are therefore not subject to the 800% risk weighting requirement if they can be segregated in case of an insolvency of the bank. Pursuant to the applicable insolvency law, crypto assets can be segregated in an insolvency of a Swiss bank if (a) the bank has agreed to always keep them available for the client and (b) they are either held on an individual blockchain address for the client or on a pooled blockchain address whereby it is clear which share of the pooled crypto assets is attributable to the client. Only if crypto assets are held in a form that does not comply with these requirements will they be subject to the 800% risk weighting requirement imposed by FINMA.
- Proprietary trading of crypto assets: Crypto assets held by a bank for proprietary trading / on its own books must generally be included in such bank’s balance sheet. This applies regardless of whether they are kept in segregated or pooled custody. Thus, a bank will need to assign 800% of any crypto assets held for proprietary trading/custody activities to its risk-weighted assets.
- Staking: In practice, banks may provide staking services to clients in different forms, each of which may be treated differently from a Swiss capital requirements perspective. It therefore needs to be assessed on a case-by-cases basis whether staking services trigger Swiss capital requirements. Relevant factors include, among others, whether the crypto assets are held on blockchain addresses of the client or pooled/segregated blockchain address of the bank or how a client may retrieve its staked crypto assets.
The BCBS Standard on the Prudential Treatment of Crypto Assets Exposure
1. Purpose of the BCBS Standard
The BCBS Standard intends to introduce an internationally harmonized standard for the treatment of crypto assets under the capital requirements set out under the Basel Framework. The BCBS Standard generally distinguishes between (i) crypto assets, which are defined as private digital assets based on cryptography and distributed ledger technologies (DLT) or similar technologies (Crypto Assets) and (ii) tokenized traditional assets, which are defined as dematerialized securities that are issued through DLT or similar technologies (Tokenized Traditional Assets).
Pursuant to the BCBS Standard, banks are required to assess the Crypto Assets and Tokenized Traditional Assets (together, the Digital Assets) to which they are exposed and – based on the Classification Conditions outlined below – allocate such Digital Assets to the Group 1 or Group 2 as defined under the BCBS Standard. Based on such allocation, the BCBS Standard provides for different risk weights and capital requirements, taking into account the specific risks inherent to a respective Digital Asset. The BCBS Standard, therefore, provides for an approach that considers the specific risks inherent to a Digital Asset and applies different risk weights and capital requirements based on the underlying asset, features and the risks inherent to a Digital Asset.
To conduct such allocation and ensure an effective monitoring on an on-going basis, banks will be required to put in place the appropriate risk management policies, procedures, governance, human and IT capacities to evaluate the risks of engaging in Digital Assets.
2. Capital Requirements for Tokenized Traditional Assets and Stablecoins
a) General Requirements
The BCBS Standard defines Group 1 Digital Assets as Digital Assets that satisfy all the classification conditions outlined below. Group 1 Crypto Asset include Tokenized Traditional Assets (Group 1a) and Crypto Assets with effective stabilization mechanisms (Stablecoins) (Group 1b).
- Classification Condition 1: The Digital Asset is either (i) a Tokenized Traditional Asset; or (ii) has a stabilization mechanism that is effective at all times in linking its value to a traditional asset or a pool of traditional assets (e., reference or underlying asset(s)). Tokenized Traditional Assets will typically satisfy Classification Condition 1 if they have the same level of market risk as the underlying non tokenized asset. For tokenized financial instruments such as bonds, equities, or derivatives, this means that the Tokenized Traditional Assets must confer the same ownership, financial and/or membership rights as the traditional underlying financial instrument. Stablecoins will only meet Classification Condition 1 if the implemented stabilization mechanism, in particular, (i) effectively minimizes fluctuations in the market value of the Stablecoin and (ii) enables a risk management similar to the risk management applicable to the underlying traditional assets.
- Classification Condition 2: All rights, obligations and interests arising from the Stablecoins or Tokenized Traditional Asset arrangement must be clearly defined and legally enforceable in all jurisdictions in which the asset is issued and subsequently redeemed. In addition, the applicable legal framework must ensure settlement finality in relation to transactions in the Stablecoin or Tokenized Traditional Asset.
- Classification Condition 3: The functions of the Digital Asset and the network on which it operates, including the DLT or similar technology on which it is based, are designed and operated to sufficiently mitigate and manage any material risks. Satisfaction of Classification Condition 3 will, in particular, require that the functions of the Digital Assets, such as issuance, validation, redemption and transfer, do not pose any material risks that could impair the transferability, settlement finality or, where applicable, redeemability of the respective Digital Asset.
- Classification Condition 4: The entities that execute redemptions, transfers, storage or settlement finality of the Digital Assets, or manage or invest such assets, must: (i) be regulated and supervised, or subject to appropriate risk management standards; and (ii) implement and disclose a comprehensive governance framework.
Tokenized Traditional Assets and Stablecoins that satisfy the Classification Conditions 1 through 4, are generally subject to the risk weights and capital requirements applicable to the traditional credit and market risk exposures of the underlying asset as set out in the existing Basel Framework with a crypto-specific add-on. For example, a tokenized corporate bond in the form of a Traditional Tokenized Asset held in the banking book will be subject to the same credit risk weight as the non-tokenized corporate bond held in the banking book.
b) Add-on for Infrastructure Risks
The technological infrastructure on which all Digital Assets are based, such as DLT, is still relatively new and may pose additional risks even in cases in which the Tokenized Traditional Assets or Stablecoins satisfy the Group 1 Classification Conditions. The BCBS Standard therefore requires that under the national implementation of the BCBS Standard the competent national supervisory authorities must have the power to apply an add-on to the capital requirement for exposures to Group 1 Digital Assets. The add-on for infrastructure risks will initially be set at zero but will be increased by authorities based on any observed weakness in the infrastructures underlying the Group 1 Digital Assets.
3. Capital Requirements for other Digital Assets
The Group 2 Digital Assets consist of Tokenized Traditional Assets and Stablecoins that do not satisfy the aforementioned Classification Conditions and unbacked Crypto Assets. Whilst each Digital Asset will have to be assessed on a case-by-case basis, we expect that most of the Digital Assets to which banks currently have an exposure will be qualified as Group 2 Digital Assets.
The BCBS Standard in turn distinguishes between Group 2 Digital Assets that meet the hedging recognition criteria set out under the BCBS Standard (Group 2a) and such Digital Assets that fail to meet such hedging recognition criteria (Group 2b). For Digital Assets to fulfill the applicable hedging recognition criteria, the respective hedging position relating to the Digital Asset will have to satisfy a number of requirements under the BCBS Standard, namely in relation to tradeability, clearing, market liquidity and available data relating to the hedging position. For Digital Assets that provide for a hedging arrangement that satisfies the applicable hedging recognition criteria, the BCBS Standard sets out adapted market risk exposure rules with an additional 100% capital charge.
For Group 2 Digital Assets that do not provide for a sufficient hedging arrangement, banks will ultimately be required to apply a 1250% risk weighting for the calibration of the applicable capital requirements under the Basel Framework.
4. Exposure Limits
In addition to the capital requirements summarized above, the BCBS Standard will introduce an exposure limit to Group 2 Digital Assets. Thereunder, a bank’s total exposure to Group 2 Digital Assets should not exceed 2% of the bank’s total Tier 1 capital and should generally be lower than 1% of the bank’s total Tier 1 capital. Banks breaching the 1%-threshold will be required to apply the stricter Group 2b capital requirements to the amount by which the limit is exceeded. Breaching the 2% limit will result in the entirety of the bank’s Group 2 exposures being subject to the Group 2b capital treatment.
The BCBS Standard will in a next step be incorporated into the consolidated Basel Framework. According to the BCBS Report, the BCBS Standard should be implemented into national law by January 1, 2025. The national legislators and regulators will therefore need to assess if and how they incorporate the BCBS Standard into their existing regulatory capital framework.
In Switzerland, it is generally expected that FINMA will review its current practice in light of the BCBS Report. However, it remains to be seen whether the Swiss legislator will follow the requirements set forth by the BCBS Standard in their entirety or will apply a separate Swiss approach that deviates in certain respects from these requirements.
That said, the implementation of the new rules imposed by the BCBS Report will likely not be the only FinTech-related adjustment to Swiss financial market law that will be discussed in 2023. In particular, the Swiss Federal Council announced last Friday, December 16, 2022, that it intends to revise the so-called FinTech license pursuant to article 1b of the Banking Act with the aim of further strengthening the protection of clients and their funds. While the contemplated amendment appears to focus on the introduction of a segregation of client funds in case of an insolvency of a FinTech company, it will need to be seen whether the amendment also has an effect on the capital requirements of FinTech companies, in particular, whether the CAO and the implementing FINMA practice, which is currently not applicable to FinTech companies, shall in the future also apply to crypto assets held by FinTech companies.
This Bulletin expresses general views of the authors as of the date of this Bulletin, without considering any particular fact pattern or circumstances. It does not constitute legal advice. Any liability for the accuracy, correctness, completeness or fairness of the contents of this Bulletin is explicitly excluded.