Introduction
Recently, the Financial Services Forum, jointly with a number of other trade associations, responded to the Basel Committee on Banking Supervision’s consultation on capital requirements for cryptoassets, or “crypto.” In this post, we lay out the key points from our joint letter and provide some thoughts on the future evolution of bank capital requirements for crypto. Overall, the consultation prescribes a punitive capital treatment for crypto that does not account for the specific risks of these assets or the way in which large banks manage these risks. The proposed capital treatment risks pushing crypto activity well outside the regulated banking sector and into less well-regulated corners of the financial system. Doing so would deprive businesses and investors of the opportunity to deal with banks in this new market, would impede responsible innovation, and would increase systemic risk to the economy. Bank regulators should reconsider the proposed requirements with an eye toward establishing a risk-sensitive regulatory framework that does not preclude banks from contributing to the development of this new market.
Banks Should Contribute to Crypto Development and Innovation
Technological innovation is the hallmark of a growing economy. And banks have long been and will continue to be important incubators for financial innovation. Crypto as a new financial innovation has garnered quite a lot of recent attention and not all of it has been good. Some have derided crypto solely as a “scam” or a tool for facilitating illicit activity. These claims are unhelpful and premature given the nascent state of this market. Like all new innovations, it is hard to predict how crypto will evolve and how it will fit into the economy in the years to come. And the crypto of today will likely bear little resemblance to the crypto of tomorrow. Figuring all of this out takes time and the innovative efforts of a broad range of diverse participants. What can be predicted, however, is that more participants working together will have a better chance of successful and responsible innovation than fewer participants. And there is good reason to believe that large banks have a lot to offer in innovating crypto. Specifically, large banks have deep expertise in facilitating financial intermediation and risk management across a range of financial markets. This deep expertise, including the lessons of the past, can most assuredly be put to effective use as the economy works through the complex issues associated with building safe and effective uses for crypto technologies. Bank participation will improve the quantity and quality of innovation while also giving regulators a clean line of sight into this new and emerging market.
Crypto Capital Requirements Should Reflect Risk and Leverage Existing Requirements
There is no doubt that crypto entails risk. There is also no doubt that banks should be subject to a sensible capital regime that accounts for these risks. Unfortunately, the recent consultation proposes a punitive and blunt capital charge that effectively assumes that a holding of certain crypto exposures loses 100% of its value. More importantly, the proposed treatment largely ignores how banks risk manage and hedge these positions to reduce risk, which would render any significant crypto activity uneconomic.
The associations’ joint response letter proposes a different and better approach to crypto capital. Our proposal is data-based, reflects the actual risk-management practices of banks, and broadly fits within the existing capital regime for large banks, which is already designed to account for exposures to volatile assets. In short, we have proposed a conservative, data-based approach for crypto exposures that would result in a capital charge that is only slightly less than that of the Basel proposal for an outright and unhedged holding of crypto. The key difference in our proposal, however, is that we propose that hedging be recognized for crypto assets that have a demonstrated, liquid, two-way market. This treatment is fully consistent with the existing capital treatment for other volatile financial assets, such as certain currencies or commodities. For cryptoassets that are newer and less well tested, we propose a treatment that coincides with the proposal’s treatment until such time that a liquid, two-way market for these cryptoassets can be demonstrated.
This approach to crypto capital is risk-sensitive and establishes appropriate guardrails to ensure safe and sound banking practices while allowing for an onramp to a more risk-sensitive capital treatment. In addition, the proposed treatment is broadly consistent with the existing capital framework for large banks. Consistency with the exiting regime is an important feature of our proposal. The existing large bank capital regime has been subject to significant development and enhancement for over a decade. As markets evolve, regulators should first work to leverage the existing capital framework before adding new and untested components that unnecessarily complicate the framework.
Crypto and Financial Stability
New products and markets present new risks that must be managed. Experience has shown that these risks can grow rapidly and present the greatest risks to financial stability when they exist largely outside the regulatory perimeter. The recent pandemic experience has shown that innovations occurring largely outside the regulated banking sector exhibited the most instability and are in the greatest need of consideration. Bank capital requirements should not be set in a manner that explicitly incentivizes the development of crypto markets outside the banking system. Rather, bank regulation should allow and not preclude bank participation and innovation in these markets. The active participation of regulated banks should also improve the ability of regulators to monitor these markets as they develop. The current capital proposal risks excluding regulated banks from this market and concentrating these activities in less well-regulated corners of the financial system, setting the stage for increased systemic risk. Capital requirements that are in line with our proposed approach would help ensure broader participation in these markets, which would improve transparency, oversight and financial stability.
Conclusion
Like all new innovations, the future path of crypto is uncertain. To realize the full potential of crypto for our economy, it is imperative that the market benefit from broad participation that includes those with deep expertise in financial markets and risk management. Large banks are indeed a deep well of just this kind of experience that can surely contribute to responsible and durable innovation in crypto markets. Large bank participation will also promote a safe and sound regulatory approach to crypto that can inform regulation in other sectors, while enhancing the ability of regulators to monitor this emerging market. The Basel Committee’s proposed requirements should be reconsidered in light of the need to embrace responsible financial innovation in a manner that promotes stability and serves the entire economy.