Increasing risks of cryptocurrencies for banks call for strong regulation

Dubai: Global banking regulators are seriously considering the risks and rewards of exposing banks to the fast-growing crypto-asset class.

The recent consultation on the prudent treatment of the exposure to banks’ crypto-assets by the Basel Banking Supervision Committee (BCBS) provides a much-needed regulatory framework as banks worldwide explore the potential risks and benefits of their exposure in this rapidly evolving asset class. to Fitch Ratings.

The BCBS proposal recommends a distinction in the prudent treatment of crypto-assets. Traditional assets that are through signatures will be eligible for the same capital requirements as the underlying assets if they confer similar rights.

The prudent treatment of fully reserved crypto-assets with stabilization mechanisms such as stablecoin is aimed at capturing the risks of the underlying assets and the unsecured commitment of the entity exchanging the crypto-asset for its underlying assets or cash.

Higher risk weight

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

To avoid higher capital requirements, banks holding stable money will need to monitor the value difference in the underlying asset pool on a daily basis and conduct a detailed assessment of the stabilization mechanism, which excludes newly established crypto-assets.

What is a stable coin? A Stablecoin is a new class of cryptocurrencies that seeks to provide price stability and is backed by a reserve asset. Stablecoins have gained traction as they try to offer the best of both worlds – the instant processing and security or privacy of payments of cryptocurrencies, and the volatile stable valuations of fiat currencies. In short, stable coins are cryptocurrencies that try to link their market value to an external reference. Stable coins can be pegged to a currency such as the US dollar or to a trading price such as gold. The key here is the value of the stable portfolios.

Banks will also be required to verify ownership of the underlying pool of traditional assets, with classification requiring formal approval from supervisors. The associated regulatory burdens of this exposure are likely to deter banks from owning stable currencies, especially those issued by third parties, as the bank has little control over the underlying reserve pool and stabilization mechanism.

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Low exposure levels

According to the BCBS, banks are currently exposed to crypto-assets. However, the rapid development of the asset class and the rapid growth of non-stabilized cryptocurrencies increase significant risks for banks with exposure to cryptocurrencies.

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

The higher capital and operating requirements with respect to cryptocurrency may hinder the acceptance of banks on a large scale, which is likely to hold these assets as custodians and not on balance sheets. The penalization of cryptocurrencies and their derivatives is likely to discourage cryptocurrency trading, 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 a legal tender. In a communication following the G7 meeting earlier this month, finance ministers and central bank governors stressed that global stable currencies must meet strict standards and not start before the appropriate legal, regulatory and supervisory requirements are adequately addressed. not.

A new era of digital currency from the central bank Governments around the world are increasingly focusing on issues surrounding cryptocurrencies, and some central banks are examining the central bank’s digital currencies. The BCBS’s proposals exclude the treatment of central bank’s digital currencies, which, if introduced, are likely to have similar risk profiles to central bank’s cash. A number of countries have begun experimenting with a central bank digital currency (CBDC), with others likely to launch pilot schemes in the next two years. The authorities will compromise between the risks and benefits associated with a commonly used CBDC as they take this work forward. “The use of CBDCs will create opportunities to strengthen the inclusion of the financial system, innovation, resilience and efficiency, but it could also lead to new risks,” said Monsur Hussain, an analyst at Fitch Ratings. Fitch sees the benefits of CBDCs in their potential to improve government-backed cashless payments, with innovations in line with the broader digitalisation of daily life. For central banks in some emerging markets (EMs), an important driver for investigating CBDCs is the opportunity to bring subbank communities into the financial system and improve the cost, speed and resilience of payments. Although the rise of digital payment systems, which has a strong networking effect, risks creating oligopolies in the payment space, Fitch expects that the widespread use of CBDCs could erode the monopoly of private providers over payment data and the central banks’ ability to can improve and track financial data for money laundering and financial crime prevention. Key risks The introduction of CBDCs risks reducing the role of banks in day-to-day financial transactions and a significant loss of privacy. ‘We believe that the introduction of CBDCs will inevitably involve households and businesses converting some of their commercial bank deposits into CBDCs. Although equitable, banks will have to reduce their balance sheets – a process known as disintermediation, ” said such risks are likely to increase if CBDC wallets are managed directly by central banks, rather than by authorized financiers. to manage settings. Even in the latter case, funds can still flow from deposit accounts to the CBDC wallets if there is fear of financial instability. Another challenge facing CBDCs is how to replicate the anonymity of cash. Users may be reluctant to accept a digital cash substitute if it does not provide adequate privacy.