Zou Chuanwei: Interpretation of Basel Agreement’s classification and supervision of encrypted assets

Around the three pillars of the Basel Agreement (minimum capital requirements, regulatory review and market discipline), discuss how the Basel Agreement handles crypto asset exposure.

Original title: “Zou Chuanwei: Basel Agreement and Crypto Asset Supervision”

On June 10, 2021, the Basel Committee (BCBS) issued a consultation document “Prudent Handling of Exposure to Encrypted Assets”, incorporating the exposure of banking financial institutions to encrypted assets into the regulatory framework of the Basel Agreement. This consultation document expands the definition of encrypted assets, establishes a standard for the classification of encrypted assets, and discusses how to deal with the exposure of encrypted assets around the three pillars of the Basel Agreement-minimum capital requirements, regulatory review and market discipline.

It is worth noting that the Cryptoasset defined by the Basel Committee is not limited to the commonly referred to as virtual assets such as Bitcoin and Ethereum, but also includes digital assets such as tokenized securities and stable coins. In fact Aiming at the new asset types that banking financial institutions will involve in the era of financial technology. This consultation document has a bright forward-looking color, reflecting the spirit of the Basel Accord to keep pace with the times. In view of the key position of the Basel Agreement in financial supervision, this consultation document is of great significance to the supervision of encrypted assets.

What are crypto assets?

The definition given by the Basel Committee is: encrypted assets are private digital assets that mainly rely on cryptography, distributed ledgers or similar technologies, while digital assets are digital representations of value that can be used for payment, investment, or acquisition of goods Or service.

This definition has the following main points:

First, encrypted assets are digital assets rather than physical assets, but not all digital assets are encrypted assets, only those that mainly rely on cryptography, distributed ledgers or similar technologies. For example, although stocks, bonds, and commodities recorded in the accounts of the Central Securities Registry (CSD) or custodian are digital assets, they are not classified as encrypted assets. This point involves the difference between the account mode and the Token mode in the financial infrastructure. In the account model, the central securities registry dematerializes securities and makes securities the electronic accounting subjects in the central securities registry’s account, so that securities transactions do not involve the physical delivery (non-liquidity) of paper certificates, but are embodied as Debit and credit operations of related accounts. Cryptography, distributed ledgers or similar technologies can also achieve dematerialization and non-liquidity, using Token to represent value, and Token transfer to represent value circulation. Although both the account model and the token model can support digital representation of value, there are important differences in management methods, transactions, clearing and settlement, and privacy protection. First of all, accounts are generally managed centrally, and users need to provide identity certification information to the account manager when opening an account. Token can be managed centrally or decentrally, with better openness. The user only needs to prove that he knows some specific information (mainly the private key). Secondly, financial accounts are real-named, and Token supports controllable anonymity, which can better protect user privacy, but it also creates challenges for financial supervision. Third, accounts have different levels, and transactions are embodied as debit and credit operations of related accounts, so they are also hierarchical. Tokens can be directly traded point-to-point without relying on intermediaries, and transactions are naturally cross-border. Finally, different users have different account “views”, and Token is a shared ledger.

Second, encrypted assets are private digital assets, and the value basis is the private sector or market institutions. In this way, central bank digital currency (CBDC) is excluded from encrypted assets (some central bank digital currencies use an account model, which does not meet the definition of encrypted assets in terms of existence). But this definition is unclear. Securities in the form of tokens issued by public sector agencies other than the central bank should also belong to the category of encrypted assets. For example, the World Bank issued Bond-i, the world’s first bond created and managed using blockchain in 2018.

Third, the use of encrypted assets includes three aspects: payment, investment, and obtaining goods or services. This corresponds to the classification of encrypted assets in securities supervision-payment type, securities type and functional type. The goal of crypto-asset supervision is to promote financial stability and financial consumer protection, prevent crypto-assets from being used for money laundering, terrorist financing, and tax evasion, and is in line with the direction of carbon emission reduction.

In general, encrypted assets are the value expressed in Token in addition to the central bank’s digital currency. This distinguishes encrypted assets from physical assets and non-physical securities based on a central securities registry or custodian. The characteristics of encrypted assets in terms of management methods, transactions, clearing and settlement, and privacy protection are the key reasons why they can become a new asset type, but the new risks introduced thereby also constitute the focus of encrypted asset supervision.

Crypto Asset Classification Standard

The Basel Committee divides encrypted assets into two categories on the basis of value-category 1 and category 2. Among them, category 1 encrypted assets are further divided into two subcategories 1a and 1b. The Basel Committee adopted an exclusion method in the classification and adopted very strict standards for Type 1 encrypted assets. Anything that does not meet the requirements is classified into Type 2 encrypted assets.

Type 1 crypto assets

Type 1a crypto assets include the tokenization of cash, deposits, loans, bonds, stocks, commodities or other traditional assets. The “traditional assets” here refer to assets recorded in the accounts of the central securities registry or custodian (ie account model). Type 1a encrypted assets and corresponding traditional assets have the same legal rights, except for their different existing forms, which are reflected in asset ownership, future cash flow, and settlement order. If a certain type of encrypted asset needs to be redeemed or converted into a traditional asset before it can have the same legal rights as a traditional asset, it does not meet the criteria for type 1a encrypted assets. What needs to be noticed is that even if 1a encrypted assets have the same legal rights as the corresponding traditional assets, their differences in trading venues, investor groups, and trading methods will affect their liquidity, market value, and use as collateral. Products to mitigate credit risk.

Type 1b encrypted assets do not have the same legal capabilities as the corresponding traditional assets, but have achieved a value-linked relationship through a stable mechanism. The core of the stability mechanism is a trusted issuing agency. The issuing institution issues encrypted assets based on a sufficient amount of traditional asset reserves, and guarantees complete redeemability, that is, investors can always exchange encrypted assets 1:1 for corresponding traditional assets. There are many possible arrangements for the stabilization mechanism. There are two main points: first, whether there is a bankruptcy isolation relationship between the traditional asset pool as the issuance reserve and the issuing institution; second, who can directly redeem the crypto from the issuing institution Assets (ie groups of redeemers). These two points determine the regulatory requirements for class 1b assets.

Therefore, for type 1b encrypted assets, there are traditional assets first, and then a “mirror” of traditional assets in the Token mode is generated through a stable mechanism, while type 1a encrypted assets have no “mirror” attribute. The Basel Committee requires that all types 1a and 1b of encryption must meet the following requirements. As long as one of the requirements is not met, it belongs to type 2 encrypted assets.

(1b) Stability mechanism of encrypted assets

The stability mechanism must always be effective, which is reflected in the relative price difference between encrypted assets and corresponding traditional assets, and the number of times that it exceeds 0.1% in a year shall not exceed 3 times. Otherwise, the stabilization mechanism is not always effective.

Stability mechanisms must support risk management based on sufficient data. For example, the composition and valuation of traditional asset pools as issuance reserves.

The authenticity of the issuance of reserve assets.

The rights, obligations and rights related to encrypted assets are clearly defined and enforceable in law, and the relevant legal framework guarantees the finality of settlement (Settlement Finality)

Encrypted assets must always guarantee complete transferability and settlement finality. Class 1b encrypted assets must guarantee full redemption.

Encrypted assets must be well documented. In terms of finality of settlement, the time when the transfer of key financial risks is completed and the time when the transaction is irrevocable should be specified. Type 1b encrypted assets must be clearly defined: the composition of the redeemer group, the obligations of the redeemer, the time frame of the redemption, the traditional assets obtained by redemption, and the method of determining the value of the redemption, etc.

Encrypted asset-related functions (including issuance, verification, redemption, transfer, etc.) and the network on which it depends (including distributed ledgers or similar technologies) can adequately mitigate and manage any major risks at the design and operation levels

The related functions of encrypted assets and the network on which they are based will not harm the transferability, finality of settlement, or redeemability of encrypted assets.

Entities performing functions related to encrypted assets must follow robust risk governance, control policies and practice standards to deal with related risks, including but not limited to: credit risk, market risk, liquidity risk; operational risk, including outsourcing, fraud, and cyber risk ; Data loss risk; various non-financial risks, including data integrity; operational flexibility; third-party agency risk management; anti-money laundering and anti-terrorist financing. The entities involved include issuers of encrypted assets, operators of transfer and settlement systems, managers of stability mechanisms, and custodians that issue reserve assets.

The network on which encrypted assets are based should ensure that all transactions and participants can be traced. Relevant influencing factors include: operating architecture, whether one or multiple entities perform core network functions; degree of openness, that is, whether there are restrictions on network access; the technical role of nodes and whether there is a division of labor; verification and consensus mechanisms.

Entities that perform the redemption, transfer, and settlement finality of encrypted assets must be subject to supervision

The entities involved include operators of transfer and settlement systems, managers of stabilization mechanisms, and custodians that issue reserve assets.

Judging from these requirements, the Basel Committee has established very strict standards for Type 1 crypto assets, which can be summarized as follows. First, Type 1a encrypted assets have the same legal rights as the corresponding traditional assets. This must be guaranteed by legislation, similar to the state’s amendment to allow the central bank’s digital currency to have the same legal status as banknotes. Second, the stabilization mechanism for type 1b encrypted assets should be rigorously designed to meet the “always effective” standard, including custody, investment and liquidity management strategies for issuing reserve assets, redeemer group composition, purchase and redemption mechanism, and arbitrage mechanism. The effectiveness of price convergence between encrypted assets and corresponding traditional assets is regularly subject to third-party audits and information disclosure. Third, if Type 1 encrypted assets adopt distributed ledger technology, it can only be a consortium chain with access restrictions, not a public chain without permission, and has strong concurrent processing capabilities, and cannot affect the finality of settlement due to forks. , And can also efficiently coordinate with the account system of the central securities registry or custodian institution. Fourth, issuers of type 1 encrypted assets, custodians and investment institutions that issue reserve assets, groups of redeemers, and verification nodes of distributed ledgers must follow sound risk governance and control policies and practice standards.

At present, there are few types of crypto assets that meet the requirements of Type 1a in the world. The closest thing to type 1b assets is various stable currencies. However, it is difficult for existing stable currencies to meet the requirements of Type 1b crypto assets.

Type 2 crypto assets

Almost all existing encrypted assets belong to two types of encrypted assets, mainly including:

Virtual assets issued on the public chain based entirely on algorithms without any asset reserves or credit support, including Bitcoin, Ethereum, etc.

Tokenized securities and stablecoins that do not meet the standard for class 1 encrypted assets.

New encrypted assets, such as DeFi, formed by the combination of “encrypted assets + smart contracts”.

NFT. Currently, most artwork NFTs are copyright-free reproductions.

Based on the principle of prudence, the Basel Committee defaults that all encrypted assets belong to Type 2 encrypted assets, unless banking financial institutions prove to regulators that an encrypted asset meets all the standards of Type 1 encrypted assets through analysis, risk management, and monitoring.

Basel Agreement’s treatment of crypto asset exposure

The Basel Agreement’s handling of crypto-asset exposure follows three principles. First, functional supervision, “same risk, same activity, same treatment”. If encrypted assets provide the same economic functions as traditional assets and cause the same risks, they should follow the same regulatory treatment. For the technology used in encrypted assets, the Basel Agreement adopts the principle of technology neutrality and will not explicitly encourage or inhibit the use of certain technologies. Second, penetratingly identify the risks of encrypted assets, using mainstream risk measurement, prevention and disposal methods, so as to incorporate encrypted assets into the regulatory framework of the Basel Agreement, instead of “starting from a new start.” Third, the Basel Agreement is the minimum regulatory standard for internationally active banks, and countries can implement stricter supervision according to their own conditions. In particular, if a country prohibits its own banking financial institutions from having crypto-asset exposure, it will be considered to comply with global prudential standards. This is the case in our country. Next, discuss the Basel Agreement’s treatment of crypto assets exposure according to the three pillars of the Basel Agreement and the classification of encrypted assets.

Minimum capital requirement

Type 1 encrypted assets will be judged according to the Basel framework whether they belong to a bank account book or a transaction account book, and whether the treatment of related exposures is subject to the standard method or the internal evaluation method. The Basel Committee believes that in view of the many new features of encrypted assets, the use of the internal rating method should be very cautious.

The credit risk and market risk capital requirements of Type 1 encrypted assets should not be lower than the corresponding traditional assets, but Type 1b encrypted assets also need to introduce additional capital requirements for the stability mechanism. There are many possible situations in this regard, which require specific analysis of specific issues. For example, if there is only one redeemer for a type 1b encrypted asset, and investors can only exchange the encrypted assets for the corresponding traditional assets through the redeemer, then the investor will bear the risk of default by the redeemer. In the measurement of credit risk capital, this is equivalent to the investor holding an unsecured loan to the redeemer. For another example, if the issuance reserve assets of a certain type 1b encrypted asset are held by an entity with bankruptcy isolation status, and the law protects investors’ right to claim the issuance reserve assets, then there is no need to introduce capital requirements for the redeemer’s credit risk . In addition, given the use of new technologies in Type 1 crypto assets, additional capital requirements for operational risks can be considered.

The Basel Committee believes that the 2 types of encrypted assets and the combination of 2 types of encrypted assets (such as Bitcoin ETF), equity investment and derivatives are high-risk assets, and a risk weight of 1250% should be used. With a capital adequacy ratio of 8%, this means that banking financial institutions must have sufficient capital to absorb the losses caused by the complete “zeroing” of the prices of the 2 types of encrypted assets.

The Basel Committee believes that there is no need to introduce new treatment methods for encrypted assets in the supervision of leverage ratios, large risk exposures and liquidity ratios, and the existing treatment methods can be used. Especially in the supervision of liquidity ratio, the Basel Committee believes that encrypted assets do not meet the Qualified High-Quality Liquid Assets (HQLA) standard; in the calculation of the liquidity coverage ratio (LCR), the 2 types of encrypted assets belonging to the asset-side project use 0% The expected cash inflow rate of the 2 types of encrypted assets belonging to the debt-side project uses 100% of the expected cash outflow rate; in the calculation of the net stable funding ratio (NSFR), the 2 types of encrypted assets belonging to the asset-side project use 100% of stable funds Demand factor, the 2 types of encrypted assets belonging to the debt-side project use a 0% available stable fund factor. In other words, in the calculation of the liquidity ratio, the 2 types of encrypted assets are considered to have no market liquidity or financing liquidity at all.

Regulatory review

If banking financial institutions have direct or indirect exposure to any type of encrypted assets, they should assess, manage and mitigate risks that have not been covered by the Basel framework under the assumption of going concern, including: first, and distributed Operational risks and network security risks related to the ledger, including the loss of secret keys, the destruction of login credentials, and distributed DoS attacks; second, the risks related to the underlying technology, including the stability of distributed ledger technology or similar technology networks, distributed The verification mechanism of the ledger, the availability of services, and the credibility and diversification of node operators; third, the risks related to money laundering and terrorist financing must follow the anti-money laundering financial action task force (FATF) proposed “Risk-based” approach.

Based on the information provided by the banking financial institutions, the supervisory authority shall review whether the policies and procedures of the banking financial institutions to identify and assess related risks are appropriate, and whether the assessment results are sufficient. If there are deficiencies, the supervisory authority has the right to require banking financial institutions to implement remedial measures, including stress testing, scenario analysis, provision, additional capital requirements, and regulatory restrictions or other mitigation measures.

If the regulatory agency believes that the credit risk and market risk capital requirements for Type 1 encrypted assets are insufficient to cover the relevant risks, they can increase the capital requirements, including: first, prohibit all banking financial institutions from using internal evaluation methods; second, in the standard law Longer liquidity periods are used in internal ratings and internal rating methods; third, under the framework of market risk, basis risk is measured for the difference between encrypted assets and corresponding traditional assets; fourth, the impact of some technical characteristics of encrypted assets When its solvency is used, the adjustment coefficient of the capital requirement is used.

Market discipline

In addition to complying with the information disclosure requirements of the third pillar, banking financial institutions should also disclose the following information on the exposure of encrypted assets: First, commercial activities related to encrypted assets and how such commercial activities affect the risk status of banking financial institutions ; Second, the risk management policy for the exposure of crypto assets; third, the scope and main content of the report related to crypto assets; fourth, the most significant risks related to crypto assets that are currently and emerging, and how to manage these risks.

Banking financial institutions should regularly disclose information related to the exposure of Type 1a, Type 1b and Type 2 encrypted assets, including: first, the size of direct and indirect exposure; second, capital requirements; third, accounting classification.

summary

The Basel Committee’s “Prudent Handling of Exposure to Crypto Assets” provides the broadest regulatory definition of crypto assets. In addition to the central bank’s digital currency, encrypted assets include not only virtual assets represented by Bitcoin, but also new existing forms of traditional assets under new technological conditions. The Basel Committee acquiesces that most crypto assets belong to Type 2 crypto assets. Bank financial institutions must meet the capital adequacy ratio and liquidity under the conservative assumption that crypto asset prices are completely “zeroed” and there is no market liquidity or financing liquidity. Ratios and other requirements. However, if a certain type of encrypted assets meets the requirements of type 1 encrypted assets, the capital requirements faced by banking financial institutions will be equal to or slightly higher than the corresponding traditional capital. On the one hand, it reflects the prudential attitude and conservative values ​​of the Basel Committee. On the other hand, it provides an incentive mechanism for the combination of cryptography, distributed ledgers or similar technologies and traditional assets—innovation as long as it meets the standards set by the Basel Committee. The capital requirements will be significantly reduced. In view of the fact that there are very few qualified Type 1 crypto assets on the market, this methodology of the Basel Committee will promote innovation to serve the goals of financial stability and financial consumer protection. In response to the new problems brought about by encrypted assets, the Basel Agreement has shown good openness and inclusiveness, and the methods and tools of risk identification, measurement, prevention, and disposal have shown good universality.

Banking financial institutions occupy a pivotal position in the financial system and will play multiple roles in the encrypted asset ecosystem. They may include issuers of type 1 encrypted assets, custodian institutions and investment management institutions that issue reserve assets, investors and investors of encrypted assets. Market makers, virtual asset service providers (VASP), and verification nodes for distributed ledgers, etc. Therefore, the Basel Committee’s “Prudent Handling of Exposures to Encrypted Assets” will have an all-round impact on the ecology of encrypted assets by restricting banking financial institutions and will affect the handling of encrypted assets by securities and insurance supervision.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/zou-chuanwei-interpretation-of-basel-agreements-classification-and-supervision-of-encrypted-assets/
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