Crypto - Q3 2022

List of topics covered:

• Keynote speeches from Burkhard Balz and Joachim Nagel discuss the continued development of Central Bank Digital currencies across the world, including the benefits and risks involved with their integration.
• The Basel Committee has published its second consultation paper on the prudential treatment of banks’ cryptoasset exposures.
• The UK Government has followed suit with its own publication on their progress towards determining an approach for cryptoassets and stablecoins.

In this article, we have summarised what these developments are, and what they might mean to regulated firms.

Keynote Speeches

Burkhard Balz, Member of the Executive Board of the Deutsche Bundesbank, delivered a keynote speech on: The landscape in 2030 - Central Bank Digital Currencies (CBDC) or private digital payment solutions

Mr Balz spoke at the Central Bank Payments Conference on 29 June 2022 where he touched upon three key topics:

1. High activity among central banks on CBDC

There is more activity than ever in this area and a great deal of progress has been made. Mr Balz notes that according to a survey undertaken by the Bank of International Settlements, more than two-thirds of central banks worldwide will possibly issue or are likely to issue retail CBDC in the short or medium terms.

The introduction of CBDC globally now seems to be a foregone conclusion. If they haven’t already done so, Banks around the world should be beginning to pay real attention to how this would work operationally and start sizing the impacts that it could have on their risk profile, and the market.

2. Good reasons to come up with CBDC

Mr. Balz reiterated the benefits that the introduction of a CBDC could bring, including:

• The decreasing use of cash: As the digital age continues to transform the Financial Sector the use of cash in our modern economies continues to decline. CBDC gives a digital solution that would retain the central banks’ ability to deliver traditional monetary policy without needing to print banknotes. The decline of cash should also, in theory, curb the size of secondary cash markets.
• The possible implementation of a pan-European payment solution removing national constraints on payment systems in the Eurozone: Despite the common currency, payment systems are subject to national regulations when cross border transactions occur in the Eurozone. Introduction of a CBDC would remove this red tape as transfers could be made without the need for credit transfers or direct debits. This can be expected to simplify the payment systems that operate today, and thereby reduce the costs associated with it.
• Mr Balz also discusses the potential for collaborations with the private sector. Although this will be a central bank currency, distribution would be required from private banks and services. This infrastructure needs to be built on top of the Digital Euro (or any CBDC for that matter).

The message here is clear; Mr Balz wants to move away from the exiting view that CBDC will replace the need for the private banking sector. Conversely, he believes the private sector will play a crucial role in the implementation and success of a CBDC.

3. CBDC: A new offering in often well-occupied markets

Firstly, it is worth noting that despite technological advances, CBDCs have many similarities to traditional cash. They are central bank money that will have legal status and therefore, CBDCs will be accepted effectively everywhere. There are also significant differences. A CBDC must be developed to be stored alongside commercial bank money, but distinguishable from such funds. The physical form of cash makes it easily distinguishable from bank money or payment cards, but moving this idea digitally is somewhat more problematic.

CBDC integration will therefore require cooperation between central banks and commercial banks as private payment solutions will need to accommodate this public method of payment.

Lael Brainard, Vice Chair of the Federal Reserve delivered a keynote speech: Crypto-assets and decentralised finance through a financial stability lens

Following another period of heightened volatility in crypto markets, Lael Brainard highlighted the need for responsible innovation. In her keynote speech, she discusses how the turbulence in the market reminds us of the need for regulation in the market to provide a foundation of financial resilience. We don’t need to cast our minds too far back to remember a time where underregulated and overly complex and misunderstood financial products caused the global financial meltdown. Although the size of the market for cryptoassets is far from insignificant, now is the time for central banks and regulators to act to ensure that they are not too late in introducing crypto regulation to safeguard financial stability and resilience. Crypto markets seem to be closely linked to global markets, and the downturn in markets has caused significant volatility. Bitcoin for example has dropped over 75% from its all-time high price, with similar or higher drops in most other cryptocurrencies. The stable coin Terra also crashed, triggering panic in the crytpo markets. This volatility has begun to stress platforms who are not immune to the impact of deleveraging, fire-sales and contagion effects that are seen in traditional markets. This has limited some customers ability to access funds and has raised some concerns over the liquidity of such platforms.

The global economic slowdown has been amplified in the crytpo space, where market volatility is nothing new. The size of the market and market participation has meant that this latest cycle of slowdown has caught more attention than ever from central banks and regulators looking to ensure financial stability. Regulators are working to implement regulation and inevitability this will come both in the UK and the EU, but the continued volatility in the market in the meantime is inevitable.

Some lessons from the Crypto Winter − speech by Sir Jon Cunliffe, Deputy Governor of the Bank of England for Financial Stability

Jon Cunliffe sets out lessons learned from the recent instability and losses in crypto markets – also called the ‘crypto winter’. He discusses how:

• Technology cannot remove all financial risks: Financial markets are inherently risky and cryptoassets with no intrinsic value only see this risk and volatility exacerbated. No matter the success of the underlying technologies, this risk will not be completely removed.
• Regulators should speed up their work: Despite the inherent risk, the lack of regulation leaves both customers and wider financial stability in a vulnerable state.
• Future regulation should be designed on the principle of ‘same risk, same regulation’: Regulation should be designed appropriately according to the riskiness of the sector. In the case of cryptoassets, the volatility and risks are clear; and therefore, regulation must be introduced to limit the impacts of this to the wider economy.
• Appropriate regulation will support innovation: Despite the need for strong and coherent regulation, it must be introduced to allow the innovation and technology advances that the crypto world has seen to continue.

Sir Cunliffe points to progress both on the international front (through the Basel Committee and the FSB), and also on the domestic front, through his role in the Bank of England, in introducing regulation to cryptoassets. Although the need for strong and robust regulation is clear, Sir Cunliffe reminds us that this should in no way limit the innovation and technological advances that the cryptoasset space has induced.

Joachim Nagel: President of the Deutsche Bundesbank Digital euro - opportunities and risks

Mr Nagel discuses two potential risks with cryptoassets:

• Bank run: In the event of economic instability, citizens would be able to convert their bank deposits to central bank money within seconds. This could lead to liquidity issues in extreme cases and remove funds from traditional banks.
• Structural disintermediation: The removal of funds from commercial banks removes a cheap and stable source of funding. This could limit the supply of banks credit and lead to knock on impacts into the real economy.

He also goes on to discuss two potential opportunities:

• Monetary and foreign exchange policy: The introduction of a CBDC would secure the future role of the traditional central bank in an increasingly digitalised world. This allows central banks to continue to deliver monetary policy as the future of money continues to evolve.
• Payment transactions: A digital Euro would support a Europe wide payment system based on European infrastructure, removing restraints that currently exist at cross-border level.

Progress with European regulations

Basel Committee publishes second consultation document on the prudential treatment of banks' cryptoasset exposures

In this second consultation, the BCBS builds on the proposals from their first consultation issued in June 2021; it broadly set out to define cryptoassets into two groups:

Group 1 cryptoassets: Those that meet the full set of “classification conditions”. Group 1 cryptoassets include tokenised traditional assets (Group 1a) and cryptoassets with effective stabilisation mechanisms (Group 1b), which would be subject to at least equivalent risk-based capital requirements based on the risk weights of underlying exposures as set out in the existing Basel capital framework.

Group 2 cryptoassets: Those that fail to meet any of the classification conditions. As a result, they pose additional and higher risks to the firm and the market in comparison with Group 1 cryptoassets and consequently would be subject to a newly prescribed conservative capital treatment.

This consultation begins to set out how prudential regulation and capital requirements could be implemented to ensure financial stability going forwards in light of this growing asset class.

The main topics covered as follows:

• Infrastructure risk add-on: The introduction of an add-on to risk-weighted assets (RWA) to cover infrastructure risk for all Group 1 cryptoassets.
• Recognition of hedging for certain Group 2 cryptoassets: Group 2 cryptoassets that meet a set of hedging recognition criteria may be subject to modified versions of the market risk requirements, which permit a limited degree of hedge recognition in the calculation of a bank’s net exposure.
• Removal of accounting classification link: The capital requirements that will apply to cryptoassets have been delinked from their classification as tangible or intangible assets under the accounting standards.
• Operational risk clarifications: The proposal relating to operational risk and resilience has been clarified to delineate more clearly between risks that would be covered by the operational risk framework, and those that should instead be captured in the credit and market risk frameworks.
• Detail on application of liquidity rules: Additional detail added to specify the application of the liquidity risk requirements, including the treatment of cryptoliabilities (i.e., bank issued cryptoassets).
• Group 2 exposure limit: Introduction of an exposure limit, which will initially limit a bank’s total exposures to Group 2 cryptoassets to 1% of their Tier 1 capital.

This consultation is another step in the direction of specialised prudential regulation for cryptoassets. As banks and other financial institutions begin to gain increasing exposure in this volatile market, strong and proper prudential regulation is an important step to ensuring financial stability. The PRA’s policymaking progress on this matter is however currently lagging behind their European peers. See below:

A deep dive into crypto financial risks: stablecoins, decentralised finance (DeFi) and climate transition risk

The ECB published this article highlighting the potential financial stability risks associated to crypto markets. Main points include:

• The growing size of the crypto-asset markets could begin to pose risks to financial stability and could reach a systemic threshold.
• The significant role that stablecoins would play within the stability of crypto markets and financial markets more widely. The cross-border nature of cryptocurrencies can also amplify these effects as volatility is not slowed by traditional economic borders.
• Appropriate regulations should be implemented before stablecoins growth poses systemic risks to financial stability. Stablecoins are now used as collateral in cryptoasset derivatives and as liquidity providers for DeFi. These interlinkages in the crypto markets can again exacerbate market volatility and cause it to quickly spread.
• The need for regulation of DeFi markets: As DeFi continues to grow as part of the expanding crypto space, it must be properly regulated. Increasing amounts of value are distributed in DeFi loans and other DeFi products and it remains an underregulated space. In the interest of customer safety and economic stability, it must be properly regulated as part of the wider crypto market.
• The consideration of cyrptoassets in relation to climate transition risks and the significant footprint. It is clear that most cyrptoassets do not correctly price-in their disproportionate energy consumption. Governments may need to intervene to align the market with wider ESG goals.

As with other central bodies, the ECB is signalling a clear intention to introduce regulation of cryptomarkets. The ECB also highlights that government intervention and regulation may look to address the climate impact of this market.

Progress with UK regulations

UK regulatory approach to cryptoassets and stablecoins; consultation and call for evidence

The government published the results of their consultation, seeking views on how the UK can build a regulatory framework that can harness the benefits of distributed ledger technology (DLT) while minimising any potential risks. DLT is the idea of splitting the ledger amongst many peers such that when a transaction is made from one peer to another, every peer on the network can see this transaction in the ledger. In this case every peer has access to an up to date and reliably correct ledger. This is the underlying technology from which blockchains are built.

Results can be summarised as follows:

• The Electronic Money Regulations 2011 and Payment Service Regulations 2017 provide a robust foundation for payment firms in the UK; however, these are not designed to explicitly cover stablecoins. The government considers the foundations sufficient such that amending the E-money regulations would provide a consistent regulatory framework.
• The government also intends to amend the Banking Act 2009 to include stablecoins. This would apply where risks could be potentials systemic and therefore Bank of England supervision is required.
• The government also sees it necessary to extend the scope of the Financial Services (Banking Reform) Act 2013 to ensure that stablecoin payment systems are subject to competition regulation by the Payment Systems Regulator (PSR).

Aside from regulatory changes, the government recognises the potential benefits of integrating DLT into the financial system such as new forms of payment, decentralised finance loans and tokenisation in financial markets. The government does accept that careful management of this integration is required to mitigate potential risks including anti-money laundering concerns and consumer education.

As we see cryptoassets playing an increasing role in our financial sector, we can expect future regulatory changes to carefully balance the financial stability considerations, alongside those around customer outcomes and wellbeing.