Category: Monetary and Financial Institutions

The Basle Committee consults on bank cryptoasset exposures

The Basel Committee on Banking Supervision (BCBS) yesterday (10 June 2021) released a consultative document setting out preliminary proposals for the prudential (i.e. capital adequacy) treatment of banks’ cryptoasset exposures. A report I read in the financial press suggested that Basel was applying tough capital requirements to all cryptoassets but when you look at the actual proposals that is not correct (credit to Matt Levine at Bloomberg for picking up on the detail).

The BCBS is actually proposing to split cryptoassets into two broad groups:

  • one which looks through the Crypto/DLT packaging and (largely) applies the existing Basel requirements to the underlying assets with some modifications; and
  • another (including Bitcoin) which is subject to the new conservative prudential treatment you may have read about.
The proposed prudential treatment is based around three general principles
  • Same risk, same activity, same treatment: While the the BCBS does see the “potential” for the growth of cryptoassets “to raise financial stability concerns and increase risks face by banks”, it is attempting to chart a path that is agnostic on the use of specific technologies related to cryptoassets while accounting for any additional risks arising from cryptoasset exposures relative to traditional assets.  
  • Simplicity: Given that cryptoassets are currently a relatively small asset class for banks, the BCBS proposes to start with a simple and cautious treatment that could, in principle, be revisited in the future depending on the evolution of cryptoassets. 
  • Minimum standards: Jurisdictions may apply additional and/or more conservative measures if they deem it desirable including outright prohibitions on their banks from having any exposures to cryptoassets. 
The key element of the proposals is a set of classification conditions used to identify the Group 1 Cryptoassets

In order to qualify for the “equivalent risk-based” capital requirements, a crypto asset must meet ALL of the conditions set out below:

  1. The crypto asset either is a tokenised traditional asset or has a stabilisation mechanism that is effective at all times in linking its value to an underlying traditional asset or a pool of traditional asset
  2. All rights obligations and interests arising from crypto asset arrangements that meet the condition above are clearly defined and legally enforceable in jurisdictions where the asset is issued and redeemed. In addition, the applicable legal framework(s) ensure(s) settlement finality.
  3. The functions of the crypotasset and the network on which it operates, including the distributed ledger or similar technology on which it is based, are designed and operated to sufficiently mitigate and manage any material risks.
  4. Entities that execute redemptions, transfers, or settlement finally of the crypto asset are regulated and supervised

Group 1 is further broken down to distinguish “tokenised traditional assets” (Group 1a) and “crypto assets with effective stabilisation mechanisms” (Group 1b). Capital requirements applied to Group 1a are “at least equivalent to those of traditional assets” while Group 1b will be subject to “new guidance of current rules” that is intended to “capture the risks relating to stabilisation mechanisms”. In both cases (Group 1a and 1b), the BCBS reserves the right to apply further “capital add-ons”.

Crypto assets that fail to meet ANY of the conditions above will be classified as Group 2 crypto assets and subject to 1250% risk weight applied to the maximum of long and short positions. Table 1 (page 3) in the BCBS document offers an overview of the new treatment.

Some in the crypto community may not care what the BCBS thinks or proposes given their vision is to create an alternate financial system as far away as possible from the conventional centralised financial system. It remains to be seen how that works out.

There are other paths that may seek to coexist and even co-operate with the traditional financial system. There is also of course the possibility that governments will seek to regulate any parts of the new financial system once they become large enough to impact the economy, consumers and/or investors.

I have no insights on how these scenarios play out but the stance being adopted by the BCBS is part of the puzzle. The fact that the BCBS are clearly staking out parts of the crypto world they want banks to avoid is unremarkable. What is interesting is the extent to which they are open to overlap and engagement with this latest front in the long history of financial innovation.

Very possible that I am missing something here so let me know what it is …

Tony – From the Outside

Joe Wiesenthal contrasts the differing visions represented by Bitcoin and Ethereum

Joe Weisenthal (Bloomberg) wrote an interesting opinion piece discussing the differing visions that Bitcoin and Ethereum offer for the future of finance and money. I am a self declared neophyte in the world of cryptocurrency and DeFi so it may be that the experts in those domains will find fault but I found his thesis interesting. The article is behind the Bloomberg paywall but this is what I took away from it.

  • He starts with the observation that, after a decade since its inception, we seem to have arrived at the consensus that Bitcoin is best thought of as something like a digital version of gold (or “digital gold”).
  • That was not necessarily the original intent and battles have been fought between different factions in the Bitcoin community over differing visions.
  • The most recent example being the “Blocksize War” that played out between 2015 and 2017 where an initiative to increase transaction capacity by expanding the size of each Bitcoin block was defeated by others in the community who saw this as a threat to the network decentralisation they believed to be fundamental to what Bitcoin is.
  • Weisenthal notes that other players in the Crypto/DeFi domain have a different vision – Ethereum is currently one of the dominant architects of this alternative vision (but not the only one).
  • The distinguishing feature of Ethereum in Weisenthal’s thesis is that, in addition to being a cryptocurrency, it is also a “token”
  • He argues that, whereas Bitcoin requires a fundamental act of faith in the integrity of Bitcoin’s vision of the future of money, token’s have a broader set of uses to which you can assign value.
  • Once you introduce tokens the focus shifts to what precisely do you intend to do with them – in Weisenthal’s words “… once you’re in the realm of tokens, you don’t need faith, but you still need a point“
  • He notes that we have already seen some dead ends play out – Initial Coin Offerings were a big thing for a while but not any more partly due to many of the projects not stacking up but also because many of them were just another form of IPO that were still unregistered (hence illegal) securities offerings in the eyes of the law.
  • We have also seen some developments like Non Fungible Tokens that are interesting from a social perspective but not necessarily going to shake the foundations of the status quo.
  • A third possibility is that DeFi starts to become a real force that starts to shake up the existing players in the conventional financial system.
  • This third option is the one that Weisenthal (and I) find most interesting but there is still a long way to go.

This is most definitely a topic where I am likely to be missing something but Weisenthal’s article offers an interesting discussion on the contrasting visions, assumptions and objectives of the two currently dominant tribes (Bitcoin and Ethereum). Most importantly it highlights the fact that the vision of DeFi being pursued by Ethereum (or alternatives such as Solana) is radically different to the vision of the future of money being pursued by Bitcoin.

Tony – From the Outside

My Adventures in CryptoLand – Net Interest

Marc Rubinstein lays out a detailed account of his initial explorations of decentralised finance. His professional background (like mine) is grounded in the conventional financial system so I found this very useful. Even better it is a short read with some hard numbers (time and cost) on the user experience.

My only quibble is that he calls these decentralised financial enties “banks”. Call me pedantic but none of the institutions discussed are banks and I think the distinction still matters if we want to understand how much of conventional banking will remain as this new chapter in financial innovation plays out.
Link to Marc’s blog here – www.netinterest.co/p/my-adventures-in-cryptoland

Tony – From the Outside

JP Koning’s “over consumptionist” theory of Bitcoin and decentralisation

Interesting post by JP Koning exploring the current debate about the value of Bitcoin and its energy demand.

There are two extreme theories about cryptocurrency energy consumption, both of them bitterly opposed to each other. The first I’ll call the big waste theory. Cryptocurrencies such as Bitcoin and Ethereum serve no useful purpose. Yet they are sucking up huge amounts of useful electricity. Let’s ban them.

The second theory is the vital cog theory. Cryptocurrencies are a useful bit of global financial infrastructure. And so the huge amounts of energy that they are consuming is beneficial. Let’s not impede them.

“The overconsumption theory of bitcoin (and decentralization in general)”, JP Koning, May 2021

Koning offers an alternative “overconsumptionist theory” – worth reading

Tony – From the Outside

Mortgage Mayhem – Net Interest

Marc Rubinstein has written another really interesting post on the economics of the American mortgage market which you can find here. The post is useful not only for his account of the mechanics of why the American mortgage market is prone to boom and bust but also for reminding us of some of the ways in which the American approach is very different from that employed in other markets. 

Lending to finance home ownership is an increasingly big part of most modern financial systems but the ways in which the process is done differ a lot more than you might think from casual inspection. I have previously flagged a post that Marc did on financing the American home. Read that in conjunction with a post I did on financing the Danish home. Marc also did an interesting post looking at the tension between competition and financial stability.

Tony – From the Outside

Tether offers a bit more detail on the composition of its reserves

… but Jemima Kelly at FT Alphaville remains a sceptic. I think the FT headline is a bit harsh (“Tether says its reserves are  backed by cash to the tune of . . .  2.9%”). Real banks don’t hold a lot of “cash” either but the securities they hold in their liquid asset portfolios will tend to be a lot better quality than the securities that Tether disclosed.

The role of real banks in the financial system may well be shrinking but the lesson I take from this FT opinion piece is that understanding the difference between these financial innovations and real banks remains a useful insight as we navigate the evolving new financial system.

Let me know what I am missing …

Tony – From the Outside

Explaining the value of Dogecoin

I don’t profess to be able to explain the value of Dogecoin but Matt Levine offers an interesting perspective curtesy of a research report published by Galaxy Digital Research. Apart from the left field explanation of what underpins Dogecoin’s value, the relatively short report (22 pages) offers a useful recap of the story of how this variation of digital money came to be.

Here is a short extract from the report

“When we set out to write this report, we expected to find what we’ve always known: Dogecoin is a joke, but it’s also a joke… not credible, resilient, or adopted. But as we reviewed the data, we found that, despite its deficiencies, Dogecoin has remarkably strong fundamentals and powerful forces supporting its rise: a genuine origin story, longevity, and a growing community of users who appear determined to meme a Shiba Inu-themed global currency into existence. We don’t expect Dogecoin to become the world’s most valuable cryptocurrency any time soon, but DOGE should not be ignored.”

“Dogecoin: The Most Honest Sh*tcoin” by Alex Thorn, Head of Firmwide Research and Karim Helmy, Research Associate, Galaxy Digital Research, 4 May 2021

Matt’s column has a link to the report itself which is worth a read if you are interested in Dogecoin in particular or the broader topic of digital money.

Tony – From the Outside

Central bank digital currency

Izabella Kaminska (FT Alphaville) offers another perspective on what the development of a Central Bank Digital Currency CBDC) by the People’s Bank of China means for China itself, the rest of the world and the USD in particular.

Her column is titled “Is the central bank panic about the PBOC coin justified?”. It is not clear that central banks are actually panicking at this stage (equally I am not sure that Isabella has 100% control over the titles her sub-editors apply to her articles). The article does however offer some balance to the narrative that sees China’s moves in this space forcing other central banks to follow suite.

I am yet to fully come to terms with the questions posed in her article but this (for me at least) is definitely an area to watch and seek to understand.

Izabella has been a reliable source of insight on this and the broader questions associated with the increased role of fintech in our payment systems. I can also recommend a column she wrote in July 2019 titled “Why dealing with fin techs is a bit like dealing with pirates”. A paper by Tobias Adrian and Tommaso Mancini-Griffoli titled “The Rise of Digital Money” is also worth reading if you are interested in this topic (one of my posts offers a short overview of the paper and a link to the original).

Tony – From the Outside

Andrew Haldane

Claire Jones writing for the Financial Times Alphaville column confesses a fondness for the speeches of Andrew Haldane (departing chief economist at the Bank of England) . She offered a selection of favourites (you can access her column by signing up to Alphaville if you are not an FT subscriber).

I also rate pretty much everything he writes as worth reading often more than once to reflect on the issues he raises. To her top three Haldane speeches, I will add one he did in 2016 titled “The Great Divide” which explored the gap between the way banks perceive themselves and how they are perceived by the community.

Tony – From the Outside