Opinion

Basel Committee Lags the Market in Digital Asset Regulation

Vlad Totia

The Basel Committee on Banking Supervision has announced it is to revert and revisit a set of rules on
capital adequacy requirements for cryptoassets held by banks that were viewed as punitive, resulting in
substantial pushback from a coalition of trade associations and a wide range of other market participants.
The controversial proposals were for banks to reserve capital to cover the value of cryptocurrency holdings
in full. This requirement would equate cryptocurrencies to the very riskiest assets, including those for which
banks lack the information to calculate exposures.
The coalition argued that this capital requirement would make it economically unviable for banks to
participate in this market, and put them at a competitive disadvantage while hindering progress towards a
digital future for the financial services industry.
The BIS has overshot in its attempt to create a legal framework for the market and push institutional
adoption and use of digital assets. While there clearly is an argument for the responsible management of
an inherently volatile asset by financial institutions, the strong market resistance shows that there is a lot
more appetite for innovation in the private sector.
The market is running ahead of regulators in this regard, but approaches vary between those banks that
are pushing ahead with digital asset engagement – potentially building competitive advantage but exposing
themselves to risk as regulation catches up – and those that are holding back pending regulatory clarity.
The longer it will take to have a functioning framework, the more difficult it will be for the ecosystem to
develop robust common standards. With the BIS scheduling its next consultation for next summer, banks
and other market participants are now facing the prospect of another year’s delay.
The Committee will now reassess its proposals and has stated: “Members reiterated the importance of
developing a conservative risk-based global minimum standard to mitigate prospective risks from
cryptoassets to the banking system, consistent with the general principles set out in the consultative
document. Accordingly, the Committee will further specify a proposed prudential treatment, with a view to
issuing a further consultative document by mid-2022.”

UK and US Take Differing Stances in Assessing the Financial Stability Risks of Cryptocurrencies

Recent statements by representatives of the Bank of England, the President’s Working Group on Financial Markets, and the Financial Stability Board (FSB) suggest that consensus on the potential of cryptocurrencies to put the stability of financial systems at risk is diverging, at least in emphasis.

In the US, the President’s Working Group on Financial Markets, together with the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, released a report in which it claims an urgent need to regulate stablecoins and the entities that issue them. The potential risks raised by the group include payment system disruption, concentration of economic power, and destabilising runs. This is the next in a series of attempts by the US to regulate systemically important parts of the digital asset industry, and this approach particularly highlights a focus on regulating the environment in which digital assets function, rather than regulating the assets themselves.

In contrast, in a speech at SIBOS, Bank of England deputy governor for financial stability Sir Jon Cunliffe stressed that, while the risks that cryptoassets pose to the financial system are now ‘relatively limited’, that assessment may change rapidly. This marks a shift in attention from addressing stablecoins as a first priority towards a broad-brush approach to the digital asset class as a whole. Cunliffe’s key point was that the USD 2.3 trillion market value of cryptocurrencies today may comprise a relatively small part of the total USD 250 trillion global financial system, but it could more than suffice to cause issues given the lesson of the USD 1.2 trillion sub-prime mortgage sector in 2008. Crypto technologies could offer ‘radical improvements in financial services’ but are already a concern. Cunliffe underlined the fact that policymakers around the world have only just begun to develop a framework appropriate for digital assets but they should pursue it ‘as a matter of urgency’.

Cunliffe’s comments were echoed by Bank of England Deputy Governor Sam Woods, Chief Executive Officer of the Prudential Regulation Authority, who stated a willingness to ‘front-run’ regulation – i.e. to lead global regulatory efforts rather than wait for a consensus to emerge – in order to prevent UK banks from accumulating over-large exposure to cryptoassets without supporting capital. Referring to recent Basel Committee proposals to apply a risk weighting of 1,250% in setting the capital backing for cryptocurrency holdings, translating into requiring capital at least equal in value to them and disregarding banks’ ability to hedge exposures. Woods said that UK rules may not exactly match the Basel Committee approach, but that they would be ‘very conservative’.

The announcement is another example of a change in attitude by an important public entity, as only 5 months ago BoE governor Andrew Bailey stated, ‘If consumers invest in these types of product [cryptocurrencies], they should be prepared to lose all their money.’

In marked contrast, the Financial Stability Board’s Patrick Armstrong presented a view at September’s Global Digital Finance Summit that cryptoassets – while on the radar and growing in value – are still too small to cause concern for global financial stability. His view is predicated on the asset class remaining relatively insignificant in proportion to total financial assets, real assets, and household wealth. The FSB acknowledges the risk that investor confidence in cryptoassets could be damaged through volatility, fraud, theft, or operational failures, but believes this is unlikely to affect overall stability. Use cases for cryptocurrencies remain niche, although monitoring is warranted due to a lack of the systemic safeguards built into fiat currencies and other assets.

Total Cryptocurrency Market Capitalisation Hits USD 2 Trillion Again

For the first time since May, the total market capitalisation of cryptocurrencies has rebounded above USD 2 trillion, according to some exchanges and data trackers like CoinGecko. This is reflective of the strong interest and the plethora of regulatory and technological progress that the ecosystem has seen for this past year. This ranges from the likes of J.P. Morgan allowing wealth clients access to crypto funds on demand, to Mastercard overhauling its crypto card programme, to Allianz implementing blockchain in order to streamline international motor insurance claims.

With this latest rise in value, total cryptocurrency market capitalisation now once again exceeds the market capitalisation of corporate titan Amazon – but it has reached this position in a third of the time it took for Amazon to grow from a bookseller to today’s technology giant. Blockchain is making strides towards becoming a mature industry and its use cases are starting to have an impact on the way traditional industries operate.

With the current rebound in market value, the health of the digital asset ecosystem as a whole also shows strong signs of improvement. Bitcoin dominance of the overall asset class fell from around 71% in January to a current level of 43.4%. This diversification of asset allocations within the cryptocurrency space shows that other projects are receiving funding, from both retail and institutional sources.

While total market capitalisation and price changes are relevant to traders and attract much attention, in the long term it is the success of specific projects that pushes blockchain technology forward. Around this time last year, Amazon’s valuation was roughly 15 times that of cryptocurrencies, however advancements such as the latest Ethereum hard fork or Cardano’s work on smart contracts continued apace. Ultimately, value will be driven by real transaction volumes and utility in preference to a speculative belief in future potential.

This rapid growth in value is both a sign of the exponential growth of technology and a guide to the future trajectory and value of crypto assets in general, as they move from today’s still relatively small and largely cryptocurrency-driven market to a future in which they underpin all financial instruments and services.

Bitcoin Adoption in El Salvador Raises Policy Questions for Cryptocurrencies

El Salvador has been everywhere in the news recently as the first country to adopt bitcoin as legal tender. This puts the cryptocurrency on par with the US dollar, which has held this status since the country abandoned its own currency, the colon, in 2001. The move marks the first time in history that a country has adopted a fully digital and decentralised currency for official national use. Salvadorans can now transact, take loans and pay tax with bitcoin, if they so choose. Slowly but surely, adoption of digital assets has moved on from something solely for retail users, or used in niche circumstances such as paying wages to sporting stars, towards the mainstream of public sector acceptance.

While the launch of the programme did not run perfectly smoothly, with the government’s official Chivo wallet experiencing a temporary blackout due to usage exceeding system capacity, the infrastructure is now in place for one of the most interesting economic experiments in recent history. With this adoption come many questions, particularly surrounding how central banks and other national and international financial institutions will deal with settling payments with the small Central American nation. Will the Central Reserve Bank (CRB) of El Salvador take bitcoin and exchange it for USD? Will it eventually issue its own central bank digital currency (CBDC)? Given the volatility of cryptocurrencies today, will the CRB take steps to hedge against massive price movements?

One solution that could offer more long-term stability to the national economy would be for the CRB to create a stablecoin – a token pegged to and backed by a reliable underlying asset – against its own reserve of bitcoin, and issue that same stablecoin for use as a form of payment. This solution would be similar to a CBDC, essentially a tokenised version of the national currency, but would give the government the possibility of amending the peg should circumstances such as major price swings require it to take action to protect its economy, giving it some degree of monetary control.

With many other potential challenges ahead for this first-of-its-kind experiment, it is clear that policymakers all over the world will pay close attention to how the Latin country goes about tackling them. El Salvador may be the first country to take this leap but, given the noises from several other nations, it may very well not be the last.

What Today’s ‘London’ Hard Fork Changes for the Ethereum Network

Ethereum is the second most used blockchain network in the world, second only to Bitcoin. Today marked a significant milestone in its development. The ‘London’ hard fork, as Thursday’s major upgrade is called, is part of a more extensive set of enhancements leading to Ethereum 2.0 that will effectively see the network undergo massive changes like changing from a Proof of Work model to Proof of Stake.

Arguably the most important aspect of the London hard fork is one of the five Ethereum Improvement Proposals (EIPs) that went live: EIP-1559. This protocol introduces transaction fee ‘burning’ to the Ethereum network. Before the update, each Ethereum transaction was accompanied by an additional sum in the form of a bid for miners to process it. This bid – known as the ‘gas’ fee – was made in small sub-units of the Ethereum network’s native cryptocurrency, ether, called gwei (1 gwei = 0.000000001 ether). The sender had to set a fee based on willingness to pay for space in the block of finalised transactions. Naturally, when the network is very busy, gas prices increase substantially due to competition for the miners’ processing services.

EIP-1559 changes this model completely by introducing a base fee (BASEFEE). This simply represents the minimum fee needed to be paid so that a transaction can be included in a block. The fee fluctuates depending on market congestion. The capacity of the network has been doubled, from a maximum of 12.5 million gas limit per block up to 25 million. There still remains the possibility to ’tip’ the miners to make a transaction more urgent, but this is optional. The base fee is destroyed or ‘burnt’ upon completion of the transaction.

The London hard fork changes a lot for Ethereum and for blockchain in general. Beyond the involved technical details of how the network is becoming more efficient and scalable, the world’s second most popular blockchain has undergone a massive upgrade to its core system without so much as a hiccup. Within the first 24 hours, 4,700 ETH was burned (c. USD 13 million). The vast majority of dApps (Decentralised Applications), most of the DeFi ecosystem, and many other payment systems and platforms are built on Ethereum. The fact that the network upgrade went by seamlessly is very encouraging for digital assets, as it proves yet again that the technology behind the hype is strong, tenable and increasingly mature.