Last week, the Bank for International Settlements (BIS), known as the Central Bank of the Central Banks, published a precedent-setting consultation paper on the treatment ofCryptographic currencies In banks. As part of this, for the first time, the super-regulator in banking regulated the bank’s perception of risk regarding the holding of cryptocurrencies.
Supporters of theBitcoin Interpret this as a historical recognition of cryptocurrencies, especially Bitcoin, in the banking system. This, from the perception that regulation, however stringent, is preferable to prohibition. To illustrate, with the publication of the consultation document, the price of bitcoin soared by 5%.
In our opinion, however, an in-depth analysis of the BIS requirements leads to the opposite conclusion: the BIS makes the holding of bitcoin manifestly unprofitable for banks, and even drops the ground under the aspiration that bitcoin and the like can be used as accepted currencies in the banking system.
Different types of coins
In essence, the BIS divides the cryptocurrencies into two groups.
The first includes currencies based on traditional assets, such as stocks, bonds, commodities and fiat currencies. It includes tokens (value units that represent a particular asset) and “stable coins”, which are fully backed by fiat currencies. BIS, the risk weight of the first group will be the same as that of the underlying assets on which it is based.
Under Basel III, the weight of an asset’s risk is derived from the risk attributed to its holding, and affects the amount of capital to be placed against it. The weights range from 0% to 1,250%. Cash, gold and AAA-rated government bonds are assigned a risk weight of 0%, which means that there is no need to hold capital against the exposure.
Therefore, tokens backed by these assets will be assigned a 0% risk weight. Central bank digital currencies will also be treated as regular Fiat currencies, ie zero risk weight.
To illustrate the treatment of risk-bearing assets, tokens on corporate bonds will be assigned the risk weight of the bond, depending on its credit rating.
But to her and a thorn in her side. The allocation of capital in accordance with the underlying asset will oblige the banks to ensure that the legal and commercial rights granted by the token are identical to those granted by the holding in the underlying asset. As for “stable currencies”, banks are required to ensure that the currency is backed by full reserves of the relevant traditional asset.
Therefore, banks that hold these currencies are likely to bear legal and operational costs and be required to establish strict controls. The price of a currency classification mistake can be high, such as raising capital requirements and regulatory sanctions, which will make the risk in investing unprofitable.
To illustrate the risk, we will mention the Tether currency, which, contrary to its definition as a “stable currency”, which is fully backed in dollars, has been revealed to not actually be charged. This allowed “hiding” losses and risks to holders amounting to hundreds of millions of dollars.
In addition, the BIS explains that because cryptocurrencies are based on rapidly evolving technologies, they have an increased potential for operational risks. Therefore, the BIS will require additional capital (add-on) beyond that to be allocated against the asset itself, at a rate to be settled later.
Farthest from currency
On the other hand, the BIS proposes to classify cryptocurrencies, such as Bitcoin andEtherium, As assets with the highest risk weight in banks – 1,250%. This is a particularly significant determination.
To understand how substantial this is, let’s compare other types of assets. Under the standard approach applied in Israel, in consumer credit the risk weight is 75%, in mortgages the average risk weights range from 35% to 60% (depending on the LTV ratio) and in corporate credit with an international investment rating between 20% and 100%, depending on the credit rating ( In Israel in practice almost always 100%).
Hence, based on a simplistic assumption of core capital requirements of 8% against risk assets, the volume of capital against a consumer credit portfolio is about 6%, for mortgages between 2.8% and 4.8% and against corporate credit between 1.6% and 8%.
For the world’s leading banks, which use advanced approaches and internal capital allocation models, the risk weights are lower, sometimes dramatically. For example, a mortgage portfolio may have a risk weight of less than 20%.
On the other hand, a risk weight of 1,250% is rare, and is attributed to highly leveraged investments, which expose investors to the full loss of investment. For example, holding an inferior and highly leveraged layer of securitization transaction.
A risk weight of 1,250% means that for every dollar held in a cryptocurrency, the bank will be required to hold a capital dollar. That is, 100% capital. In a simplistic comparison, this is a capital 25 times larger in relation to a mortgage portfolio, 16 times larger than a consumer credit portfolio, 12.5 times larger than a corporate credit portfolio and infinite in relation to cash.
Moreover, the message to banks is that in order to invest in Bitcoin, they must be willing to lose all their investment and absorb it in their regulatory capital. Given the sharp volatility in the price of bitcoin, which in the past year has doubled in value from $ 30,000 to $ 60,000, and returned almost all the way down, it is hard to argue with the rationale of the BIS.
Meanings for Banks and Bitcoin
In our opinion, as long as the BIS determinations remain the same in the final document that will be published, the likelihood that banks will hold cryptocurrencies is nil. The main reason for this is that banks do not measure their results by purely profitability, but on the basis of return on capital (RoE).
To illustrate, a cryptocurrency should yield a phenomenal annual return of 100% – so that its return on capital equals a solid mortgage portfolio that yields about 4%. Because of the tremendous volatility and risk in investing in Bitcoin and the like, the decision of bank captains to refrain from holding it is almost self-evident.
Moreover, the BIS determinations keep Bitcoin light years away from a currency revolution in the mirror of banks. This is due to the gap between the two ends of the scale – “traditional” Fiat coins with a risk weight of 0% – compared to 1,250% for cryptocurrencies.
In addition, while Fiat currencies have additional values in the eyes of banks, being a liquid asset counted for the purpose of the liquidity cushion required by banks under Basel III, volatile cryptocurrencies will not fall into this definition and will not give banks liquidity value.
Therefore, in our opinion, precisely in the week when al-Salvador became the first country in the world to recognize Bitcoin as a legal tender in its field – the BIS illustrated that for banks, Bitcoin is the farthest from a currency possible.
The entities in this column may invest in securities or instruments, including those mentioned in it. The aforesaid does not constitute investment advice or marketing, which takes into account the data and the special needs of each person