Vital movement, but they’re too low for Bitcoin

The BIS recently proposed Basel III capital requirements for banks with cryptoassets on their balance sheets. The proposal treats stablecoins with caution, rightly suggesting that they can more or less fit into the existing Basel framework. But the BIS has offered the treatment of what it calls Group 2 cryptoassets – cryptocurrencies that have no issuer, like bitcoin – completely misses the biggest risk: the risk of regulation for banks managing bitcoin. Traditional banks are simply not operationally or technologically configured to hold assets on the balance sheet, such as bitcoin, which settle irreversibly within minutes.

Bitcoin has no operational fault tolerance.

This is one of the reasons why bitcoin does not integrate well into existing banking systems, where recoveries, transaction reversibility, and operational fault tolerance are common. In addition, most banks still only reconcile their accounts with central banks or correspondent banks once a day or a few times a day.

It’s not hard to imagine a scenario in which this is a problem for a bank that trades bitcoin. Due to a quick settlement, the bank could build up disproportionate bitcoin exposure and not even find out until it reconciles overnight. Additionally, Group 2 cryptoassets have none of the mechanisms built into traditional financial markets to alleviate settlement issues – not the discount window, permitted delivery defaults, collateral substitution in securities financing. or ETF market makers allowed to create uncovered short positions, among a myriad of examples. tolerance to operational failures in traditional markets.

Additionally, the structural features that protect against settlement risks in traditional finance do not apply to Bitcoin. Central institutions can serve as lenders of last resort or as clearing houses for banks to resist temporary settlement defaults, such as the Fed (dollars); DTCC (securities); ICE, CME and LCH (derivatives); and LBMA member banks (gold). And for these assets, the banking system as a whole controls almost all of the underlying collateral.

But the banking system will never control most bitcoins, ethers, or other Group 2 cryptoassets. Why? Because individuals own the vast majority, and it is eliminated (or lost) and rarely traded, if at all. Only an estimate 22% of the bitcoin supply is floating. During bull markets, this percentage can drop to 12%. Guarantees are always rare and failure to deliver them on time is a fault.

To be clear, none of this is a Bitcoin problem. I have been a Bitcoiner since 2012 and welcome new entrants to the growing network. But I’m also a Wall Street veteran who started three new ventures at big banks – and, as a longtime ‘plumber’ of crypto and legacy systems, I see the Basel III framework neglecting a clear disconnect between traditional financial markets and crypto-assets. .

Fortunately, there is a safe and healthy way to integrate bitcoin and other Group 2 crypto assets into banking systems:

  • Carry out all bitcoin activity in a ring-fenced bank that is either stand-alone or a branch away from the failure of a traditional bank (leveraged).
  • Do not use any leverage in the bank. No remortgage. Mortgage is acceptable, but the bank should not allow leverage greater than 1: 1. Keep in mind that Bitcoin does not have a lender of last resort or a clearinghouse.
  • Do not take any credit or interest rate risk within the bank. Hold 100% of cash reserves, treasury bills or similar high quality short-term liquid assets. The bank makes money on fees, which crypto fintechs have been doing for years due to the high volume of transactions.
  • Pre-finance transactions, so that the bank settles second or simultaneously instead of settling first and thus avoids the “back door” leverage caused by a counterparty that does not deliver.
  • Do not allow any collateral substitution or mixing in the prime brokerage.
  • Design IT and operational processes for fast, irreversible resolution, with minute-by-minute risk monitoring and reconciliation processes.

A bank structured according to these guidelines should present minimal risk to the payment system, regardless of bitcoin price volatility, as the bank is designed to withstand a bank panic. But it’s not just theoretical. A regulatory banking regime that meets the above requirements already exists, and it sits in an unlikely place: Wyoming.

It didn’t happen by accident. Wyoming got to work. First, Wyoming built the Trade Law foundation before adopting its charter of the ad hoc depository institution for cryptoassets in 2019. Then he led a rule-making process that has already gone through two public comment periods. For his rule-making for crypto-assets, Wyoming had extensive access to people on the information frontier of crypto assets – including Bitcoin Core developers, CTOs, specialist lawyers, and a consumer advocate. Next, Wyoming hired Promontory to help write a 750-page supervisory exam manual for bank supervisors. He then trained his examiners and has now started training judges in his courts.

The result is a regulatory regime that is much stricter for banks than the requirements proposed by the BIS, and that prioritizes settlement risks that the BIS proposal missed. The perception has always been that states are leading a “race to the bottom” in banking regulation, but in this case the opposite is true: Wyoming’s laws are stricter and they rightly focus on locking in the risk associated with the payment system resulting from disparities in speed of settlement and finality.

Outside of Wyoming, Texas, Nebraska and Arkansas are the only states in the United States to have clarified the commercial law status of crypto-assets – something that the BRI proposal Rightly considers a prerequisite before banks can hold cryptoassets on their balance sheets. Of course, banks must have clear legal title to the assets they own. Currently, this is only possible in four US states.

To be clear, banks can and should provide custodial services for Group 2 cryptoassets, just as they do for securities. But the BIS capital rules would allow banks to go much further than that, to hold bitcoins on the balance sheet, thus taking on the main risk (i.e. proprietary trading). Ironically, none of the states that have allowed crypto-asset banking (Wyoming, Texas, and Nebraska) go as far as the BIS proposal.

The information frontier for Bitcoin is not on Wall Street. It’s not in Silicon Valley either. This is where the developers of Bitcoin Core and the “whales” (the big owners of bitcoin) are located. They came to Wyoming in 2019 to help design a safe and healthy way to plug Bitcoin into the mainstream financial system, and they were super focused on settlement. I hope the BIS will incorporate their findings. Traditional banks have leverage, and the leverage magnifies mistakes. Getting it wrong could prove bad not only for the creditworthiness of the banking system over time, but also for the bitcoin markets by adding to the already high volatility in bitcoin prices.

About William G.

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