Banks Won’t ‘HODL’ Bitcoin

“Bank for International Settlements to Allow Banks to Hold 1% of Bitcoin Reserves,” cries the headline of an article about the BIS’s proposed new regulations for banks holding crypto assets.

The article was retweeted by Changpeng “CZ” Zhao, CEO of crypto exchange Binance, with the following comment: “Banks are now using bitcoin for reserves. Probably nothing. Crypto Twitter has gone crazy. Zhao’s comment was retweeted by thousands times and “liked” by more than 10,000 people.

If the BIS really intends to “reach out” to bitcoin by allowing banks to hold it as reserves, as the article claims, that would indeed be great news for bitcoin as a class of d. ‘assets, but maybe not for those who hope it would eliminate the banks. . But unfortunately, the BIS, which is an organization of the major central banks of the world, has no intention of doing such a thing. The article unfortunately ignores the proposals of the BIS. Far from reaching out to bitcoin, the BRI is cutting the rope.

CoinDesk columnist Frances Coppola is a freelance writer and speaker on banking, finance, and economics. His book “The case for popular quantitative easingexplains how modern money creation and quantitative easing work, and advocates “helicopter money” to help economies emerge from recession.

The BIS proposes that banks’ total exposure to all cryptocurrencies (not just bitcoin) and most stablecoins should not exceed 1% of their Tier 1 capital. But Tier 1 capital is not no reservations. And that’s a restriction, not a permission.

Bank reserves

Bank reserves are a type of electronic money issued by central banks and used by licensed banks to make payments. Solvent banks have more assets than they have deposits, but only a fraction of these assets are in the form of bank reserves. This is where the term “fractionally reserved” comes from. This does not mean that the bank’s balance sheet is not balanced. It refers to the fact that the business of commercial banks is to earn profits by exchanging borrowed liquid assets (deposits) for higher yielding illiquid assets (loans).

Since only a fraction of the bank’s assets can be used to settle deposit withdrawals, banks are always at risk of a bank run, i.e. when customers demand all of their deposits at once. . In a typical bank run, the bank sells its illiquid assets at a steep discount to obtain the reserves it needs to repay its customers. We call this a “fire sale”. Eventually, it runs out of assets to sell and is forced to close its doors.

To limit the likelihood of bank runs and distress sales, regulators require licensed banks to hold a certain proportion of their balance sheets in the form of liquid assets. Traditionally, in the United States, banks had to hold sufficient bank reserves to guarantee at least 10% of eligible deposits – this was known as the “reserve requirement”. But the Federal Reserve abolished the reserve requirement in March 2020. It was replaced by the BIS’s “Liquidity Coverage Ratio” (LCR), which requires banks to maintain enough high-quality liquid assets to meet all known and anticipated payment demands over a 30-year period. – daytime period.

High quality liquid assets

High-quality liquid assets include bank reserves and other assets that can be easily exchanged for bank reserves, such as US Treasury bills. Assets do not include cryptocurrencies. Nothing in the BIS proposal changes that. Banks don’t use bitcoin for reserves, and if the BIS proposal is passed by regulators, they never will.

But if Tier 1 capital isn’t reserves, what is? Well, it can be considered as a cushion that protects depositors from losses in case the bank fails.

When a bank fails, the total realizable value of its assets is usually less than the total value of its liabilities and equity. So not everyone will get their money back. Claims on the bank’s remaining assets are therefore settled in a strict order based on the rank of the claim.

Read more: CBDCs, not crypto, will be cornerstone of future monetary system, says BIS

Secured receivables (loan against which the bank has pledged) and all “super-senior” receivables are paid in priority. Next come depositors and senior bondholders, who are the bank’s unsecured creditors. Then, if there is anything left, the holders of junior (“subordinated”) debt are paid. At the bottom of the stack are the shareholders, who usually receive nothing.

It should be obvious that if depositors want their money back, there must be enough equity and junior debt to absorb the losses. This is called banking “capital”. Bank capital is divided into three categories: Common Equity Tier 1 (CET1) capital, which approximates equity; Additional Tier 1 capital (AT1), which is typically debt convertible into equity; and Tier 2 capital, which is a broader category of subordinated debt. CET1 capital is first in line for losses if a bank files for Chapter 11 bankruptcy, followed by AT1. Tier 2 is generally only affected if the bank goes into liquidation.

The capital ratios reported by banks are CET1, Tier 1 and total capital to total risk-weighted assets. The “leverage ratio” introduced after the 2008 financial crisis is the ratio between Tier 1 capital and total unweighted assets. Here, for example, is how JP Morgan & Chase released its Q1 capital and leverage ratios:

(The “Additional Leverage Ratio” (SLR) is a US-specific version of the BIS Tier 1 Leverage Ratio.)

Capital requirements

The BIS Tier 1 capital requirements specify that banks must have a minimum total capital of 8% of risk-weighted assets, of which 6% must be Tier 1. National regulators, however, generally have stricter requirements, especially for the biggest banks – the ones that are “too big to fail”. After all, no one wants the government to have to bail out the big banks again like they did in 2008. So in the example above, JP Morgan has much higher Tier 1 and Totals capital ratios. than the BIS minimum.

Now that we’ve clarified the difference between capital and Tier 1 reserves, let’s take another look at this BIS proposal for crypto assets. The BRI provides a handy chart showing how it divided crypto assets into two groups, each with two subgroups, and assigned different capital requirements to each group:

(Bank for International Settlements)

Group 1 consists of traditional tokenized assets and stablecoins that meet narrow stability and redeemability criteria. Group 2 is everything else. Group 2 is considered riskier than group 1 and is therefore subject to much stricter regulations.

All cryptocurrencies, including bitcoin, belong to group 2. The same goes for most stablecoins.

Bitcoin Limits

The 1% exposure limit only applies to Group 2 assets. This means that because Group 2 assets are extremely risky, banks will not be allowed to have much exposure to them. In the example above, JP Morgan has Tier 1 capital representing 13.7% of total risk-weighted assets. Thus, for JP Morgan, total group 2 crypto assets (including bitcoin) cannot exceed 0.137% of its total risk-weighted assets – and considerably less of its total non-risk-weighted assets. Granted, for a bank the size of JP Morgan, that’s still a lot of bitcoin. But it should be recalled that the previous version of the BIS proposals, published in June 2021, did not impose a limit on total exposure. So far from encouraging banks to hold bitcoin, the revised proposals actually make it more difficult.

In fact, the BIS proposals make it extremely expensive for banks to hold or trade bitcoin for their own account. Regulations for group 2a and 2b assets in the chart above require banks to write off bitcoin holdings entirely from capital. The BIS proposals for 2021 explain that the 1,250% risk weight for Group 2b assets is effectively a 100% capital charge: “An exposure of $100 would result in risk-weighted assets of $1,250, which when multiplied by the minimum capital requirement of 8% results in a minimum capital requirement of $100 (i.e. the same value as the original exposure, because 12 .5 is the reciprocal of 0.08).

Read more: 9 out of 10 central banks explore digital currency, says BIS

For group 2a assets, positions may be netted and the hedging effect taken into account before applying the capital requirement. But for group 2b, any hedging should be ignored and the capital requirement applied to the larger of the total gross long and short positions.

Simply put, this means banks cannot use customer deposits or issue senior bonds to fund the acquisition of bitcoin or any other cryptocurrency. They can only finance them with capital. This ensures that should the value of their crypto holdings drop to zero, none of their customers or creditors will be affected. But equity financing is considerably more expensive than debt financing – and shareholders might frown upon a bank taking such risks with their funds.

These regulations, if passed, will only apply to banks holding and trading private cryptocurrencies and stablecoins for their own account. They will not prevent banks from providing crypto custody and trading services to their customers. And they won’t stop banks from issuing their own tokenized assets and stablecoins. In fact, as these could meet the criteria for Group 1 assets, the proposals arguably encourage banks to do so.

A place for CBDCs

And the elephant in the room are central bank-issued crypto assets called central bank digital currencies (CBDCs), which are completely excluded from this framework. The BIS proposals do not allow banks to use bitcoin as part of reserves. But CBDCs could potentially expand or replace reservations. And because they would be issued by the central bank, the BIS’s draconian capital requirements would not apply to them. So not only do these proposals make holding bitcoin decidedly unattractive for banks, they set the stage for CBDCs to enter the crypto world.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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