Commercial Bank Coins and Central Bank Digital Currencies Potential Prudential Treatments

Commercial Bank Coins and Central Bank Digital Currencies Potential Prudential Treatments | April 2019

A plethora of digital assets and instruments based on crypto and blockchain technology have emerged on the scene, including cryptocurrencies, utility coins, and security tokens.1 Launched by small startups and ventures over the past decade, these imperfect digital instruments and their underlying technology have showcased numerous potential improvements for the world of finance, more recently catalyzing large multinational financial institutions and central banks to investigate the issuance of their own new digital instruments, namely commercial bank coins and central bank digital currencies (CBDCs).2

The development and deployment of new commercial and central bank digital instruments raises many legal and regulatory questions as industry and regulators struggle to classify them under existing frameworks for commodities, securities, currency, and other traditional asset types. The IIF observes that the prudential treatment of such digital instruments is an emerging issue that warrants greater attention given the significant role these new asset types may play in the future economy. This note outlines some important policy issues that will need to be considered further.

Commercial Bank Coins3 Several commercial banks—including MUFG, J.P.Morgan, Banco Bradesco, Bank Busan, and Rizal Commercial Banking Corporation—are working on creating new digital assets such as “stablecoins,”4 to reduce counterparty and settlement risk, decrease capital requirements, enable instant value transfer, and improve overall efficiency. Before these benefits can be realized, however, there are some significant policy and regulatory issues to address, including the prudential treatments. It is acknowledged that these specific treatments will depend on the legal framework of the jurisdiction of the asset and the attributes of each specific instrument.

Scenario 1: Bank A holds a coin issued by Bank B Credit Risk: is the coin equivalent to senior debt issued by Bank B? Is it sub-ordinated? Is the coin actually reserved (“cash-backed”) by Bank B; if so, is that cash ring-fenced, or could the ability to reserve the coin in the future become susceptible to Bank B’s creditworthiness; would a haircut on the reserving be applicable? Market Risk: is the coin fixed against a national fiat? Could that vary at some stage in the future, and is a haircut applicable? Is the coin fungible as per the fiat that it’s pegged to, or could it be subject to illiquid demand?

1 For more detail on recent market developments, see our recent IIF report Crypto Course Correction, January 2019, https://www.iif.com/Publications/ID/3227/Crypto-Course-Correction. 2 The Basel Committee on Banking Supervision (BCBS) recently released Instructions for Basel III monitoring, which provides information on banks’ treatment of crypto assets under the credit risk, counterparty credit risk, market risk, and liquidity frameworks. Crypto assets in this BCBS context include assets secured by cryptography and that enable decentralized applications such as Bitcoin and Ethereum. Those assets are distinct from the scope of our research note, which centers specifically on proposed digital coins and currencies issued by commercial and central banks. 3 Terminology in the wider discourse is still evolving, and terms such as “coins” and “tokens” are sometimes used interchangeably and/or imprecisely, and with new labels continuing to proliferate. For the purpose of this paper, we have used the term “coins” throughout, and endeavored to apply a conceptual approach that may be valid in scenarios where a “token” does not carry direct monetary value but still generates a risk exposure for the holder. 4 “Stablecoins” are digital instruments that are generally pegged to an extrinsic stable asset, such as fiat currency or gold.

Bank Liquidity & Funding: are the coins considered equivalent to physical coins and banknotes under the Net Stable Funding Ratio (NSFR)?5 What level of High-Quality Liquid Assets (HQLA) might be required for these holdings? Context: to what extent do the above considerations vary depending on whether the coin is held for trading, for settlement operations, or as collateral for a guarantee (for example, in trade finance)? Variation: this scenario could be varied, to consider a case where there are multiple issuers – for instance where a coin is issued as a joint initiative of a consortium of Banks C, D & E, perhaps via a Special Purpose Vehicle (SPV). Some additional considerations might emerge, including: is the credit risk a reflection of each of the banks participating in the SPV? Is the coin reserved by cash held by the SPV (and where is that cash held)? Would it be possible for one of the SPV participants to sell their interest, and if so, could that be to a non-bank buyer? Would the presence of a non-bank entity in the SPV issuing consortium change the status of the coins?

Central Bank Digital Currencies Concurrently, the emergence of central bank digital currencies—a new variant of fiat money utilizing digital technologies and designs that may include crypto and/or blockchain solutions—is increasingly plausible, with growing interest from various governments and central banks. According to a recent study by the Bank for International Settlements (BIS), approximately 70% of central bank survey respondents are already—or at least intending to in the near future—exploring the potential implications and feasibility of introducing such currency into their respective economies.6 As outlined in our IIF paper Asymmetric Disintermediation in December 2018, the adoption of CBDCs would likely have a significant impact on the future of money and the financial system, including commercial bank balance sheets, financial intermediation, and monetary policy, depending on the specific design of each CBDC.7

Those same design considerations could also have a profound effect on the applicable prudential treatment, as outlined in Scenario 2.

Scenario 2: Bank A holds a coin (CBDC) issued by Central Bank X Credit Risk: is the CBDC equivalent to other liabilities issued by that central bank? Is it subject to the same Standardized or Advanced Internal Ratings-Based approaches that currently apply in Basel jurisdictions for sovereign exposures? Market Risk: is the CBDC fixed against Central Bank X’s “traditional” fiat currency, or is it floating as a parallel currency, with its own FX risk? Could that vary at some stage in the future, and would that potential affect the applicable treatment? Bank Liquidity & Funding: would the CBDC be considered as “coins and banknotes” or “claims on central banks with residual maturities of less than six months” for the purpose of the NSFR? Would holdings of the CBDC be eligible to be considered as HQLA, for the Liquidity Coverage Ratio (LCR)? Context: to what extent do the above considerations vary depending on whether the coin is held for trading, for settlement operations, or as collateral for a guarantee?

5 Under the Net Stable Funding Ratio, the Required Stable Funding factor (RSF) for "coins and banknotes” is 0%. 6 BIS, Proceeding with caution – a survey on central bank digital currency, January 2019, https://www.bis.org/publ/bppdf/bispap101.pdf. 7 IIF, Asymmetric Disintermediation: Digital Disruption and Bank Balance Sheets, December 2018, https://www.iif.com/Publications/ID/3198/Asymmetric-Disintermediation.

Next Steps The continued development of mainstream commercial and central bank digital assets will present important questions about their prudential treatment. With these instruments potentially becoming more sophisticated and widely-utilized in the coming years, there is an opportunity to provide greater clarity for all participants.

The questions described in the above scenarios are not exhaustive, and rather are merely indicative of the types of considerations that need to be examined. It is further stressed that these considerations are not unique issues for digital coins and currencies, and the emergence of these instruments does not necessarily need a whole new framework. Regulatory treatments should reflect the underlying risk profiles, and it may therefore be that we need new definitions and calculation methodologies that can support the existing framework – these are topics that the IIF will further explore with our members and the regulatory community.

Accordingly, the IIF plans to provide industry recommendations on design considerations and prudential treatments later in 2019.