Regulating the Crypto Ecosystem: The Case of Unbacked Crypto Assets

After completing this reading, you should be able to:

• Define and describe crypto assets, including the categories broadly used by global financial regulators to classify them.
• Evaluate the key components within the crypto ecosystem, the potential risks generated by these components, and potential regulatory responses to address those risks.
• Identify and describe some of the global approaches to the regulation of unbacked crypto assets, including the BCBS’ proposed treatment of banks’ exposures to crypto assets.
• Examine the considerations and steps introduced by the Bali Fintech Agenda (BFA) for developing a regulatory framework for crypto assets.

Crypto Assets: Definition and Classification

Crypto assets represent a diverse set of digital assets that rely primarily on cryptography and distributed ledger technology (DLT). These assets have emerged as a prominent component in the financial sector, offering new opportunities and challenges in regulation and usage across global markets. Understanding the various types of crypto assets is essential for navigating this evolving landscape.

By definition, crypto assets are digital assets that utilize cryptographic principles for activities such as securing transactions and managing asset transfers on decentralized networks. These assets range from digital currencies intended to operate as a medium of exchange to tokens designed for specific blockchain applications.

Categories of Crypto Assets

Globally, financial regulators categorize crypto assets into four broad categories, each with distinct characteristics:

Unbacked Crypto Assets

These are digital currencies, often decentralized, such as Bitcoin and Ether. They are primarily used as speculative investments rather than for transactions and do not have any backing with physical or financial assets. They exhibit high volatility and are seen as poor stores of value.

Here are a few examples:

• Bitcoin (BTC) is the seminal unbacked crypto asset, primarily used as an investment rather than a currency for day-to-day transactions.
• Ethereum (ETH) not only serves as a store of value but also powers the Ethereum network where smart contracts operate.
• Litecoin (LTC) was created to offer faster transaction times than Bitcoin, positioning itself as a more practical payment option, though it too is largely speculative.

Unbacked assets are characterized by their decentralized nature, with no central authority controlling their issuance or supply. This feature, while promoting autonomy, also contributes to their volatility, making them less suitable for everyday use.

Utility Tokens

Utility tokens provide holders with access to a product or service, typically within a particular platform or network. Their primary function is to facilitate operations on a blockchain network, much like tokens used within online games.

Examples:

• Basic Attention Token (BAT) rewards users for engaging with advertisements in the Brave browser, fostering a privacy-centric advertising model.
• Golem (GNT) allows users to monetize their computing power by renting it out within the Golem network for computational tasks.
• Filecoin (FIL) tokenizes storage space, allowing users to earn by providing storage to others on its network.

These tokens are inherently tied to the performance and adoption of the underlying platform, aiming to incentivize usage rather than simply being a financial instrument.

Security Tokens

Security tokens represent an investment in assets such as company stocks or other significant assets. They might provide rights like dividends or profit shares, although their definition varies across jurisdictions. Often, existing securities regulations apply to these crypto assets.

Examples:

• Polymath (POLY) enables the creation of security tokens compliant with regulatory requirements, simplifying tokenized securities issuance.
• Harbor offers a platform for tokenizing real estate, allowing for fractional ownership and investment.
• tZERO focuses on tokenizing securities for trading, aiming to increase market efficiency and accessibility.

Security tokens must adhere to strict regulatory standards for disclosures, investor protection, and compliance, reflecting their nature as regulated investment vehicles.

Stablecoins

These assets aim to maintain a stable value by pegging to physical or financial assets, such as fiat currencies, commodities, or other crypto assets.

Examples:

• Tether (USDT) is one of the most widely used stablecoins, pegged to the US dollar, offering stability for trading and transactions.
• USD Coin (USDC) also maintains a dollar peg but emphasizes transparency with regular audits of its reserves.
• DAI is an algorithmic stablecoin managed by smart contracts on the Ethereum blockchain, using collateral to maintain its peg.

These coins provide the volatility reduction needed for practical, everyday use within the crypto ecosystem, blending traditional finance stability with blockchain. technology.

Regulatory Considerations

The classification of crypto assets has significant implications for regulation, investor behavior, and market functionality. It informs how regulators approach these assets, ensuring they can foster innovation while safeguarding consumers and market integrity. Legal clarity from proper categorization aids in compliance, reduces uncertainty, and helps in crafting regulations that do not stifle the burgeoning technology. Each category of crypto asset carries its own set of risks and benefits, necessitating nuanced regulatory frameworks to fully leverage their potential while maintaining financial system stability.

Crypto Ecosystem Components, Risks, and Regulatory Responses

The crypto ecosystem comprises a variety of components that perform essential functions, including issuance, exchange, storage, and validation of crypto assets. While these components encourage financial innovation, they also introduce significant risks that require regulatory attention.

Key Components of the Crypto Ecosystem

• Issuers: These entities create or “mint” crypto assets, often operating in a decentralized manner. This decentralization can pose challenges in regulation and accountability, as issuers are frequently anonymous, complicating the tracking of financial activities and the enforcement of legal standards.
• Crypto asset exchanges: Serving as platforms for buying, selling, and transferring digital assets, exchanges also provide related services such as wallet provisioning and potentially lending or leverage. They are central to the operational infrastructure of the crypto ecosystem but carry risks associated with cybersecurity threats and operational failures.
• Wallet providers: These offer secure storage for crypto assets and often facilitate transfers. However, they are prone to cyber risks, especially if private keys are compromised, exposing users to potential theft and loss of funds.
• Validators/miners: Critical for maintaining the blockchain by achieving consensus as a decentralized ledger. Their processes can lead to issues such as energy inefficiency and potential selfish mining attacks, impacting market integrity.
• Underlying technology (DLT): Distributed Ledger Technology underpins crypto assets, offering both opportunities and vulnerabilities, particularly regarding security risks like 51% attacks and technological failures.
• Regulated financial institutions: These may engage with or hold exposures to crypto assets, heightening risks linked to financial stability, especially in the presence of inadequate prudential oversight.

Potential Risks of Crypto Components

Financial Stability Risks

The crypto ecosystem’s growth introduces several risks to financial stability:

• Volatility: Crypto assets like Bitcoin can experience dramatic price swings; for instance, Bitcoin’s value dropped from nearly $65,000 in November 2021 to below $20,000 by June 2022. Such volatility can lead to significant losses for investors, potentially destabilizing markets if these losses are widespread.
• Speculative nature: The use of crypto assets for speculation rather than as a medium of exchange or store of value can create bubbles. The 2017 ICO (Initial Coin Offering) bubble, where many tokens were sold at overvalued prices with little to no underlying value, is a classic example where market correction led to a crash.
• Currency substitution: In countries with high inflation or currency devaluation, like Venezuela or Argentina, cryptocurrencies have been used as an alternative to the local currency. This dollarization via crypto can undermine the central bank’s control over monetary policy, potentially leading to economic instability if large swathes of the economy bypass the national currency.
• Emerging markets exposure: In places like Nigeria or El Salvador, where crypto adoption is high, a significant drop in crypto asset values could lead to a loss of wealth, which in turn might affect economic stability. El Salvador’s adoption of Bitcoin as legal tender in 2021 is an example where national policy directly tied the economy’s stability to the volatile crypto market.

Consumer Protection

The risks to consumers in the crypto space are multifaceted:

• Operational failures: The collapse of the crypto exchange Mt. Gox in 2014, where nearly 850,000 bitcoins were lost or stolen, illustrates how operational mismanagement or security breaches can lead to consumer losses with little to no recourse.
• Cyber attacks: Crypto wallets and exchanges are prime targets for hackers due to the irreversible nature of blockchain transactions. The 2016 DAO hack on the Ethereum network, where attackers drained about $50 million worth of ether, demonstrates how vulnerabilities in smart contracts can lead to significant consumer losses.
• Market manipulation: The lack of regulation can lead to schemes like pump-and-dump, where a group artificially inflates the price of a crypto asset, only to sell off their holdings at a peak, leaving others with losses. For instance, in 2017, several lesser-known cryptocurrencies experienced such schemes, leading to regulatory scrutiny.
• Lack of recourse: Unlike traditional financial products, if a crypto asset or platform fails, consumers often have no insurance or compensation mechanisms. The absence of regulatory protections means that if an exchange goes bankrupt, like QuadrigaCX in 2019, users might lose their investments without any legal recovery options.

Market Integrity

Maintaining market integrity in crypto markets is challenging due to:

• Opaqueness: Many crypto assets lack transparency, making it difficult to verify the true market volume or the backing of certain tokens. This opacity can hide manipulative practices.
• High leverage: Exchanges often offer high leverage for trading, sometimes up to 100x, which can exacerbate market swings. The use of such leverage was a significant factor in the 2022 crypto market downturn, where leveraged positions were liquidated, further driving down prices.
• Manipulative practices: Beyond pump-and-dump, insider trading can occur when developers or early investors sell tokens based on non-public information. The 2018 case of the Centra Tech ICO showed how founders could mislead investors with false claims about partnerships or product capabilities.

Regulatory Arbitrage

The decentralized and borderless nature of crypto assets enables:

• Jurisdictional hopping: Companies might set up in jurisdictions like the Cayman Islands or Malta, known for lighter crypto regulations, to avoid stricter oversight in countries like the U.S. or EU. This can lead to a “race to the bottom” where regulatory standards are undermined.
• Undermining global standards: Without coordinated regulation, entities can exploit differences in legal environments, leading to practices that might be illegal or unethical in one country but permissible in another. This was evident with the operation of certain stablecoins which moved to less regulated areas to bypass scrutiny on reserve transparency.

Cross-border enforcement challenges: Regulatory actions in one country might not affect operations elsewhere, as seen when China banned crypto transactions but trading continued through VPNs and offshore platforms.

Regulatory Responses

Monitoring and Data Collection

To effectively understand and mitigate the risks associated with crypto assets, regulatory bodies must develop consistent taxonomies that categorize these assets based on their function, risk, and legal nature. This categorization aids in the systematic collection of data, which is crucial for comprehending market dynamics, user behaviors, and systemic risk exposures. Without reliable data, it’s challenging to gauge the impact of crypto assets on financial stability or to tailor regulations appropriately. This involves not only gathering information on transaction volumes and market capitalization but also understanding the flow of funds, user demographics, and the operational models of crypto entities. Regulators might use tools like blockchain analytics to trace transactions or collaborate with industry players to ensure the data collected is accurate and comprehensive.

Legal and Regulatory Frameworks

• Enhancing legal powers: Regulators need to be equipped with clear legal mandates to supervise crypto-related activities. This includes the authority to enforce regulations not only within their jurisdiction but also to coordinate across borders for effective oversight. Without these powers, enforcing compliance becomes a patchwork, leaving significant regulatory gaps. For instance, a regulator might need the ability to subpoena information from overseas exchanges or to collaborate with foreign counterparts in case of cross-border fraud.
• Defining legal status: A pivotal aspect of regulation is determining the legal classification of crypto assets. Whether an asset is considered a security, commodity, or currency influences how it is regulated. This clarity helps in applying existing laws or crafting new ones to suit the unique nature of crypto assets. For example, if an asset is deemed a security, it would fall under securities law, requiring issuers to follow strict disclosure norms.
• Domestic and cross-border collaboration: The global nature of crypto assets necessitates strong collaboration between domestic and international regulatory bodies. This collaboration can take the form of memorandums of understanding, joint task forces, or participation in international regulatory forums like the Financial Stability Board (FSB). Such cooperation is essential for managing the risks of regulatory arbitrage and ensuring that regulatory measures are consistent across different jurisdictions.

Prudential and Conduct Regulation

• Licensing and authorization: Crypto service providers, especially those like exchanges and wallet services, should be subject to licensing requirements. This ensures they adhere to operational, security, and compliance standards that are necessary to protect consumers and maintain market integrity. Licensing might involve passing tests on operational resilience, cybersecurity measures, and AML/CTF compliance, similar to traditional financial institutions.
• Capital requirements: For entities that handle large transaction volumes or provide custody services, maintaining adequate capital is vital to absorb potential losses or operational risks. This might mean setting minimum capital thresholds or ensuring reserves are in place, akin to banking regulations, to prevent systemic issues in case of failure.
• Disclosure and transparency: Issuers and service providers should be mandated to provide clear, comprehensive information through mechanisms like white papers. This disclosure should cover the asset’s functionality, associated risks, governance structures, and operational details. Transparency here helps investors make informed decisions and reduces the chances of fraudulent schemes.

Consumer Protection Measures

• Education: Enhancing financial literacy specifically tailored to the complexities of crypto assets is essential. Regulators can collaborate with educational institutions or use public campaigns to inform consumers about the risks, benefits, and mechanics of crypto investments, aiming to reduce instances of fraud or misunderstanding.
• Security standards: Regulators should establish and enforce cybersecurity and operational resilience standards for crypto entities. This includes requirements for secure storage of assets, robust encryption, regular security audits, and incident response plans to protect against cyber threats and operational disruptions.
• Recourse mechanisms: Developing systems for dispute resolution and asset recovery is necessary when service providers fail or are compromised. This might involve setting up ombudsman services or ensuring that crypto assets held in custody are segregated from the company’s assets, providing a legal basis for asset recovery in bankruptcy scenarios.

Market Integrity Regulations

• Surveillance and enforcement: Crypto markets should be subject to rules preventing market abuse, similar to traditional securities markets. This involves platforms having mechanisms to detect and prevent manipulation, such as pump-and-dump schemes or insider trading. Regulators might need to extend their market surveillance capabilities or collaborate with exchanges to monitor trading activities.
• Conflict of interest: Where entities perform multiple roles, conflicts of interest can arise. Regulations should ensure that these entities have governance structures in place to manage conflicts transparently, perhaps through independent oversight or by requiring clear separation between different business functions within the same company.

Global Regulatory Approaches

• BCBS proposed treatment: The Basel Committee on Banking Supervision’s approach to crypto asset risk involves assigning high risk weights to unbacked crypto assets for banks, reflecting the volatility and potential for significant losses. This conservative treatment aims to ensure banks maintain adequate capital against these exposures, reducing the systemic risk they might pose.
• IOSCO recommendations: For crypto trading platforms, the International Organization of Securities Commissions (IOSCO) recommends adopting governance, transparency, and conflict of interest management practices. These guidelines seek to align crypto markets with the regulatory standards of traditional securities markets, ensuring investors receive similar protections against malpractice and market manipulation.

Global Approaches to Regulation of Unbacked Crypto Assets

Unbacked crypto assets, such as Bitcoin, are notorious for their inherent volatility and lack of underlying asset support. This category of digital assets poses unique regulatory challenges globally. To address the risks associated with unbacked crypto assets, diverse approaches are being taken by regulatory bodies worldwide to establish comprehensive frameworks.

Global Regulatory Approaches

• European Union (EU): The Markets in Crypto Assets (MiCA) regulation is part of the EU’s initiative to provide a unified framework that addresses the management, issuance, and exchange of crypto assets. It requires that all issuers and key service providers meet strict licensing, transparency, and capital requirements to protect consumers and ensure market integrity.
• Japan: Japan has revised its Payment Services Act to include comprehensive regulations on exchanges and wallet providers, ensuring thorough KYC (Know Your Customer) protocols and asset segregation. The regulations also impose caps on the leverage for retail customers to control speculative volatility.
• United Kingdom (UK): The UK’s Financial Conduct Authority (FCA) has clarified the regulatory position on crypto assets. While security tokens fall within the regulatory perimeter, unbacked crypto assets remain outside, but the FCA emphasizes strict advertising rules to protect consumers against misrepresentation and misuse.
• Switzerland: Swiss regulations distinguish between payment, utility, and asset tokens, providing guidelines that encompass financial market laws adjusted for digital assets. These include requirements for token issuers and provisions for the segregation of crypto assets in cases of custodian insolvency.
• Albania: Albania’s “Fintoken Act” of 2020 aims to regulate digital tokens and virtual currencies for investment purposes. This law provides a comprehensive regulatory framework that includes licensing, monitoring, and supervising entities involved in the distribution, trading, and custody of crypto assets.
• Nigeria: In 2018, it declared that crypto assets are not legal tender, reinforcing restrictions on crypto-related financial activities. In 2021, the CBN prohibited regulated institutions from dealing with and facilitating payments for crypto service providers, although the Securities and Exchange Commission (SEC) issued guidelines for digital assets by 2022 to clarify regulatory responsibilities.

BCBS Proposed Treatment for Banks’ Exposures to Crypto Assets

The Basel Committee on Banking Supervision (BCBS) has developed proposals to address the prudential treatment of banks’ exposures to crypto assets, aiming to manage the risks these assets pose to the banking sector. This initiative is driven by the rapid growth of crypto assets and their potential to impact financial stability. The primary goal is to create a regulatory framework that reflects the unique risk profiles of different types of crypto assets while ensuring banks maintain sufficient capital to absorb potential losses.

The BCBS has categorized crypto assets into two broad groups to tailor the regulatory treatment:

Group 1 Crypto assets: These are crypto assets with effective stabilization mechanisms or those that are tokenized traditional assets (like securities). They are further divided into:

• Group 1a: Tokenized assets that replicate the risk profile of traditional assets. These are subject to existing capital requirements based on the underlying asset’s risk.
• Group 1b: Stablecoins that meet specific criteria for stability, such as having a reliable stabilization mechanism and being backed by high-quality, liquid assets. These might receive a preferential treatment if they pass stringent conditions related to asset backing, redemption rights, and regulatory oversight.

Group 2 Crypto assets: These include unbacked crypto assets like Bitcoin, which do not meet the criteria for Group 1. They are characterized by higher volatility and less transparency regarding their backing, leading to a more conservative regulatory approach:

• Group 2a: Includes those crypto assets where some degree of hedging is permissible. However, the risk treatment remains conservative.
• Group 2b: Unbacked crypto assets without recognized hedging mechanisms, which are subject to the most stringent capital requirements.

Prudential Treatment

1. Capital Requirements

   For Group 1 assets: The capital treatment mirrors that of traditional assets. For tokenized assets (1a), banks are required to apply the standard risk weights as they would for non-tokenized versions of those assets. For stablecoins (1b), if they meet the BCBS criteria, they might qualify for lower risk weights, acknowledging their reduced risk profile due to stabilization mechanisms. However, if these criteria are not met, they fall into a higher risk category.

   For Group 2 assets: A very conservative approach is adopted:

   • Group 2a: Banks must apply a risk weight of 1,250% to the net exposure, effectively requiring them to hold capital that matches the exposure value, as these assets are seen as high-risk due to their volatility and lack of backing.
   • Group 2b: Similar to 2a, but with no recognition of hedging, thus maintaining the full 1,250% risk weight, which essentially means banks must hold capital equivalent to the exposure to cover potential losses.

2. Exposure Limits

   • The BCBS proposes that banks should limit their exposure to Group 2 crypto assets. This is to prevent banks from becoming overly exposed to these high-risk assets. The limit is suggested to be no more than 1% of the bank’s Tier 1 capital for aggregate exposures to Group 2 assets, with any excess treated under the even more stringent Group 2b capital requirements.

3. Infrastructure Risk Add-on

   For Group 1 crypto assets, an additional infrastructure risk add-on might be applied to account for the risks associated with new, untested technologies like blockchain. This add-on would increase the capital requirements to cover potential operational and technology-related risks.

4. Operational Considerations

   Banks are expected to undertake enhanced due diligence when engaging with crypto assets, particularly understanding the technology and legal risks involved. They must also have robust risk management frameworks to handle the unique aspects of crypto assets, including volatility, liquidity risks, and cybersecurity threats.

   Regulators will need to closely monitor banks’ crypto asset activities, possibly requiring more frequent reporting or stress testing to assess the impact of these assets on bank stability.

Challenges and Future Adjustments

Given the fast-paced innovation in blockchain and crypto assets, the BCBS framework might need periodic review to remain relevant as new types of crypto assets emerge or as the risk profiles of existing ones change. Ensuring that these regulations are uniformly adopted across different jurisdictions is challenging due to varying national approaches to crypto regulation. This can lead to regulatory arbitrage if not carefully managed. In addition, banks will need to adapt their systems, processes, and risk models to comply with these new standards, which could be resource-intensive, particularly for those with significant crypto exposures.

Regulatory Framework for Crypto Assets: The Bali Fintech Agenda

The Bali Fintech Agenda, developed by the IMF and World Bank, provides a comprehensive framework for policymakers to navigate the regulatory challenges posed by financial technology, including crypto assets. It consists of 12 policy elements aimed at harnessing fintech’s benefits while mitigating its risks. Here, we focus on how the BFA applies to the regulation of crypto assets, particularly unbacked ones.

Key Considerations from the Bali Fintech Agenda:

• Monitoring developments closely (BFA Element V): The crypto ecosystem is rapidly evolving, making continuous monitoring essential for understanding market trends, technological advancements, and emerging risks. Authorities are encouraged to engage in ongoing surveillance of the crypto market, employing tools like blockchain analytics, web scraping, and industry engagement to gather data. This includes tracking the size of the market, types of assets traded, and user behavior patterns to assess regulatory needs. The goal is to stay ahead of developments to ensure that regulatory frameworks can respond promptly to new challenges or opportunities.
• Adapting regulatory frameworks and supervisory practices (BFA Element VI): The dynamic nature of crypto assets necessitates a regulatory framework that can adapt to new risks and opportunities. This includes updating legal frameworks to include crypto assets or creating new regulations where necessary. Flexibility in regulation is key to managing the unique aspects of these assets. Authorities must work towards legal certainty, clarifying the legal status of crypto assets. This might involve amending existing laws or crafting new ones to address specific aspects like consumer protection, market integrity, and financial stability. Moreover, determining the regulatory scope is crucial, focusing initially on those crypto assets and activities that pose the greatest potential impact on financial stability or consumer protection.
• Developing robust financial and data infrastructure (BFA Element X): One of the significant hurdles in regulating crypto assets is the lack of reliable data. The BFA emphasizes the importance of improving data collection mechanisms to better understand and regulate crypto markets. Creating consistent taxonomies for categorizing crypto assets aids in this process, allowing for more uniform data gathering and regulatory application. Regulatory reporting must be mandated from crypto asset service providers, covering activities, user numbers, transaction volumes, and risk exposure. This step is vital for bridging data gaps, which in turn supports informed regulatory decisions and helps in monitoring systemic risks.

Steps Introduced by the Bali Fintech Agenda for Crypto Asset Regulation

• Assessment of risks

The BFA advocates for the continuous evaluation of risks posed by crypto assets, acknowledging that these risks can shift with technology, market conditions, or regulatory changes. Regulators need to look at both direct exposures, like market risk from holding crypto assets, and indirect exposures, such as through derivatives or lending activities linked to crypto. This ongoing risk assessment ensures that the regulatory response remains relevant and effective, adapting to the changing landscape of crypto assets.

• Determining regulatory priorities

Given the resource constraints many regulatory bodies face, they must prioritize their efforts based on perceived risk and impact. The BFA suggests focusing on areas where the crypto market might pose the highest risks to financial stability or consumer welfare. This might mean initially concentrating regulatory efforts on centralized entities like crypto exchanges or wallet providers that handle significant volumes or could potentially become systemically important. Such prioritization helps in allocating limited resources effectively to address the most pressing concerns.

• Scope of regulation

The BFA encourages regulators to decide whether to adopt an entity-based or activity-based regulatory approach. For unbacked crypto assets, the focus might initially be on entities performing key functions like exchanges and wallet services due to their central role in consumer interaction. This involves defining which crypto assets and related activities fall under regulation, ensuring that those with significant market influence or risk are appropriately covered.

• Enhancing domestic collaboration

Crypto assets cut across different sectors, necessitating collaboration among various regulatory bodies, including those overseeing financial services, technology, and law enforcement. The BFA emphasizes cross-sectoral coordination to ensure a cohesive approach to regulation. This could involve establishing formal agreements or creating collaborative task forces to address the multifaceted nature of risks associated with crypto assets. Effective domestic collaboration prevents regulatory gaps and ensures that all relevant aspects of crypto regulation are covered.

• International cooperation

Given the global nature of crypto assets, regulatory efforts must transcend national borders. The BFA suggests working towards regulatory harmonization to avoid arbitrage where entities might exploit regulatory differences across countries. This includes setting up mechanisms for sharing information on cross-border activities, enforcement actions, and consumer complaints. International cooperation is crucial for managing the risks that come with the borderless nature of crypto transactions, ensuring that regulatory actions in one jurisdiction do not inadvertently increase risks in another.

• Developing regulatory capacity

Regulating crypto assets requires a deep understanding of blockchain technology, the operations of crypto markets, and the associated risks. The BFA highlights the need for building or acquiring technical knowledge through training programs, hiring specialists, or engaging with industry experts. This capacity development ensures that regulators are equipped to understand and manage the complex and evolving nature of crypto assets effectively.

• Consumer and market protection

A key aspect of the BFA is to protect consumers and maintain market integrity. This involves enhancing public awareness about the risks and benefits of crypto assets through educational initiatives to prevent misinformation and reduce consumer harm. Additionally, implementing security standards, ensuring transparency in operations, and establishing procedures for consumer recourse are essential. These steps help in safeguarding consumers against potential fraud, manipulation, or operational failures within the crypto ecosystem.

Question

According to the BCBS proposed treatment, how are banks expected to treat exposures to Group 2b crypto assets (unbacked, without hedging)?

1. Apply standard risk weights based on the underlying asset.
2. Apply a 1,250% risk weight, requiring full capital coverage.
3. Apply a lower risk weight if the asset meets specific stability criteria.
4. Limit exposure to no more than 10% of Tier 1 capital.

Correct Answer: B

According to the Basel Committee on Banking Supervision (BCBS), Group 2b crypto assets are those that are unbacked and do not meet the eligibility criteria for hedging or stability. These assets are considered highly speculative and volatile. To account for their risk:

• A 1,250% risk weight is applied, which effectively requires banks to hold capital equal to the full value of the exposure. This treatment ensures that the bank has adequate capital to cover the entire potential loss associated with the crypto asset.

A is incorrect: This applies to Group 1a assets.

C is incorrect: This applies to certain Group 1b stablecoins.

D is incorrect: The limit is 1% not 10% and this is an exposure limit, not the risk weighting itself.