Basel cryptoasset rules are too obstructive
Justin
2025-03-29Eurosystem cash solution for DLT transactions: a start but not enough.
Hurdles to blockchain adoption in capital markets are falling away. The US’ abandonment of Staff Accounting Bulletin 121 was a key step and the Eurosystem’s advancing work on cash settlement solutions are welcome. However, there are still major stumbling blocks to be addressed.
The Eurosystem announced in February 2025 that it is expanding its work to create a solution for the cash leg settlement of distributed ledger technology transactions in central bank money.
This approach has two prongs: first, a rapid delivery of an interoperability link for the Target settlement system, to be followed by a ‘more integrated, long-term solution… [which] will also include international operations, such as foreign exchange settlement’.
The announcement follows the conclusion of the European Central Bank’s wholesale central bank money trials in 2024, where three national central banks collaborated with the private sector in a series of experiments. The three solutions tested were an interoperability link with Target Instant Payments System driven by Banca d’Italia, a trigger solution (a DLT infrastructure to bridge T2 and market DLT platforms) driven by Deutsche Bundesbank and a full DLT interoperability solution with tokenised central bank money pioneered by Banque de France.
It is not yet clear from the ECB’s announcement whether its long-term integrated solution will be the Bundesbank’s trigger solution or Banque de France’s full-DLT interoperability solution. But DLT accessibility to central bank money is coming.
Official endorsement of a DLT solution
For those working on the integration of DLT into capital markets, this is certainly good news. An officially endorsed solution for the cash leg settlement of DLT securities transactions on a delivery-versus-payment basis has been high on the industry’s wishlist for several years now. The ECB is to be commended for its efforts in advancing this issue and fostering the market’s development.
Perhaps a similar solution will emerge in the US. The drafting of Trump’s executive order (which inadvertently implied a ban on Fedwire, the US interbank payment system), suggests that the US may be happy to allow private sector solutions like stablecoins to fill the gap. The political momentum is certainly there and, given the Securities and Exchange Commission’s withdrawal of the much-criticised SAB 121, it clearly extends beyond the White House.
Despite this momentum, there remains at least one major obstacle to DLT adoption by market participants. The Basel Committee’s rules on prudential exposure to cryptoassets will hold back development in this space. These rules were created in 2022 and are set to come into force in January 2026.
Basel Committee rules
The rules begin fairly clearly. DLT-based assets are divided into four categories. Type 1a are traditional assets represented on blockchain that meet certain conditions (tokenised traditional assets). Type 1b are cryptoassets with effective stabilisation mechanisms that also meet certain conditions, for instance, reserve-backed stablecoins.
Then type 2a are cryptoassets that satisfy the hedging recognition criteria (primarily bitcoin and ether because of their formal futures markets). Type 2b are unhedgeable cryptoassets, for example, most other cryptocurrencies, including tokenised traditional assets, stablecoins and unbacked cryptoassets that aren’t included in the previous groups.
These conditions stipulate that, for inclusion in type 1, the tokenised asset must: represent the same credit risk as the traditional asset and provide the same ownership rights; the rights must be legally enforceable in the relevant jurisdictions; be transacted on a network where material risks are effectively mitigated; and be managed by regulated and supervised entities.
While type 1 assets can be treated the same way as their traditional off-chain counterparts, type 2b assets face an extremely punitive 1250% risk weighting, implying that banks must hold capital 1:1 against them. Holdings are also capped at 1% of the bank’s tier 1 capital. JP Morgan’s tier 1 capital as of September 2024 was $278.99bn, so it would be forced to keep its 2b cryptoasset holdings under $3bn.
This is not necessarily unreasonable on its face. Cryptoassets are volatile and banks can create systemic risk. Limiting their exposure to the market might be prudent.
Public and private networks
At present, however, the definition of type 1 assets is understood by industry participants to require that digital assets can only adhere to that category if they are issued on private ‘permissioned’ ledgers. The classification condition referring to the network’s risk management requires that ‘all participants are traceable’, which would seem to rule out a public network like Ethereum where anyone can be a validator and participate in the validation process of transactions.
This means that even high-quality instruments like bonds from the triple A-rated European Investment Bank, if issued on a public blockchain like Ethereum, will be treated as unhedgeable cryptocurrencies (type 2b), effectively making it impossible for banks to take such instruments on their balance sheets.
Even though the end investors will not be so limited, this would fundamentally alter the market’s dynamic, since banks are expected to hold some of a bond in their inventory, in order to make markets in it after issuance. Moreover, banks often engage in repurchase agreements in which they receive securities from their counterparties in exchange for cash, holding the securities as their own for the duration of the transaction.
This view does not appear to be universally held among regulators. The European Banking Authority’s CRR III Article 501d2a distinguishes tokenised traditional assets like blockchain bonds from cryptoassets for the purposes of capital requirements. This allows tokenised traditional assets to be treated as the assets they represent regardless of whether they are issued on a private or public blockchain.
And that is the right approach. Public blockchains offer specific advantages and features that can make them as reliable and secure as any private blockchain or traditional financial infrastructure.
Public blockchains favour accessibility and interoperability. Contrary to private blockchains and much like the internet, public blockchains are open and based on standardised protocols that facilitate the interaction between different systems, fostering accountability, innovation and competition.
Moreover, as no single party controls public networks, no one can willingly or accidentally tamper with its records or data. Public blockchains have, therefore, strong reliability and operational resiliency as they eliminate single points of failure or attack.
While these arrangements may not follow traditional accountability structures, public blockchains introduce new ways to achieve the safety and vitality that are expected from any financial infrastructure.
Developers, validators, nodes and asset issuers all have incentives to keep a check on each other and make sure that the network will work according to its programmatic protocol rules and that changes will be implemented only after proper vetting.
The decentralised nature of public blockchains is not, however, a limitation for having asset controls that issuers can apply according to their compliance needs and regulatory requirements, like know-your-customer/anti-money laundering checks or the possibility of clawing back or freezing tokens.
The Basel Committee’s rules on prudential exposure to cryptoassets are in urgent need of clarification, grounded in a thorough, reasonable and clear assessment of the true characteristics and risks of digital assets. Only then can we approach a logical system for the prudential treatment of blockchain-based assets.
Source: Lewis McLellan
