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BIS Delivers Resounding Rejection to Bitcoin for Payments

Resounding Rejection
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EDITOR NOTE: The adoption of cryptocurrency presents us with a paradoxical dilemma: the aim of cryptocurrency is to create a “legitimate” and decentralized monetary system outside the world’s central banks; yet for any cryptocurrency to gain legitimacy, it must submit itself to the regulatory control and centralization of the very banking system it initially was designed to reject. So, there you have it. As of late, there has been a strong lobbying effort for bitcoin to be considered a financial asset, if not a “currency,” by GAAP standards. The Bank of International Settlements gave bitcoin a resounding rejection (NO!), which may, at least for now, have dealt bitcoin a fatal blow with regard to monetary legitimacy. Contrary to its initial impetus, bitcoin, as a currency, cannot stand on its own. But it does make for a highly volatile, and therefore potentially rewarding, “speculative asset.” But a currency, it is not, and financial companies like Square or SoFi will have to choose between remaining in the crypto world by continuing to offer it, or by going the route of more traditional and regulated assets. The BIS may have rejected bitcoin. But when it implements the Basel III accord in January 2023, the new currency and Tier 1 asset that’s going to be a gamechanger for the banking industry is, believe it or not, physical gold. You can’t compare the two, as one embodies intrinsic value while bitcoin’s value is a technological innovation (blockchain) whose applications can certainly be put to good use, just not in the realm of monetary and financial transactions.

June 14, 2021 | The global bank regulatory community delivered a resounding rejection of the world of bitcoin and other “untethered” crypto tokens last week. Tokens are “tethered” when they are tied to the value of a real currency. By applying the highest possible capital weighting to bitcoin, the Bank for International Settlements (BIS) essentially put crypto assets that are not fixed in value against a traditional currency into the financial bait bucket under Basle III/IV.

“When the only tool you know how to use is a hammer, everything looks like a nail,” remarked our friend Ed Kane, Professor of Finance at Boston College, upon hearing the news.

In the world of global bank capital requirements, 8% capital vs assets is the standard that is set equal to 100% risk weight. Capital risk weightings go from “zero” for most government debt exposures, to 20% risk weight for parastatal entities such as Fannie Mae and Freddie Mac, to 50% for secured loans on real estate, to 100% for typical unsecured corporate exposures. By assigning a 1,250% risk weight to crypto assets, the BIS is essentially saying “no thanks" to bitcoin.

The impact of this impending decision will be felt widely. First and foremost, new banks such as Square (NYSE:SQ) and SoFi Technology (NYSE:SOFI), both of which have acquired banking charters, must now decide whether to remain in the world of non-banks. To actually adopt a banking charter, as SQ has done, means leaving the world of crypto assets behind.

The rules applicable to the world of regulated banks do impact the world of non-banks, however. The tendency of corporate chieftains such as Elon Musk at Tesla (NYSE:TSLA) to “invest” liquid funds into bitcoin will likewise be tempered by the fact that banks effectively cannot take positions in tokens. Indeed, the concerted lobbying effort to see bitcoin considered an “asset” under GAAP may have been dealt a fatal blow.

The BIS decision exposes one of the central contradictions of bitcoin and other crypto assets, namely the tension between being a means of exchange for goods and services and a speculative commodity. The volatility of bitcoin and other speculative tokens renders these virtual collectibles too abstract for insured depository institutions. Edward Price, writing last week in The Financial Times, illustrates the point:

“Self-assured speculators, and early-adopters, like crypto because its value can increase. Those with the opposite temperament, those seeking a hedge, like crypto because it may keep its value if fiat explodes. Those who study crypto can only scratch their heads. Is it an asset or a currency? For commerce or for wealth? The question, however, misses the point. Money is always used as liquidity, savings and record-keeping. Crypto is no different. It’s just particularly rubbish at the first two and obsessive on the third.”

The BIS decision hopefully serves as a wake-up call for all of the happy bitcoin enthusiasts who actually believe that this penny arcade version of “money” could ever survive in a significant way in the government-centric world of money and banking. Since WWII, the obligations of governments in the OECD have occupied the pinnacle of risk assets, even when these government are traveling the road to perdition in terms of issuing public debt.

While some observers want to believe that the BIS designation carries with it come type of recognition for crypto, with friends like these bitcoin needs no enemies. Authoritarian regimes from China to India have made clear that bitcoin and other crypto tokens will not be tolerated besides "official" money. But in the rest of the world, the BIS rules make investing in bitcoin prohibitively expensive.

First, readers need to understand that when the BIS says 100% risk weight, that means putting up 8% capital vs a given asset. With bitcoin and other untethered cryptos, a 1,250% risk weight means putting up 100% real cash capital for the face value of the token.

If you as a bank own $100 worth of bitcoin, that means putting up $100 in capital. And the capital allocation changes with the value of the bitcoin, meaning more real capital if the value of bitcoin rises – the opposite of how, for example, margin requirements work for stocks. When the value of a stock rises, the customers buying power increases.

With bitcoin owned by banks, however, the situation is the opposite. As the value rises, the bank must increase the capital allocation to the asset. What the BIS exposure draft means is that banks will never take principal positions in or lend against bitcoin. The BIS treatment of equity exposures to banks is instructive as shown below.

Zero percent risk weight: An equity exposure to a sovereign, Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund, a multilateral development bank (MDB), and any other entity whose credit exposures receive a zero percent risk weight under regulatory capital rules.

20 percent risk weight (1.5% capital): An equity exposure to a public sector entity, Federal Home Loan Bank, Fannie Mae, Freddie Mac and the Federal Agricultural Mortgage Corporation (Farmer Mac).

100 percent risk weight (8% capital): Equity exposures to:

  • Certain qualified community development investments,

  • The effective portion of hedge pairs, and

  • Non-significant equity exposures, to the extent that the aggregate carrying value of the exposures does not exceed 10 percent of total capital.

250 percent risk weight (20% capital): Significant investments in the capital of unconsolidated financial institutions in the form of common stock that are not deducted from capital.

300 percent risk weight (24% capital): Publicly traded equity exposures.

400 percent risk weight (32% capital): Equity exposures that are not publicly traded.

600 percent risk weight (48% capital): An equity exposure to an investment firm, provided that the investment firm would (1) meet the definition of traditional securitization in the regulatory capital rules were it not for the application of the definition and (2) has greater than immaterial leverage.

In response to news that tiny El Salvador has made bitcoin legal tender, an official at the BIS and former member of the executive board of the European Central Bank (ECB), Benoit Coeure, insists that bitcoin has not passed the test of being "a means of payment."

Coeure notes: "We have been clear at the BIS that we don’t see bitcoin as having passed the test of being a means of payments. Bitcoin is a speculative asset and should be regulated as such."

In order to qualify for 1,250% risk weighting (100% capital), bitcoin and other untethered crypto tokens occupy the riskiest corner of the financial world. Indeed, as one banker told the FT, by assigning such a punitive risk weight to these tokens, the BIS is essentially saying to the banking industry that bitcoin is not a permitted asset for banks.

Of course, as the Federal Reserve, ECB and other G-20 central banks develop their own electronic currencies, you can be very sure that these officially blessed tokens will have zero risk weights. Soon the world of crypto tokens will again be an exclusive playground for criminals, terrorists and money launderers as legitimate users of electronic payments migrate to stable value tokens. Adios bitcoin!

Original post from The Institutional Risk Analyst

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All articles are provided as a third party analysis and do not necessarily reflect the explicit views of GSI Exchange and should not be construed as financial advice.

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