Implementation of Basel Committee cryptoassets standard to provide additional clarity for banks looking to engage in cryptoassets business.

On 7 February 2024, the Hong Kong Monetary Authority (HKMA) released a consultation paper on its proposal for implementing new regulations on the prudential treatment of cryptoasset exposures (Consultation Paper).

The Consultation Paper comes shortly after the Financial Services and the Treasury Bureau and the HKMA issued a consultation paper in December 2023 outlining their legislative proposal for a regulatory regime governing stablecoin issuers in Hong Kong (see this Latham blog post). On 20 February 2024, the HKMA also published guidance on digital asset custody services and sale and distribution of tokenised products conducted by banks. Together, these papers offer guidance and greater certainty to banks interested in providing digital asset services (including digital asset issuance, custody, and dealing services).

This blog post summarises the proposed regulations set out in the Consultation Paper as well as next steps for banks, known in Hong Kong as authorised institutions (AI).

Background

The HKMA is a member of the Basel Committee on Banking Supervision (Basel Committee), and implements Basel Committee standards through local legislation.

In December 2022, the Basel Committee issued a new standard: Prudential treatment of cryptoasset exposures. The standard primarily sets capital requirements that apply to banks’ holdings of cryptoassets (including stablecoins, tokenised traditional assets, and other unbacked cryptoassets). The standard is scheduled to be implemented by member jurisdictions by 1 January 2025.

Subsequently, the Basel Committee published two consultative documents — Disclosure of cryptoasset exposures and Cryptoasset standard amendments — in October 2023 and December 2023, respectively.

The Consultation Paper outlines how the HKMA proposes to implement the Basel Committee’s standard into Hong Kong law, including through amendments to the banking capital, liquidity, disclosure and exposure limit rules, and its supervisory policy manual and other guidance.

Not all of the additional requirements proposed in the two consultative documents have been incorporated in this Consultation Paper. The HKMA intends to further update the local implementation proposal after the conclusion of the Basel Committee’s consultation process.

Scope of Application

Cryptoassets will be defined as private digital assets (i.e., digital representation of value, which can be used for payment or investment purposes or to access a good or service) that depend on cryptography and distributed ledger technologies (DLT) or similar technologies.

Dematerialised securities (securities that have been moved from physical certificates to electronic book-keeping) that are issued through DLT or similar technologies are considered to be within the scope of the prudential treatment and are referred to as “tokenised traditional assets”.

Conversely, dematerialised securities using electronic versions of traditional registers and databases that are centrally administered are not within scope. In addition, the prudential treatment of central bank digital currencies (CBDCs) is excluded from this new standard, which is consistent with the expectation that CBDCs will be treated in the same way as ordinary money.

Proposed Regulations for the Prudential Treatment of Cryptoasset Exposures

To determine the prudential treatment of a bank’s cryptoasset exposures, the relevant cryptoasset must be categorised. The two broad groups will be:

Group 1 cryptoassets are cryptoassets that meet all the classification conditions, consisting of:

• Group 1a: tokenised traditional assets (e.g., tokenised bonds, loans, and commodities)
• Group 1b: cryptoassets with effective stabilisation mechanism (e.g., stablecoins)

Group 2 cryptoassets are cryptoassets that fail to meet any of the classification conditions, consisting of:

• Group 2a: cryptoassets (including tokenised traditional assets, stablecoins, and unbacked cryptoassets) that pass the “Group 2a hedging recognition” criteria (hedging recognition criteria)
• Group 2b: all other cryptoassets (including tokenised traditional assets, stablecoins, and unbacked cryptoassets) that fail the hedging recognition criteria

To be classified as Group 1a or Group 1b, cryptoassets must meet on an ongoing basis all four classification conditions:

• Classification Condition 1: The cryptoasset is either: (i) a tokenised traditional asset; or (ii) has a stabilisation mechanism that is effective at all times in linking its value to a traditional asset or a pool of traditional assets (i.e., reference assets).
• Classification Condition 2: All rights, obligations, and interests arising from the cryptoasset arrangement are clearly defined and legally enforceable in all the jurisdictions where the asset is issued and redeemed. In addition, the applicable legal frameworks must ensure settlement finality in both primary and secondary markets. Banks are required to conduct a legal review of the cryptoasset arrangement to ensure this condition is met, and to make the review available to the HKMA upon request.
• Classification Condition 3: The functions of the cryptoasset and the network on which it operates, including the distributed ledger or similar technology on which it is based, are designed and operated to sufficiently mitigate and manage any material risks.
• Classification Condition 4: All entities that execute redemptions, transfers, storage, or settlement of the cryptoasset, or manage or invest reserve assets, must: (i) be regulated and supervised, or subject to appropriate risk management standards; and (ii) have in place and disclose a comprehensive governance framework.

If a cryptoasset fails to meet any of the classification conditions, then it will be necessary to assess whether it can pass the hedging recognition criteria, which considers matters around its related hedging instruments and applies thresholds for market capitalisation, liquidity, and trading data. The default position is that Group 2 cryptoassets belong to Group 2b unless the bank can demonstrate to the HKMA that all hedging recognition criteria are met.

As part of determining whether certain classification and other conditions are met, the bank may need to obtain a legal opinion around the arrangements.

Banks must fully document the information used in determining compliance with the classification conditions and make this available to the HKMA on request. In advance of any acquisition of a new type of cryptoassets, an AI must inform the HKMA of its classification assessment of the cryptoassets. In case the HKMA does not agree with the assessments undertaken by banks, the HKMA will have the power to override banks’ classification decisions.

Capital and Other Requirements for Cryptoassets

Briefly, Group 1 cryptoassets are subject to capital requirements based on the risk weights of the underlying exposures (i.e., the underlying, traditional assets) as set out in the existing Basel framework so implemented in Hong Kong. For example, a tokenised corporate bond held in the banking book will be subject to the same risk weight as the non-tokenised corporate bond held in the banking book.

As Group 2 cryptoassets pose additional and higher risks compared with Group 1 cryptoassets, they are subject to a newly prescribed conservative capital treatment with a risk weight of 1250%. However, for Group 2a cryptoassets, a limited degree of hedging (i.e., offsetting long and short positions) is permitted, with the capital charge applicable to the net position.

In addition to the conservative capital treatment for Group 2 cryptoassets, there will be an exposure limit that only applies to systemically important banks (SIBs) e.g., global systemically important banks (G-SIBs) and domestic systemically important banks (D-SIBs). This constrains the total amount of Group 2 cryptoassets such SIBs can hold to generally below 1% of Tier 1 capital, and they must not exceed 2% of their Tier 1 capital. If the 1% limit is breached, the SIB must notify the HKMA as soon as practicable and the breach must be rapidly rectified.

In addition to the capital requirements, there will be amendments to introduce more clarity on applying the risk treatment, liquidity, leverage, and large exposures requirements to banks’ cryptoasset exposures.

Banks that wish to engage in crypto-related business will need to implement suitable governance and risk management arrangements. In particular, banks will need to inform the HKMA of their policies and procedures, assessment results, and cryptoasset exposures or activities in a timely manner. They will also need to demonstrate that they have fully assessed the permissibility of such activities, the associated risks, and how they have mitigated such risks.

Next Steps

Comments to the proposal set out in the Consultation Paper should be submitted on or before 6 May 2024.

Banks that are interested in engaging in cryptoasset business should begin to assess their risk management policies, procedures, governance, human, and IT capacities to evaluate the risks of engaging in cryptoassets and how they can comply with the proposed standard.

As noted above, the HKMA intends to further update the local implementation proposal after the conclusion of the Basel Committee’s consultation process.

The HKMA plans to launch a preliminary consultation on the proposed amendments to the rules in the second half of 2024. Afterwards, it will launch a consultation on draft amendments to the rules, and industry consultation on draft revised banking return and completion instructions in Q1 2025. The finalisation, gazetting, and tabling of the revised rules with the Legislative Council for negative vetting is expected to take place in Q2 2025. The HKMA intends to put the new standard into effect no earlier than 1 July 2025.

Latham & Watkins will continue to analyse and report on the new developments to the proposed regulations for the prudential treatment of cryptoasset exposures in Hong Kong.