EU Assigns Highest Risk Weighting for Crypto Assets Requiring 1:1 Backing

European lawmakers are making the bloc’s financial institutions pony up to play with cryptocurrencies.

This, as the European Parliament’s Economics and Monetary Affairs Committee on Tuesday (Jan. 24) voted in a cross-party compromise on imposing strict new requirements for banks conducting or enabling business dealings with crypto assets.

The requirements include a provision that bank holdings of unbacked crypto should be given the highest possible risk weighting, and recommends the volatile digital assets also be further limited as a proportion of a bank’s total issuance of core financial instruments.

The primary requirement being recommended is an interim treatment to apply a 1,250% risk weight to crypto assets until Dec. 31, 2024. The risk weight means financial institutions must hold enough capital in reserve to cover and guard against a complete loss of a crypto asset’s value in order to purchase and transact with it.

The higher an asset’s risk weight is, the more capital a banking organization must maintain in order to meet capital adequacy requirements — the number is determined by dividing the banking organization’s capital by its risk-weighted assets.

The provisions are tied to broader efforts to bring European Union (EU) rules into accordance with banking standards suggested by the Basel Committee on Banking Supervision, a group of regulators and central bankers from across the world and an international standard-setter for the industry.

The Basel Banking Committee’s 2022 proposal has already been approved by the Group of Central Bank Governors and Heads of Supervision (GHOS), with a successful vote taking place in December of last year.

Read more: European Commissioner: Crypto Rules Needed Worldwide

The Basel Committee’s “Prudential Treatment of Cryptoasset Exposures,” part of what is known as the Basel III global accord, suggests that banks need to treat crypto with caution. It recommends that exposure to certain cryptocurrency assets should not exceed 2%, and must generally be lower than 1% of Tier 1 capital — a core class of financial instrument widely considered to be a measure of an institution’s resilience.

“As a result of the classification conditions, cryptoassets must be designed to be redeemable for a predefined amount of a reference asset or assets, or cash equal to the value of the reference asset(s),” the Basel Committee’s document recommends, adding that, “In addition, the cryptoasset arrangement must include a sufficient pool of reserve assets to ensure the redemption claims of cryptoasset holders can be met and banks that banking book exposures to cryptoassets must analyze their specific structures and identify all risks that could result in a loss. Each credit risk must be separately capitalized by banks using the credit risk standards.”

The EU’s new requirements mirror this recommendation. Having been approved by the European Parliament, the measures will separately need to be negotiated with national finance ministers from the bloc’s member states who meet in the Council of the EU as part of a fuller, bundled package of upcoming bank capital reforms.

The requirements are viewed as preliminary measures meant to prompt banks to hold enough capital to cope with crypto market shocks without the need to dip into taxpayer funded national liquidity solutions and helping prevent instability in the crypto marketplace from spilling over into the traditional financial system.

The EU plans to publish a report in June of 2023 that details its findings over the next six months and proposes more extensive rules for banks operating in crypto to be implemented in 2025.

“Today’s agreement is an important step in finalizing the EU implementation of the international Basel III reforms,” Caroline Liesegang, head of Prudential Regulation for the Association for Financial Markets in Europe (AFME), a lobby group that represents traditional finance organizations such as investment banks, said in a public response to the news.

“More work is still needed on the crypto assets proposal to better define its scope to ensure tokenized securities are not captured,” she added, drawing attention to the fact that the scope of the requirements surrounding crypto may be too wide and apply as well to tokenized securities, not just cryptocurrency assets.

The Basel-recommended hard cap on banks’ exposure to crypto has already seen push back by a consortium of a dozen industry groups including the Global Financial Markets Association and Institute for International Finance, among others.

Together, the groups stated that as an impact of the requirements, “it may not be economically viable and rational [for banks] to make the investments necessary to facilitate clients’ needs on crypto asset-related activities. As a result, banks would be limited in their ability to respond to their customers’ demand for access to cryptoasset products and services. That outcome is not in the best interests of customers, investors or the financial system more broadly and likely would result in a shift of activity in this space to the nonbank sector,” which is less regulated, the public letter said.