ISDA Paper Calls for Re-Think on Bank Crypto Capital Rules

With global authorities increasingly assertive in their warnings over the potential financial stability threat from the merging of crypto-asset and fiat markets, a paper from the International Swaps & Derivatives Association (ISDA) seeks to reinforce industry arguments that proposed capital rules for banks holding crypto-assets are overly stringent, by highlighting the benefits of hedging using derivatives.

Noting that the Basel Committee on Banking Supervision has made “particularly punitive” proposals over the capital treatment of banks’ crypto-asset exposures, ISDA says it believes an appropriate, risk-sensitive framework for these assets is essential as it would enable banks to offer customer services in this growing asset class.

The Basel proposal involved the grouping of crypto-assets into one “Group 2” bucket, however responses to its consultation argued that they should be divided into two sub-classes, including a new “Group 2a” for assets for which there is a “liquid two-way market”. The paper cites these as being Bitcoin cash, Bitcoin, Ether; whereas Group 2b includes Litecoin, BAT, Neo, XRP, and Dogecoin.

In the paper, ISDA argues that hedging these assets with their respective futures or ETFs is effective, therefore the capital treatment should allow for offsetting a given Group 2a crypto asset with its futures or ETFs. The paper also argues that the basis risk profile of Group 2a crypto-asset futures is comparable with that of existing financial assets.

The paper analyses the correlation between spot and futures markets and assesses the hedge effectiveness of the using futures and ETFs. It finds correlation between Group 2a spot (Bitcoin and Ethereum) and their futures is “sufficiently high to support effective hedging”.

It adds that the basis between spot Bitcoin and Ethereum and their respective futures has historically been relatively muted, which would also enable effective hedging, being within the same magnitude as the basis between large equity indices and their futures.

The paper further says that analysis using the hedge accounting quantitative test under International Accounting Standard 39 (IAS 39) demonstrates that hedging Group 2a spot using their futures and ETFs is “highly effective”. The IAS 39 hedge accounting quantitative test was used to assess the hedge effectiveness of Bitcoin and Ethereum and their respective futures and ETFs. The result showed an effective hedging relationship between spot Bitcoin and Ethereum and their respective futures and ETFs. “This supports the industry position that offsetting a Group 2a spot crypto asset against its futures or ETFs should be allowed,” ISDA argues. “These findings show an opportunity to establish a crypto-asset hedging framework by using the strong hedging relationship and relatively small basis between Group 2a crypto assets and their futures and ETFs.”