There has been a rapid increase in the number and types of crypto assets in recent years with the estimated market capitalization hitting all-time highs while attracting both institutional and retail investors. Although the relative exposure of banks, insurers, trust companies and other financial institutions to crypto assets is not high at this time, the size of the crypto asset market itself and the risks tied to market volatility justify further review. Recognizing this trend, regulators around the globe are analyzing the risks associated with crypto assets, which include liquidity risk, credit risk and Know-Your-Customer/Anti-Money-Laundering (AML/KYC) risk, and are seeking to establish the appropriate frameworks to regulate these assets.

On July 5, 2021, the Office of the Superintendent of Financial Institutions (OSFI) published a letter (Letter) to Federally Regulated Financial Institutions (FRFIs) requesting their feedback on the prudential treatment of crypto asset exposures, which we explore in this Insight.

The Basel Committee on Banking Supervision consultation paper

The Letter issued by OSFI follows the Basel Committee on Banking Supervision’s (BCBS)¹ consultation paper issued only one month earlier on June 10, 2021. BCBS is seeking feedback on its preliminary proposal for the prudential treatment of banks’ exposure to crypto assets and is proposing to classify crypto assets into two groups:

• Group 1: Tokenized traditional assets and stablecoins that meet a certain set of conditions, which include that:

• The crypto asset represents a legal claim in jurisdictions where the underlying asset is issued
• Material risks of the crypto asset and the network on which it operates, including the distributed ledger or similar technology, are mitigated
• Specified functions, such as redemptions, transfers or settlement, are performed by regulated entities

• Group 2: All other crypto assets not captured by Group 1.

Group 2 crypto assets are considered higher risk and, according to the BCBS, should be subject to a more conservative prudential treatment compared to Group 1.

OSFI consultation

OSFI issued the Letter seeking comments from the industry based on questions posed in the BCBS consultation paper as well as specific FRFI-directed questions. OSFI has indicated it supports the development of a risk-sensitive prudential framework for crypto asset exposures and will rely on the feedback received from FRFIs to inform the regulation of FRFIs in this space, and to ensure Canadian perspectives are well-represented in international discussions on the subject.

The consultation seeks feedback from FRFIs on 18 questions raised by the BCBS consultation paper annexed to the Letter along with the following six questions to assist OSFI in developing its own framework:

1. How would the proposed capital treatment for crypto assets in the BCBS consultation paper interact with your current or contemplated business models in this space?
2. Are there further regulatory capital or other prudential perspectives, beyond those contemplated in the BCBS paper, which OSFI should consider in more detail with respect to indirect crypto asset exposures, such as through crypto asset exchange traded funds (ETFs)?
3. Are there additional risks from hedging a cash-settled exposure with a direct exposure (and vice versa) that should be considered, such as basis, operational, or technology risks?
4. Are there additional considerations relevant to non-bank FRFIs that OSFI should be mindful of when developing a prudential framework for crypto assets?
5. Can you identify any existing crypto assets that you believe should qualify for Group 1 treatment that do not based on the proposed classification conditions? What modifications to the classification conditions would be necessary to allow these crypto assets to qualify for Group 1 treatment?
6. For Group 2 crypto assets, the BCBS consultation paper does not provide any recognition to the netting of long and short positions, while it notes there are additional risks to speculative short positions. Is this a prudent capital treatment with appropriate incentives?

Feedback from FRFIs on the six questions set out above along with the questions raised by the BCBS consultation paper annexed to the Letter can be submitted to OSFI at consultations@osfi-bsif.gc.ca until September 30, 2021. FRFIs are also encouraged to submit comments directly to the BCBS on its consultation paper by September 10, 2021.

Concluding thoughts

With the significant market growth of crypto assets globally and ongoing international consultations on how such assets should be regulated, OSFI has presented FRFIs with a unique opportunity to engage in discussion and help shape the regulatory framework for crypto assets in Canada. Feedback from the industry is also important given that the framework may impact OSFI’s capital guidelines. OSFI has published draft capital guidance for banks, insurers and trust companies which is anticipated to take effect in January 2023. OSFI’s existing and draft capital guidance does not currently contain express requirements or criteria for crypto assets. Given the degree of market volatility associated with crypto assets and OSFI’s overall prudential approach, it is possible that FRFIs may be required to maintain a larger “buffer” for crypto exposure than they would for exposure to other asset classes.

FRFIs wishing to submit comments should review the Letter and the BCBS consultation paper in further detail and be cognizant of the upcoming autumn deadlines set out above.

^{1. The BCBS is a global standard setter for the prudential regulation of banks. Providing a forum for cooperation among central banks and bank supervisors, the BCBS seeks to strengthen the regulation, supervision and practices of banks worldwide in order to enhance financial stability. The BCBS does not possess any formal supranational authority, but relies on its members’ commitments (45 members from 28 jurisdictions, which includes both the Bank of Canada and OSFI) in order to achieve its mandate.}

For more information and for assistance with preparing submissions to OSFI, please contact Marisa Coggin.

A special thank you to Jaspal Nagra (summer student) for his assistance with this article.