SM: Bank capital, cryptocurrencies, and what these mean for the competitiveness of the financial sector.
The new, the old, the conventional and the cutting-edge.
If you thought that ten years on from the global financial crisis, we were finished regulating the financial sector, then my guests joining me here today will surely change your mind.
I’m Scott Martin from Deloitte’s Centre for Regulatory Strategy, coming to you from the beating heart of the City of London’s financial centre.
I’ve got Rod Hardcastle and Suchitra Nair with me here to talk about some of the most important developments we’re seeing in European financial policy, and what they will ultimately mean for the sector.
I’ll talk to Rod about just how much of an impact we think the Basel 3 agreement will have on European banks, and then, pivoting to the very latest in financial innovation, Suchitra will tell us what keeps European policymakers up at night when they think about the risks from cryptocurrencies, what they have planned, and what we think will happen next.
All this in the next twenty minutes or less. It’s going to be fast, it’s going to be fresh. And we’re glad you’re here.
This, is Regulated Radio.
(Brief musical play-in)
SM: It was a cold December day in Frankfurt last year when the world’s most powerful central bankers and financial supervisors descended to finally strike a long-delayed agreement central to the project of repairing the post-crisis banking sector.
The agreement, as most of you will know, was called the “finalisation of Basel 3”.
It’s also referred to by some as “Basel 4”, but who’s counting? The agreement, however, was meant to address perceived flaws in the way that banks calculate the risks they are taking, and by extension, the amount of capital that they need to hold against those risks.
Policymakers wanted to ensure that all large banks calculated their exposures to risk in a comparable way, even when they used sophisticated in-house models to do so.
The resulting framework, although still years away from implementation, has been criticised by some as having the potential to substantially increase the amount of capital banks, and particularly European banks, need to hold – and, as a result, constrain their ability to grow, lend and compete going forward.
So, as mentioned, I’m delighted to have Rod Hardcastle, my colleague in Deloitte’s Centre for Regulatory Strategy, here with me today to talk about this.
Hi Rod, welcome to the show.
RH: Hi Scott, thanks for having me on
SM: So capital requirements are obviously a very important issue for the banking sector, maybe the most significant regulatory demand they have faced for the last ten years since the crisis. What’s been happening recently in the world of Basel?
RH: Well Scott, it’s not so much what’s been going on in Basel as what’s been going on in the European Union.
SM: You’re right, a lot of observers have noted that we still need to see legal implementation of the Basel accords in EU law for them to have any effect on European banks. Are you seeing signs that Europe won’t move forward with adoption?
RH: Not quite yet – but watch this space! You remember the European Commission asked the European Banking Authority for their thoughts on how Basel 3 should be implemented in the EU?
SM: Yes, that was their “Call for Advice” document, as they called it, last Spring?
RH: That’s right! Well, since then, the EBA has been busy.
SM: Okay, how so?
RH: Well, they’ve done their own high-level impact analysis – more on that in a moment – and they’ve issued a data request to a number of banks of varying sizes across the EU in order to undertake a more detailed impact assessment which will guide their thinking and advice they eventually give to the Commission. That advice is due to be delivered to the Commission by the middle of 2019.
SM: Okay, so it seems that the EBA’s assessment and resulting advice will be very influential in the process of how Europe adopts Basel 3. What do you think the advice will be?
RH: Hmmm - that old saying about forecasts being difficult, especially when they are about the future, comes to mind…
SM: Oh, we don’t trade in those excuses here at Regulated Radio. Give us your best guess!
RH: In order to answer that, we need to have a look at the EBA’s initial impact analysis of Basel 3 for EU banks. It was published at the same time as the Basel committee’s assessment of the global impact, so there are some pretty clear comparisons that can be drawn. We need to remember that the EBA’s full report is still 8 months away, but its initial analysis shows that EU Banks face a significant increase in required capital under Basel 3: nearly 17% across all banks, and nearly 25% for European banks that qualify as Global Systemically-Important… and this is confirmed by the Basel committee’s analysis, which shows that EU G-SIBs are significantly more affected by the changes in Basel 3 than American or Asia-Pac banks.
SM: A lot of observers have been predicting for years that these rules would hit European banks harder than others. This looks like fairly substantial, and even official, evidence that this will really be the case.
RH: Absolutely Scott, that’s what the numbers tell us, on the basis of the numbers that banks have submitted to the authorities.
SM: But, that’s not exactly in line with the “no increase in overall capital” story the Basel committee was telling, is it?
RH: Not by a long shot! But you should remember that the “no increase in capital” commitment was made based on the aggregate increase that the global group of large banks would see, not European ones in particular. And, sure enough, global-level estimates published this year show a much smaller capital increase for banks worldwide. One that’s only about 3.5%.
SM: So will European banks just have to take the hit and deal with much higher capital needs versus their international peers?
RH: Well, given that American and Asia-Pac banks aren’t affected anywhere near as much, it’s hard to see European banks - or indeed the European Parliament - being happy about implementing a set of rules that affects European banks so adversely relative to their international competitors.
SM: I can’t imagine many European governments would be pleased to see that either, particularly in those countries whose sectors are hardest hit.RH: No, definitely not!
SM: So what do you think this will mean then? Is there scope to change the rules that are put in place in Europe?
RH: I think it seems almost inevitable that the EBA’s response to the Commission’s Call for Advice will make recommendations on areas where the EU’s implementation of Basel 3 could be amended to reduce the capital impact of the new rules. While we won’t know for sure until we see the document in the middle of next year, there are a few possible changes the EBA could propose. My own view is that changes are likely to be targeted at making the regime less onerous for smaller banks and to support lending to SMEs, rather than to ease the impact on the larger banks – although the larger banks will be lobbying hard for changes that give a level playing field.
SM: Can you give us some specific ‘for-instances’?
RH: Well, in terms of what particular changes might be proposed, I would not be surprised if there is a proposal to retain one of the existing operational risk approaches for smaller, non-systemic banks, as the new Standardised Measurement Approach is considerably more data- and calculation-intensive than existing approaches.
SM: Okay, should we expect to see anything done to ease the impact on mortgage lending?
RH: I expect some proposals around mortgage portfolios, as that is an area where European banks have a different approach to competitors, particularly American banks. As to what that might be, we might see some sort of exclusion of mortgage portfolios from the floor calculation, or an easing of the rules around using the “at origination” valuation for the calculation of risk weights.
SM: I don’t think any discussion of the impact of Basel 3 can be complete without asking you about this new mechanism that the Basel Committee is calling the standardised output floor. This essentially limits the capital benefit banks can receive from developing sophisticated internal risk models versus using the simpler risk calculation approaches set out in the standards themselves, right?
RH: That’s right. The standardised floor was a major sticking point in negotiations at Basel. Given that the impact of Basel 3 is material for European banks, the Commission and/or the European Parliament could quite reasonably take the view that they are not obliged to implement rules that don’t deliver the “no material increase in capital” commitment that was made at a global level by the Basel Committee, but has also since repeated by leading European policymakers for years. The floor might be set at a different level, or there might be exemptions for some portfolios, or there might be an even longer transition. The only thing I am pretty confident about is there will be a lot of noise about the floor before the European rules are finalised.
SM: And Rod, when you talk about the rules begin finalised, you mentioned that the EBA is going to play an outsized role in assessing how those rules should be adopted, but what’s the legal path to actually turning these standards into implementable laws?
RH: That’s a good question, because the answer is that it’s actually going to be quite a complex procedure in the EU. As we’ve been saying, the EBA needs to send a set of recommendations to the European Commission, but then it’s up to the Commission to review those and make up its own mind on what parts of Basel 3 it wants to adopt and how. Once it has done that, and we expect this to come in early-to-mid 2020, the Commission will publish a legislative proposal with the catchy title “CRD6/CRR3” and then the European Council and the European Parliament will both get their say on the law through political negotiations. Once all those parties are agreed, maybe after two years of talks, the legislation will be finalised and banks across Europe can finally then see exactly what it is that they’re going to have to implement.
SM: That sounds like a process that’s going to create a lot of uncertainty for the banking industry for a much longer period of time than they might have expected?
RH: Absolutely, it’s a process that’s going to make it very hard for the EU to keep to the Basel 3 implementation deadline of January 2022, and, as we’ve said, very easy for it to diverge from a faithful implementation of the standards.
SM: Wasn’t it Otto van Bismarck that said that laws were like sausages, it’s best not to see how they’re made?
RH: Maybe, but in this case, there’s just too much sausage-making going on here to ignore!
SM: I think you might be right Rod.
(Laughter)
But Rod, thanks for coming on Regulated Radio to talk to us about this, we’ll have to have you back soon as we find out more.
RH: Always a pleasure.
SM: Moving right along now - Some financial sector issues, like bank capital, have been at the top of the regulatory agenda for a long time. Others are just emerging now. Driven by the development of new technologies and platforms that allow people to interact, exchange and create new financial instruments in a way that just wasn’t possible a decade ago.
One of these new additions to the financial landscape has been the rising popularity of trading and holding cryptocurrencies among firms, governments and even the general public. A few years ago, this was primarily a story about Bitcoin, and how it stood almost alone in its uniqueness, a “currency” not tied to any government or central bank, but instead to a set of rules, a complex mathematical code and underpinned by an exciting new technology called blockchain.
But today, with some admittedly volatile fits and starts, new cryptocurrencies are proliferating all over the world, initial coin offerings are becoming more and more frequent, and the accessibility of the crypto market is making big strides as well.
You’ve probably seen evidence of this yourself. Not only when you read the news, but also when you’re commuting to work, taking a train, or at a football match. Advertisements for platforms that allow virtually anyone to invest in cryptocurrencies are popping up everywhere letting more people try their hand at making money in this new market.
Regulators, understandably, have taken note and pointed out that they might have a concern or two with the kinds of risks that these financial instruments pose to financial markets and the general public.
So to discuss this, Suchitra Nair, our fintech director here at the Centre for Regulatory Strategy, is joining us to tell us more.
Suchitra, welcome to the show!
SN: Hi Scott, it’s great to be here.
SM: So, I’ll be totally honest with you, there’s been a lot of talk about crypoassets recently, and I’ve been reading about cryptocurrencies for years, but I still struggle to get my head around what all this terminology today is referring to. Can you give our listeners a ‘back-to-basics’ refresher on what we’re actually talking about here?
SN: Well, Scott, cryptoassets is a generic term. Put it simply, it refers to a cryptographically secured digital representation of value or contractual rights. These can be transferred, stored or traded electronically. And when cryptoassets are issued through an initial coin offering (ICO) process they are typically referred to as tokens.
SM: I see, so there are actually quite a few different kinds of cryptoassets regulators are looking at?
SN: That’s right, so that’s why it’s this generic term – cryptoassets - that regulators have used to refer to all the uses of cryptocurrencies as financial products and which could pose concerns to their objectives of consumer protection, market integrity and financial stability.
SM: Okay, that makes enough sense, but changing tack a little bit, and thinking about why this has to be a concern for us. If cryptoassets are just a digital representation of value and perhaps more modern version of traditional financial assets, why are regulators so worried about crypto in particular?
SN: Well, Scott, the regulators have three main concerns when it comes to cryptoassets – money laundering and counter terrorist financing, financial stability and consumer protection..
Let’s take the first one money laundering and counter terrorist financing. One of the key features of permisionless Distributed Ledger solutions is anonymity. DLT Tokens or DLT based cryptoassets offer anonymity. That is, it is technically near impossible to identify owners of cryptotokens on permisionless DLTs . This raises the prospect in the minds of some people that they could be used to facilitate tax evasion and other criminal or illegal activities.
SM: I suppose that’s why Bitocin and other cryptocurrencies have been so popular as a method of payment for cyber criminals using ransomware techniques. You’re saying cryptos are essentially as untraceable as cash, but without the limitations of physical cash?
SN: Exactly, and that opens up a whole new front in the fight against money laundering. But of course, not every holder of Bitcoin or cryptocurrency is a criminal but there are a fair share of bad actors.
SM: Makes sense. What else are regulators concerned about?
SN: The second concern is around financial stability. Trading volumes in cryptocurrency exchanges are rising, and more consumers are using these exchanges. The financial stability risk is growing though it is not yet systemic as volumes are still significantly lower than cryptocurrencies. However the volume of derivative products rise and more regulated firms play in this space, the financial stability risk rises exponentially.
The famous Mt Gox raid highlighted what could possibly go wrong. Mt. Gox was a Tokyo-based cryptocurrency exchange that operated between 2010 and 2014 and was responsible for more than 70% of bitcoin transactions at its peak.
In early February 2014, the exchange suspended withdrawals after claiming to have discovered suspicious activity in its digital wallets. The news of the suspension resulted in the price of bitcoin plunging by 20%. The company discovered that it had “lost” more than 850,000 bitcoins, which, at the time, represented over 6% of all the bitcoins in circulation. It recovered some stolen bitcoins but not the majority and it had to file for bankruptcy.
SM: Wow, that sounds like a really interesting case. But thinking more broadly about the potential impact of cryptos on financial markets, am I right to imagine that our ability to understand the channels through which instability could transfer from cryptoassets to the broader financial market is still quite primitive.
SN: That’s right, and regulators recognise that the technology and types of cryptoassets being developed are constantly evolving so that we won’t be able to fully understand the risks it brings in future, but that doesn’t mean regulators aren’t putting a lot of effort into monitoring cryptoasset activity.
SM: And what’s the key concern around cryptoassets and consumer protection?
SN: Well, consumer protection in relation to cryptoassets is a significant regulatory concern. As you said earlier, cryptoasset adverts are very common. However not all investors fully understand the risks associated with investing or using them.
So, we’ve seen that some consumers have been victims of fraud or have lost significant amounts of money. And of course, when they do lose money in crypto many have been unable to get compensation for those losses even if they were improperly sold the product.
SM: Why is that?
SN: Well, simply because these products, for the most part, aren’t regulated and offer compensation unlike regulated products such as a bank account underpinned by a deposit guarantee scheme.
SM: I see. So there’s obviously a lot for regulators to dig into here if they choose to do so. How have you been seeing them respond to these developments so far?
SN: Yes, and they are going to exercising that choice. In the recent UK cryptoasset Taskforce report jointly published by the UK Treasury, FCA and BoE, they have said that they are going to consult on a piece to prohibit sales of derivatives that reference cryptoassets. So we will more regulatory activity in terms of retail investors and cryptoassets.
SM: Thinking a bit about our friends in Brussels. Have EU regulators done anything in this space?
SN: Both UK and EU regulators have issued warnings on the risks associated with investments in cryptocurrencies and their derivative products.
At the EU level, the 5th iteration of the Anti-Money Laundering Directive, or AML5, which should be transposed by Member States before the end of 2019, captures certain cryptocurrency activities – for e,g, Exchanges which convert Fiat currency to cryptoassets and custodian wallet providers will need to comply with stricter to comply with AML requirements.
The UK is expecting to go a step beyond that with many more types of crypto-related activity – for e.g. exchanges facilitating conversion between different types of cryptoassets. Non custodians who perform similar functions to custodians etc. The underlying objective is to prevent layering of financial crime or fraud which makes it difficult to detect. All this of course will be subject to consultation in 2019 and beyond.
SM: Okay, but do you have any sense yet on the approach that UK regulators are likely to take?
SN: Well the gist of the technical guidance is “if it walks like a duck, and talks, or rather quacks, like a duck, treat it like a duck”…in essence if any product looks or achieves the same outcomes as an existing regulatory product, it may be caught by the regulatory perimeter.
More formally, we now have a UK cryptoasset framework which categorises cryptoassets into three types – exchange tokens, security tokens and utility tokens. Security tokens are likely to be caught by existing regulation if it is for example, held for investment purposes.
SM: Is there any existing regulation that already applies to firms in relation to cryptoassets in the UK?
I think this is the blind spot for some firms as they assume that dealing with unregulated cryptoasset activity lets them off the hook.
If you are a regulated firm and are looking to engage in unregulated cryptoasset activity it is important to watch out for existing regulation that may apply such as the systems and controls requirements, SMCR and financial promotions regulation as all these may apply.
The UK Cryptoassets Taskforce report touches on these.
There is a really helpful table in the cryptoasset taskforce report which describes what types of cryptoassets are within the regulatory perimeter. For example financial instruments that reference cryptoassets are within the regulatory perimeter and is likely to be caught by MIFID II.
If in doubt, speak to the FCA. The FCA Innovate team are very open to having discussions in the innovation space and it is an opportunity worth taking up.
SM: So, do you think we’ve reached a sort of tipping point where regulatory activity is going to accelerate now across a number of different jurisdictions?
SN: I think that’s right, it’s reached a point where enough retail consumers are taking a gamble on cryptoassets and regulatory arbitrage among jurisdictions is beginning to take place.
In fact, there is a reasonable demand from cryptoasset firms to be regulated. We can see that jurisdictions who regulated ICOs first– such as Switzerland – attracted a lot of firms.
However, practically it is pretty hard to implement detailed regulatory requirements in a fast developing area. In essence, that is why we now have a framework for looking at cryptoassets with a caveat that it may evolve!
SM: So an increase in regulatory scrutiny isn’t always a burdensome thing then?
SN: It may be for some, but many players welcome it because it gives them credibility in the market.
SM: That’s a very fair point.
Suchitra, thank you so much for coming on Regulated Radio to talk to us about this.
SN: Thanks for having me.
SM: Well that’s our show!
Bank capital and cryptocurrencies, just two of the big issues in the massive shorefront of challenges that regulators and the financial sector are facing today.
Here at Deloitte Financial Services and the Centre for Regulatory Strategy we believe that regulation has been the decisive factor in the development of the financial services sector in the last ten years since the crisis.
That means that, in order to ensure a more successful decade an ahead, financial markets and the firms that operate in them are going to need a better understanding of the policy challenges they will face, and the implications that these challenges will give rise to.
But that’s why we’re here – that’s why we do Regulated Radio – giving you a short burst of food for thought on the top issues from our sharpest thinkers.
Just a friendly reminder, what you heard from us today is the personal opinions of my guests and I, they don’t constitute advice or necessarily represent the views of Deloitte LLP or its affiliates.
Now remember, if you liked the show, subscribe on iTunes, Spotify or Soundcloud! And if you’re already subscribed, you can give us a review on those platforms, or recommend Regulated Radio to a friend or colleague.
It makes the perfect early Christmas gift!
But that’s all for now. Thanks so much for joining us, and see you next time!
END
