On July 26, 2023, the Office of the Superintendent of Financial Institutions (OSFI) launched a consultation by releasing two draft guidelines (collectively, the Draft Guidelines) on the regulatory capital treatment of crypto-asset exposures: one draft guideline for federally regulated deposit-taking institutions (DTIs), and another draft guideline for federally regulated insurance companies.
These draft guidelines are open for comment as part of the consultation, and are proposed to come into effect in early 2025. Once finalized, the two guidelines would replace OSFI's interim advisory on the regulatory treatment of crypto-asset exposures (the Interim Advisory), which was released in August 2022.
The Draft Guidelines are intended to address an evolving risk environment and align OSFI's capital and liquidity approach to international developments. In particular, the Draft Guidelines are meant to follow the approach set out in the Basel Committee on Banking Supervision's (Basel Committee) guidance Prudential treatment of crypto-asset exposures released in December 2022. The Basel Committee guidance is set to come into effect on January 1, 2025.
The Basel Committee guidance splits crypto-assets into two groups, determined by whether they meet certain classification conditions. Those that meet the classification conditions are categorized as Group 1 crypto-assets, which pose fewer risks. Those that fail to meet the Group 1 classification conditions are categorized as Group 2 crypto-assets, since they pose additional and higher risks compared with Group 1 crypto-assets. Group 2 assets are subject to a newly prescribed conservative capital treatment under Basel Committee guidance.
OSFI's Interim Advisory came into effect in the second quarter of 2023. Like the Basel Committee guidance, the Interim Advisory splits crypto-assets into two groups differentiated by the severity of the risks they pose and sets conservative capital and liquidity standards for Group 2 crypto-assets. In order to meet the classification for Group 1 crypto-assets, the Interim Advisory requires the DTI or insurer to obtain a legal opinion on the rights, obligations and interests arising from the crypto-asset and the settlement finality of the crypto-asset.
In addition, the DTI or insurer must ensure that entities involved in executing redemptions, transfers, storage, or settlement finality of the crypto-asset, or managing or investing reserve assets are regulated and supervised, and that they take certain risk management measures.
Understanding the scope and classification of crypto-assets.
Following the Basel Committee guidance, the Draft Guidelines define crypto-assets as private digital assets that depend on cryptography and distributed ledger technologies (i.e. DLT, or blockchain, or similar technologies). Digital assets are described as a digital representation of value, which can be used for payment or investment purposes or to access a good or service.
The Draft Guidelines further set out that "dematerialized securities" (or securities that have been moved from physical certificates to electronic bookkeeping) that are issued through DLT or similar technologies are considered to be within the scope of the Draft Guidelines and are referred to as "tokenized traditional assets." For contrast, dematerialized securities that use electronic versions of traditional registers and databases, which are centrally administered, as well as central bank digital currencies (or CBDCs), are not within scope.
The Draft Guidelines follow the Basel Committee guidance in establishing firm criteria for Group 1 assets. The range of crypto-assets which may qualify for Group 1 treatment is narrow, being tokenized traditional assets (referred to as Group 1a), and certain types of stablecoins, being those stablecoins with effective stabilization mechanisms that aim to maintain a stable value relative to a specified asset, or a pool or basket of assets, as measured by the criteria set out in the Draft Guidelines (referred to as Group 1b). Crypto-assets which do not meet the proposed Group 1 criteria will fall into Group 2. Group 2 crypto-assets are divided into hedged crypto-assets, being crypto-assets that satisfy enumerated hedging recognition criteria (referred to as Group 2a), and "other crypto-assets" (referred to as Group 2b), capturing crypto-assets which do not meet the criteria of the other Groups.
Broadly, a majority of what are commonly referred to as "cryptocurrencies" are expected to be characterized as Group 2b crypto-assets, where exposures to these types of assets will result in significant capital deductions.
The draft guideline for DTIs.
The Draft Guideline for DTIs applies to all federally regulated DTIs, including federal credit unions. The Draft Guideline for DTIs offers two approaches to crypto-asset exposures: a simplified treatment and a comprehensive treatment. DTIs may apply the simplified capital and liquidity treatment if they have limited crypto-asset exposures, or if they wish to streamline or bypass the classification determination in the Draft Guideline.
Under the simplified treatment, DTIs would treat all their crypto-asset exposures as Group 2b exposures by applying a capital deduction to common equity tier 1 (CET1) capital for all their crypto-asset exposures. For liquidity purposes under the simplified treatment, DTIs would apply the same treatment as other non-high quality liquid assets in the liquidity coverage ratio and net stable funding ratio standards.
Under the comprehensive approach, capital and liquidity treatments would vary depending on crypto-asset classification. DTIs applying either approach would be required to consider credit valuation adjustment, counterparty credit risk, operational risk, leverage, and large exposure risk in accordance with the Draft Guideline for DTIs. Crypto-asset exposures at foreign bank branch deposits would not be considered qualifying assets.
For foreign bank branches in Canada, crypto-asset exposures would not be considered qualifying assets under OSFI Guideline A-10 - Foreign Bank Branch Deposit Requirement Guideline, and, as such, would not be included in the calculation of the foreign bank branch deposit.
The draft guideline for insurers.
The Draft Guideline for insurers is meant to complement the requirements in the Life Insurance Capital Adequacy Test, the Minimum Capital Test, and the Mortgage Insurer Capital Adequacy Test, as applicable. Insurers subject to the Draft Guideline include all federally regulated insurers, including Canadian branches of foreign life and property and casualty companies, fraternal benefit societies, regulated insurance holding companies and non-operating insurance companies.
The Draft Guideline for insurers offers a simplified approach for insurers with limited crypto-asset exposures, or to insurers wishing to streamline or bypass the classification determination and related requirements. Insurers taking a simplified approach would treat all their crypto-asset exposures as Group 2 exposures by deducting all their crypto-asset exposures from Gross Tier 1 or capital available.
Under the comprehensive approach, capital treatment by an insurer of crypto-assets would vary depending on the crypto-asset classification. Under both approaches, insurers would be required to consider additional operational risk, large exposures, and foreign insurance branch requirements. Exposures to Group 2 crypto-assets would also be subject to an exposure limit. The Draft Guideline for insurers would not permit foreign insurance branches to vest crypto-asset exposures.
Invitation to make submissions to OSFI.
The consultation on the Draft Guidelines is set to close on September 20, 2023. OSFI invites all interested stakeholders to make submissions on the Draft Guidelines before the consultation closes. This feedback will inform the final versions of the Draft Guidelines, which OSFI plans to release in March 2024.
At Gowling WLG, we are committed to monitoring legislative and regulatory developments by industry sector. Our professionals practicing in the area of financial services regulation would be pleased to assist stakeholders in the consultation process. Contact the authors or any member of our team to begin a conversation.