This week derivatives association ISDA published a paper analyzing how banks could use effective hedging for certain crypto-assets to reduce balance sheet exposures. This follows last year’s publication of proposed rules by the Basel Committee for Banking Supervision, which envisage stringent capital requirements for bank cryptocurrency exposures, giving them a 1250% risk weighting. Additionally, hedging was not counted.
The Basel crypto-asset context
The Basel Committee grouped crypto-assets into a first group of lower risk tokenized conventional assets and stablecoins versus cryptocurrencies in a second group.
A combined industry response to the Basel consultation argued that this second group be split into 2a and 2b, with only Bitcoin and Ether being classified as 2a for now. If there are very liquid markets for these crypto-assets and derivatives are clearable at a qualified central counterparty, then they believe the treatment should be different.
For these group 2a crypto-assets, it’s suggested that conventional risk reduction approaches be recognized, such as hedging, collateralization and counterparty netting. In other words, if a bank writes a derivative for crypto-assets and hedges it, then that hedge should be allowed to be offset for the Basel rules.
However, it was more or less accepted by the group that the 1250% risk-weighting applies to other riskier crypto-assets as well as limited hedging.
That industry response to the Basel Committee last year was from ISDA plus eight other capital market associations, including SIFMA.
ISDA’s hedging findings
This week’s paper from ISDA looks more deeply at the potential for hedging in the more liquid markets. Its analysis was on two fronts. Firstly, it investigated the difference between the cash and futures market prices, the basis. And secondly, it explored whether the hedging instruments available are effective.
ISDA found that the basis is higher for Ether and Bitcoin, but of a similar order of magnitude to stocks. Looking at the futures for major U.S. stock indices, the maximum absolute basis varied from 5.5% to 6.1% for stock indices with the higher figure for the NASDAQ 100. In contrast, for Ether the figure was 7.9% and 10.9% for Bitcoin.
Regarding the ability to hedge Bitcoin and Ether, ISDA explored CME and Eurex traded derivatives and ETFs and found them all to be effective, provided the crypto-asset was hedged with its associated ETF or future. The popular Grayscale Trusts were not effective hedges. Grayscale’s $13 billion Bitcoin trust currently has a 30% discount to net asset value. Despite a perception that many cryptocurrency prices are correlated with each other, ISDA also found that cross hedging between Bitcoin and Ether is not effective.
Meanwhile, the Basel Committee is planning another round of consultations on the topic over the next few months. It looks like it doesn’t intend a significantly relax its proposals. Some banks are moving ahead, such as Goldman and Nomura launching their first OTC derivatives trades.