The Basel III Framework and Digital Market Infrastructures

Jerome Kemp
President

• Baton Systems

Bill Coen
Senior Advisor

• Baton Systems

“The reforms that we made were readily apparent and needed.”

Bill Coen - Baton Systems

In PAY 21 October, Jerome Kemp, President of Baton Systems, talks to Bill
Coen about the Basel III Capital Framework and today’s emerging digital
market infrastructures. Bill is senior advisor to Baton and former Secretary
General to the Basel Committee on Banking Supervision and was one of the
principal architects of the Basel III Framework, a set of measures designed
to strengthen the regulation, supervision and risk management of banks.

The thinking behind Basel III

“Some of our thinking,” he says, “was driven by the glaring inadequacies of
the existing framework. The reforms that we made were readily apparent
and needed, like the amount and quality of capital.”

Asked by Jerome about the drivers of the Committee’s thinking post-
Global Financial Crisis as it embarked upon the revision of the regulatory
capital, which comprised the bulk of the Basel III reforms, Bill ‘s response
is unequivocal.

Bill describes some of the reforms as ‘searing lessons’ from the Global
Financial Crisis, citing in particular the credit and operational risk
frameworks as well as market risk, subsumed under ‘The Fundamental
Review of the Trading Book (FRTB).’ While some reforms were designed
to enhance existing rules, others were novel, such as the leverage ratio,
which had previously existed only in the US and Canada. The idea was to
take a ‘multiple metrics’ approach rather than to rely on single measures
that characterised the pre-Basel 3 framework. The result, Bill explains,
was a series of new standards and requirements, encompassing leverage,
liquidity, and funding as well as baseline capital ratios.

Bill goes on to speak about the system of buffers such as the Capital
Conservation Buffer where banks would be restricted on how much
capital they could distribute in the form of dividends or share buybacks if
their capital levels fell below a prescribed threshold. Another such buffer
is a Countercyclical Capital Buffer, where banks build capital to draw on in
times of market downturn. “This was driven by the Global Financial Crisis,”

“It’s imperative for regulators to keep up with the times and to have a high awareness of growing risks and bank practices, as well as market developments.”

Bill says. “Our objective was to make the framework future-proof but we
could not be certain as to how exactly these new measures would behave
in real time.”

The other two elements of the framework pertain to banks’ exposures
to central counterparties and margin requirements for non-centrally
cleared derivatives. “These were very consistent with the G20 call to move
towards central clearing for as broad a spectrum of assets as possible,”
says Bill. “All of these measures together have made for a much better,
well-informed regulatory framework.”

Bill Coen - Baton Systems

Mission Accomplished?

However, Bill thinks it is still too soon to be able to say that the broader
framework has achieved what it set out to do. “Undoubtedly the
framework is better and banking systems around the world are stronger,”
he says. “The experience that we have had with COVID so far and the
pressure we have seen in the markets, particularly on asset quality, have
been a good test case, but I don’t think it was a complete validation.”
He points out that not all the provisions of the Basel III Framework have
yet been fully implemented. “But things are definitely moving in the right
direction,” he adds.

Cryptoassets: a natural progression of the regulatory framework?

Bill explains that, although the Basel Committee only recently published
a Consultative Paper on crypto and digital assets, they were a point of
discussion for the regulatory community as far back as 2014. “This is not
a new topic,” he says. “It’s imperative for regulators to keep up with the
times and to have a high awareness of growing risks and bank practices,
as well as market developments.”

A balanced approach

When it comes to emerging or evolving issues like crypto-assets, Bill
says it is important that the regulatory community toes a careful line.
An approach that is too heavy-handed could squash a growing and
important asset class, but too light a touch could lead to very high growth
in that asset class and potential market instability. The Basel Committee’s
approach as detailed in the recently published Consultative Paper tries to
strike that balance, and is a work in progress.

“The really important
takeaway is the
acknowledgement by
the Basel Committee
of blockchain and
of technologies like
distributed ledgers.
I think there is a clear
recognition that we
have evolved in the
financial system.”

Bill Coen - Baton Systems

“The stakes are
higher when it
comes to market
infrastructure.”

The Paper makes a very clear distinction between crypto-assets (assets
using cryptography) and digitised assets (assets represented by a token).
Bill believes that this distinction is necessary.

Bill Coen - Baton Systems

“The whole notion of products like Bitcoin or Ether as currencies is a very
sensitive point for the central banking community,” he says. He explains
that the community considers that there is tremendous volatility around
these products: they are not a mature asset class, they are not issued by
a central authority and market participants lack experience in them.
They do not meet the true test of a currency, so central bankers prefer to
refer to them as crypto-assets rather than to define them as a new form
of currency.

of currency. have evolved in the

Press coverage about the Committee’s consultation has largely focused
on the proposed punitive treatment of crypto and digital assets, Bill
says. “But that’s just looking at the Bitcoin/Ether part of it,” he stresses.
“The really important takeaway is the acknowledgement by the Basel
Committee of blockchain and of technologies like distributed ledgers.
I think there is a clear recognition that we have evolved in the financial
system. There’s got to be an awareness and recognition of these
technologies and I think that the Consultation Paper provides
that recognition.”

Tokenised, digital products, on the other hand have a clear link to
the underlying assets. “This is why the distinction made by the Basel
Committee is important,” Bill says.

These relatively novel technologies represent a new way for market
participants to communicate amongst each other. Bill believes that
there has always been a sensitivity in the central banking and regulatory
community regarding the sector’s ability to keep up with the latest
developments. “There is a keen awareness that it is imperative that
policymakers and standard-setters keep up to date with the latest
technologies,” he says. “There is no way the central banking or regulatory
community can ever outpace the private sector. The best they can hope
for is to remain current on latest developments.

“The regulatory community feels an imperative to keep up to date, and,
if possible, to get ahead of the curve.”

“Let’s think about prudential rules,” Bill says. “We apply them on a bank-
by-bank basis, and if a bank runs into trouble and experiences some
pressure, there may be a knock-on-effect. The worst-case scenario is
that there is contagion.

“I don’t see the pace of change slowing down and I see the regulatory community continuing to immerse itself in these changes.”

Bill Coen - Baton Systems

“Now let’s think about market infrastructure. The volumes are orders
of magnitude higher. If a payment system has a hiccup it reverberates
around the rest of the financial system. I think it’s important to make a
distinction between the use of technology at a bank level and the use of
technology for market infrastructure. Regulators want to keep up to date
with current developments but the stakes are higher when it comes to
market infrastructure.”

This does not mean, Bill adds, that there should be additional regulatory
requirements with respect to digital assets. Market stability is a
common thread for policymakers preparing rules for banks and those
with oversight of market infrastructure. There is a keen awareness
among regulators of the need for new technologies but there is also an
acknowledgement that the stakes are high.

Innovation is key

Bill says that innovation will be a major theme over the next few years in
terms of market infrastructure. “Looking ahead,” he says, “I’m well aware
of the keenness in the regulatory community to continue to embrace
technological advances. Regulators are keenly aware of the rapid pace
of change and are doing everything they can to remain current and not to
serve as a roadblock to the benefits conferred by these advances.

“It continues to be an exciting time. I don’t see the pace of change slowing
down and I see the regulatory community continuing to immerse itself in
these changes.”

About Baton Systems

Baton Systems is revolutionising the entire front-to-back post-trade process,
introducing interoperable and connected digital market infrastructures from trade
matching through to settlement.

Empowering financial institutions to take control, Baton is redefining what post-trade
processing should look like: fully connected, friction-free, flexible and transparent.
Founded in 2016 by Silicon Valley technologists and capital market specialists, Baton’s
solutions are now being used by several of the world’s largest financial institutions to
facilitate the movement of billions of dollars of cash and securities on a daily basis.

www.batonsystems.com