The Cyprus Securities and Exchange Commission (CySEC) on the 25th of November, 2020, issued its first regulations regarding cryptocurrency.
Cyprus Investment Firms (CIFs) must first obtain authorisation from CySEC to trade in cryptocurrencies, due to the fact that they are not specifically regulated by previous financial regulation, whether in Cyprus, or at the level of the EU. The new rules laid down in Circular C417 are designed to ensure that CIFs, make provision to cover investments in cryptocurrencies, and that risks involving cryptocurrencies are managed properly. The Circular C417 deals with the Prudential treatment of crypto assets and enhancement of risk management procedures associated with crypto assets, in addition to how the risk management procedures of CIFs should be enhanced.
In particular, it covers the below:
(Pillar I) – Calculation of own funds and capital
The EBA’s report on crypto assets concludes that, there is no reference in the current prudential framework for crypto assets. Therefore, until a common application of the current rules is developed, the following treatment should be used by the CIFs when calculating their own funds and capital adequacy ratio. The guidance is as follows:
Direct investment in crypto assets on a non-speculative basis (banking book exposure)
When a CIF invests directly in crypto assets on a non-speculative basis, it should treat these investments according to Article 36(1)(b) of the Regulation (EU) No. 575/2013 (the ‘CRR’), ie. direct capital deduction from own funds.
Direct investment in crypto assets on a speculative basis (trading book exposure)
When a CIF invests directly in crypto assets for speculative basis, it should treat these as investments in a derivative product subject to both of the following risks:
- Counterparty Credit Risk (“CCR”) calculated according to Article 274 of the CRR, ie. a CIF should use the market-to-market method and apply a 10% potential future exposure percentage (PFCE).
- Market Commodity Risk calculated according to Articles 355 to 361 of the CRR.
Direct investment of CIFs’ clients in crypto assets and/or in financial instruments relating to crypto assets with the CIF acting as the counterparty to these transactions
When a CIF acts as the counterparty to its clients’ trades by taking the opposite position to each client’s transaction in crypto assets, and/or in financial instruments on crypto assets, the CIF is subject to Counterparty Credit risk and Market Commodity Risk, in accordance with the methodologies set out in point 2 above, as the CIF is acting as a market maker for its clients.
(Pillar II) – Internal Capital Adequacy Assessment Process (‘ICAAP’)
CIFs should use the ICAAP to assess the risks emanated from trading in crypto assets or in financial instruments relating to crypto assets, either for their own account, either for their clients’ accounts. Within the Internal Capital Adequacy Assessment Process, the assessment and discussion of the risks associated with the activity in crypto assets should be included together with a sensitivity analysis that shows how the risks identified affect the CIFs’ projections. In addition, any mitigations should also be discussed, stating any additional capital that should be held in relation to the identified risks.
(Pillar III) – Disclosures
CIFs should disclose within their Pillar III disclosures any material crypto-asset holdings and include information on a) the exposure amounts of different crypto-asset exposures, b) the capital requirement for such exposures and c) the accounting treatment of such exposures.
Enhancement of risks management procedures associated with crypto assets
CIFs, which trade in crypto assets and/or in financial instruments relating to crypto assets, should revisit their risk management procedures and strategies and ensure that all risks associated with crypto asset investments are taken accordingly into consideration.
Under Section 68 of the ‘old’ CIF law and section 104(2) of the ‘new’ CIF law, “CIFs must have in place sound, effective and complete strategies and processes to assess and maintain on an ongoing basis the amounts, types and distribution of internal capital that they consider adequate to cover the nature and level of the risks to which they are or might be exposed. These strategies and processes are subject to regular internal review to ensure that they remain comprehensive and proportionate to the nature, scale and complexity of the activities of the CIF.”
The lack of previous regulations for cryptocurrencies, is cited within the current Circular and thus, CySEC recommends that until a common application of the current rules is developed, the following treatment should be used by the CIFs.