Conduct ‘appropriate’ due diligence on crypto-backed lending, APRA urges

The Australian Prudential Regulation Authority (APRA) has written to regulated entities setting out its initial risk management expectations for those that engage in activities associated with crypto assets.

As signalled earlier this month, the regulator is not yet introducing new regulatory requirements.

Instead, it is responding to the rapid growth in crypto assets and the use of distributed ledger technology over the past few years by setting out “expectations” for activities associated with crypto assets.

These could include direct and indirect activities relating to tokenised traditional assets, crypto assets with stabilisation mechanisms (stablecoins), and other unbacked crypto assets – including the investment in and issuance of crypto assets, or lending linked with crypto assets.

While the use cases are still relatively limited in Australia, the regulator’s chair, Wayne Byres, noted that “while these activities can provide opportunities and benefits for the financial system and its customers, they also bring new risks that may be challenging for entities to identify, assess and manage”.

He cited the Basel Committee on Banking Supervision that recently noted that certain crypto assets have “exhibited a high degree of volatility and could present material risks as exposures increase”.

Mr Byres continued: “The risks are wide-ranging, covering, for example, operational, investment, and credit risk.”

In the letter, the prudential regulator outlined that lending activities linked with crypto assets could pose “potential challenges in credit risk management”, particularly when associated with the use of crypto assets as collateral for lending.

This, it said, was due to “potential price volatility and illiquidity”. 

“These challenges would need to be well managed, with a focus on the accuracy and reliability of valuations, the calculation of provisioning levels, and the ability to claim on the security if needed,” the letter read.

Other risks linked with using crypto-asset collateral, include “the potential for fraud, financial crime and technological”, the regulator outlined.

APRA added that the capital, funding and liquidity treatment for loans secured by crypto assets may also be “complex to determine and measure”, and would therefore “need to be confirmed with APRA”.

The regulator has therefore told regulated entities that it expects them to:

• Conduct “appropriate due diligence and a comprehensive risk assessment” before engaging in activities associated with crypto assets, and ensure that they understand, and have actions in place to mitigate, any risks that they may be taking on in doing so
• Consider the principles and requirements of Prudential Standard CPS 231 Outsourcing or Prudential Standard SPS 231 Outsourcing when relying on a third party in conducting activities involving crypto assets
• Apply “robust” risk management controls, with “clear accountabilities and relevant reporting” to the board on the key risks associated with new ventures

Writing in the letter to regulated entities, Mr Byres said: “APRA therefore expects that all regulated entities will adopt a prudent approach if they are undertaking activities associated with crypto-assets, and ensure that any risks are well understood and well managed before launching material new initiatives.” 

Looking forward, the regulator outlined that its policy road map on crypto includes:

In the period ahead, APRA revealed it plans to release for consultation a draft prudential standard for operational risk management, covering control effectiveness, business continuity and service provider management (in “mid-2022”).

Next year, it aims to consult on requirements for the prudential treatment of crypto-asset exposures in Australia for ADIs. APRA said it would “consider the need for initial prudential guidance in the interim”.

As APRA is considering “possible approaches to the prudential regulation of payment Stablecoins”, it added that it is looking at developing options for incorporating them into the proposed regulatory framework for stored value facilities (SVFs). 

Subject to the development of the broader legislative and regulatory framework, APRA envisages consulting on prudential requirements for large stored value facilities (SVFs) in 2023. 

Speaking earlier this month, Mr Byres noted that while new forms of money, such as cryptocurrencies, are increasingly becoming mainstream with more players launching into these offerings, he added there still remains “significant uncertainty over what a more digital and decentralised financial system will ultimately look like, which new types of money will gain prominence, which products and services will take off, and which will fade away”, adding that the future of money is dependent on where users “decide to place their trust”.

“Finding that Goldilocks point for regulation – not too much, not too little – so as to allow the digitisation of finance to generate maximum economic benefit, but doing so within society’s risk tolerance, is what we strive for,” he said at the time.

[Related: APRA to outline crypto expectations to banks]