To CBDC or not to CBDC

HM Treasury (HMT) and the Bank of England (BoE) have now published their much-anticipated consultation on the digital pound. It is accompanied by a Technology Working Paper, which explores, in more detail, the technological minutiae related to their proposals. The consultation runs until 7 June, with the BoE now moving onto the `design' phase of the project — where they will develop further, in both technology and policy terms, the model being proposed.

According to the IMF, the BoE is one of more than half the world's central banks actively exploring or developing central bank digital currencies (CBDCs). Currently, 114 CBDCs (representing over 95% of global GDP) are in research and development and two are fully launched — Nigeria's eNaira and the Bahamian sand dollar.

For the most part, the UK has followed a more cautious timeline than other jurisdictions — with the hope of gaining a second-mover advantage. In fact, Andrew Bailey, Governor of the BoE, has often reiterated his hesitancy as to whether a digital pound is needed — in either wholesale or retail form. A wholesale version is arguably redundant following the update of the BoE's real-time gross settlement (RTGS) system, which facilitates wholesale payments in central bank money. And a retail version was described last year by the House of Lords as being a “solution looking for a problem”.

However, this consultation marks a clear change in tone. Despite being too early to foresee a definite outcome, HMT and the BoE now deem it “likely” that a digital pound will be needed in the future for everyday payment needs. A key factor impacting this likelihood of launch (which would only occur in the second half of the decade) will be how the payments landscape continues to evolve — both in the UK and globally. Specifically:

• Whether, and how sharply, cash use continues to decline.
• The emergence of new forms of private digital money issued by new payment entities.
• Whether new forms of private digital money display adequate interoperability.
• International developments in CBDCs and private digital money.

The consultation proposes a retail CBDC “designed for everyday payments by households and business” — as opposed to a wholesale CBDC which would be used to settle high-value payments between financial firms. Unlike commercial bank holdings, each digital pound would be a direct claim on the central bank. They would sit alongside, but not replace, cash.

The BoE's model is designed around the following identified features:

• Public-private partnership
  • The architecture would employ a private-public sector partnership via the “platform model” (as originally set out in the BoE's 2020 Discussion Paper).
• Public digital money issued by a central platform operated by the BoE
  • The BoE would build and operate the “core ledger” which would provide the minimum necessary functionality for the digital pound.
  • Regulated private firms — Payment Interface Providers (PIPs) and External Service Interface Providers (ESIPs) — would act as the interface between the user and the ledger, accessing the BoE's core infrastructure via an application programming interface (API). They would provide wallets — passing anonymised instructions from the user to the BoE's core ledger (where the transactions would be processed and settled). They would deal with all user-facing interactions, including handling customers' information.
  • PIPs would provide interactions relating to payments, while ESIPs would provide non-payment related value-add services (e.g., business analytics, budgeting tools, fraud monitoring). 
  •  PIPs and ESIPs would be “robustly yet proportionately regulated” to ensure resilience, continuity of operations and protection of customers. The BoE would also likely impose some principles for operation regarding interoperability and security. 
  •  This model is technology-agnostic — e.g., the core ledger could be operated on a centralised traditional database or on distributed ledger. 

• Digital pound wallets offered by the private sector
  • These wallet providers would be encouraged to offer an array of innovative features and services, but all wallets would need to provide certain minimum functionality:
    • Access to digital pounds: customers must be able to register on the digital pound ledger and open a wallet.
    • Make payments: wallets should allow users to easily make and accept payments from merchants to other users, and commercial bank accounts, as well as switch digital pounds into cash.
    • View balances and transaction history: users must be able to view their activity.
    •  Mobility: customers must be able to switch easily between wallet providers and, if desired, close their wallet.

• Privacy-protected like for cards and bank accounts, but not anonymous
  •  Individuals' personal details would be known to their PIP in the same way they are for bank account providers today (and subject to the same privacy protections). These providers would be responsible for recording the identity of digital pound users and carrying out any necessary Know Your Customer (KYC) and Anti-Money Laundering (AML) checks.
  • Users would be able to adjust their privacy settings (to some degree) and the BoE is supportive of exploring ways to allow some small value transactions to have higher levels of privacy — e.g., through tiered identity verification or enhanced privacy controls. 

• The BoE and the Government would not see any personal data
  •  PIPs would anonymise personal data before sharing them with the BoE. The data would, however, be available to police authorities and law enforcement in certain circumstances — on the same basis as currently with other digital payments.

• Accessible to UK and non-UK residents
  •  To ensure consistency and equal treatment, non-residents' holdings of digital pounds would be on the same basis as residents. 
  •  However, non-resident access would require a recognition regime to determine which non-UK PIPs and ESIPs could offer digital pound wallets and other services. This would ensure that UK standards of resilience, consumer protection, AML, KYC and any other legal requirements are upheld. UK authorities might reserve the right not to grant access to digital pounds for non-residents from certain high-risk jurisdictions.

• Used by households and businesses
• Seamlessly exchangeable with other forms of money, including cash and bank deposits
• Accessed by users through smartphones or cards
  • Initially, use of digital pounds would be designed to operate with existing online and in-store payments technology to ensure merchants would not have to invest in new infrastructure.
  •  The specific devices would be developed by private providers — with the BoE playing a role in ensuring they meet necessary standards.
  • Although in-store, online and person-to-person payments would be the initial focus of the digital pound, that may broaden out in future. The BoE also intends to further explore offline and cross-border payments.
  •  The BoE / HMT will not be involved in any `programmability' related to the digital pound. However, PIPs and ESIPs would be permitted to implement such functionalities themselves (with user consent).

• No interest paid
  • The digital pound is not intended to be a either a vehicle for savings or a monetary policy tool.

• Limited amount per user, at least initially
  • To ensure a smooth introduction (without unintended consequences for monetary or financial stability), the BoE proposes an individual user limit of between £10,000 and £20,000. This limit would aim to constrain the degree of deposit outflow from the banking system — with the £20,000 upper bound still allowing 95% of income earners to use their digital wallet to receive their salary without regularly reaching their holding limit. 
  •  Any limit would need to ensure that incoming funds otherwise breaching this threshold would not fail. One proposed mechanism is a functionality that would automatically “sweep” a user's holdings of digital pounds above the limit into a nominated account where it can be held in another form of money, such as a commercial bank deposit.

• For everyday payments online and in-store 

• Climate change: The digital pound would be designed to support the Government and BoE's commitments to mitigate climate change. It would not make use of the same energy-intensive technologies that underpin some cryptoassets.
• Interaction with stablecoins: The digital pound should not crowd out or prevent other forms of digital innovation by the private sector. For example, as HMT and the BoE are developing their regulatory framework for systemic stablecoins, one possibility under consideration is that they could be backed by central bank held deposits. Such a stablecoin would be economically like the digital pound, but they could coexist and complement one another.
• Corporates: Although focused on use by households and individuals, corporate use of the digital pound is still being explored. The most direct way of maintaining a retail focus would be to restrict which types of business could hold digital pounds. Additional complexities would be subject to further work — including whether, and to what extent, non-resident corporates could have access and management of the holding limit.
• Financial inclusion: The digital pound could provide an extra option for some financially excluded groups. However, adoption among the financially excluded could be hampered by an unwillingness or inability to use digital payments. Digital inclusion therefore needs to be promoted alongside financial inclusion.

In the consultation, the BoE identifies its primary motivations for pursuing a digital pound as the availability of central bank money as an anchor for confidence and safety in money, and promoting innovation, choice and efficiency in payments. Other motivations include enhancing financial inclusion, payments resilience and improving cross border payments.

The BoE notes that it would seek to limit any associated financial and monetary stability risks. However, it would not seek to preserve the status quo structure of the financial system or protect any business model from the impact of technological innovation and competition.

Regarding financial stability, the BoE acknowledges that new forms of digital money, both the digital pound and stablecoins, could adversely impact banks' businesses models and affect the cost and availability of credit. The extent of bank disintermediation and impact on the cost of credit depends significantly on the speed and scale of adoption of the digital pound. This is uncertain and would vary between transition, steady state and stress. The BoE advises that this risk has been accounted for within the proposed design — through holding limits — and that the risk would further diminish as the financial system has the time and flexibility to adjust.

Regarding monetary stability, the digital pound would not fundamentally alter the traditional channels of money creation, but it might affect monetary stability. Bank disintermediation might affect the transmission of monetary policy to the real economy — and as a result, the BoE again advises that this is accounted for by keeping the digital pound model retail-focused. And, although the digital pound could affect the equilibrium interest rate, the BoE judges that this impact would be small.

Meanwhile, across the channel, the ECB's 24-month investigation phase into a digital euro is set to conclude in October 2023, with the development of a prototype. As part of this phase, the ECB has been collaborating with private sector companies and intermediaries on potential user interfaces.

Once the prototype is complete, the decision will be made on whether to go ahead with actually developing a digital euro. The EU has indicated interest in both a wholesale and retail version — with the retail version potentially adopting an intermediated design (i.e., where the ECB creates its own digital currency that is distributed via private sector companies and commercial banks).

In preparation for a potential launch, in May the European Commission will propose relevant accompanying legislation. A recent statement from finance ministers — aimed at guiding the development of this legislation — highlighted certain key elements that they want to see prioritised. These elements included privacy protection, convertibility, interoperability, avoidance of programmability and holding limits.

Interestingly, Fabio Panetta (who leads the ECB's CBDC work) recently flagged that it's unlikely blockchain technology has the processing power to support a digital euro aimed at catering to ~350 million Europeans. Instead, the digital euro may need to be designed on a centralised ledger — albeit one that is compatible with decentralised blockchains.

As the likelihood of a future `Britcoin' (and digital euro) continues to increase, financial services firms should prepare themselves for what this would mean for their business models. As the BoE has made it clear it will not “seek to preserve the status quo structure of the financial system”, these firms should commit to actively participate in shaping the design of this potential architecture, through the consultation process and other private-public engagement forums. In particular, traditional banking firms should consider how they could pivot their services and adapt to the role of PIP or ESIP.