Long reads

The Bank of England’s digital currency proposal an exploration of digital sterling

Arvin Abraham

Arvin Abraham

UK Fintech Lead Attorney, McDermott Will & Emery

Sometimes lost in the excitement around Bitcoin and cryptocurrencies is the potential for digital asset technology to revolutionise more traditional forms of money. The emergence of new and disruptive technologies in the currency space is creating incredible pressure for central banks the world over to compete and to co-opt some aspects of these new technologies to modernise traditional currencies. Central banks have grown savvy to the threat of disruption and are looking to harness technology to make their fiat currencies competitive in a digital age and to stay relevant in the face of challenger currencies like Bitcoin.

The announcement in April this year by the Bank of England (BoE) and HM Treasury of the creation of a new taskforce to explore a Central Bank Digital Currency (CBDC) is one of many such proposals by central banks around the world. While the UK is not the first country to explore the concept – China has already started trials of its digital yuan – the BoE’s exploration of a CBDC (we will refer to this as ‘Digital Sterling’) is still one of the most advanced proposals for a digital currency by a major world government. It represents a potential game changer for the UK and could revolutionise money and finance as we know it.

Before delving into the policy implications of Digital Sterling it’s important to explore exactly what the BoE means when it talks about CBDCs and a few key terms. Cryptocurrencies are, simplistically, digitally native currencies that rely on distributed ledger and blockchain technology. Fiat currencies are currencies issued by a central bank. Digital currencies are electronic currencies, which include cryptocurrencies, which may, but do not have to, utilise distributed ledger or blockchain technology.

The BoE has taken great pains to make clear that a CBDC is not a crypto currency. There are many reasons for this distinction, with a few highlights being centralisation vs decentralisation, preservation of anonymity, and the technology used. Decentralisation is a fundamental premise of Bitcoin and many (not all) other cryptocurrencies. There is no central authority issuing Bitcoin, while Digital Sterling would be issued and controlled by the BoE.

A corollary of Digital Sterling being issued by the BoE would be that anonymity would not be a feature as it is with many cryptocurrencies. As the centralised issuer, the BoE would be able to track Digital Sterling to the hands of end consumers and would know who the holders are and what their Digital Sterling is being used for. Another distinction is in the technology used. While the BoE has acknowledged that Digital Sterling could rely on distributed ledger technology, the technology underpinning Bitcoin, it does not have to be. Digital Sterling could be a tokenised version of the pound or it could simply be a unit of account on an electronic ledger. The BoE has committed to exploring a variety of technologies to facilitate Digital Sterling and to opting for the most effective approach.

It’s also relevant to contrast CBDCs with Stablecoins before diving further into the BoE’s proposal. A Stablecoin is a cryptocurrency that has its value pegged to another asset, such as another currency, the US dollar being a popular example. Stablecoins are issued by private parties, not by governments, and use a variety of synthetic means to achieve the peg to the underlying asset. Digital Sterling would not be pegged to Sterling, rather it would be Sterling in a digital form and as much an official currency of the UK as a Pound coin.

Policy Implications of Digital Sterling

Now that we have a primer on what CBDCs are and how they differ from cryptocurrencies we can dive into the BoE’s proposal. In the BoE’s original discussion paper exploring Digital Sterling, the BoE focused on the theme of promoting social good by ensuring monetary and financial stability. Although Bitcoin and other cryptocurrencies have many positive features such as the potential (still unrealised) to make transactions faster and lower transaction costs, they also have some societally destabilising features. Their volatility makes it hard for them to be reliable means of payment and their anonymity preserving features have the potential to promote fraud and crime, which has been the focus of significant regulatory attention by the FCA and other global regulators in recent months.

There is also a competitive dynamic at play. As cryptocurrencies become more mainstream, the BoE like other central banks may have a niggling concern about losing the primacy of its currency to the likes of Bitcoin. Competitive pressures combined with social good in the push for the creation of Digital Sterling, as it helps promote a stable payments infrastructure and reduces the risk of fraud while at the same time maintaining Sterling as a viable currency in a digital age and co-opting disruptive technologies.

The BoE does not have to go far to find an example of electronic money on which to pattern Digital Sterling. While it’s commonly thought that the only form of money issued by the BoE is bank notes, a much bigger portion of the money supply it provides is the reserve banking system it has in place with banks and other financial institutions. This is already an electronic system, albeit one that is only accessible to financial institutions or via financial institutions as intermediaries, which is the case when using a bankcard to make a purchase.

Another social good and goal in the creation of Digital Sterling is to democratise electronic money so that individual consumers can benefit from it. It also reflects a growing realisation of the changing nature of payment systems and the fact that the world is evolving to become increasingly cashless (physical cash). If consumers don’t have access to digital money they may at some point be locked out from being able to make routine purchases. This a particularly acute problem for the un-banked population who, without access to a bankcard that is tapping into the reserve currency system, would have no way to make payments.

How Would Digital Sterling Operate?

The BoE has not settled on a final proposal for how Digital Sterling would operate. One model highlighted in its discussion paper is to leverage a public-private partnership, in a similar way to how the reserve banking system works today. The BoE would provide the core ledger technology (meaning the platform on which Digital Sterling runs, which would record its value and process payment transactions) and the regulatory underpinnings, but would rely on banks and other private sector participants to interface with end consumers. This approach would help to spur innovation as the financial institutions involved could potentially implement their own value additive spins on Digital Sterling and how it is delivered.

Although not mentioned in the BoE’s discussion paper, it is not inconceivable that the BoE could opt for a model that disintermediates banks altogether. One could envision a scenario where the core ledger technology is expanded to provide for a direct interface with end consumers, with the BoE in control of any additional functionality and the user experience. Leveraging digital technologies, it would be able to hold digital currency for end consumers on its own ledgers (which may or may not be decentralised) at a fraction of the cost of holding cash in a bank vault.

Instead of holding money at a retail bank, consumers would be able to hold their money directly with the BoE immediately removing any possibility of bank runs and solving issues for the unbanked in a world where your national insurance number suddenly becomes your bank account number as well. This is a farfetched hypothetical, in reality, the impact on the financial system of disintermediating retail banks would likely be too disruptive for the BoE or any central bank to take this approach, but it’s interesting to explore what Digital Sterling could be leveraged for in an extreme case.

The technological architecture of Digital Sterling is focused on a needs first approach with the BoE having acknowledged that there are trades off between different design principles, which requires a balance to be struck to achieve its policy objectives. The BoE has also stated that there should be no presumption that Digital Sterling would use distributed ledger technology, acknowledging that there could be benefits to using it in enhancing resilience and availability but that this needs to be counterbalanced against its drawbacks, including negative impacts on performance, privacy and security. It has also mooted using more traditional centralised technology stacks to facilitate Digital Sterling, which could be akin to the technology currently used for the reserve banking system.

In conclusion, there are clearly many open questions on the final design and capabilities of Digital Sterling, let alone whether the project will ultimate advance past the discussion and taskforce stage and become a concrete reality. Nevertheless, the BoE’s serious exploration of the concept shows a willingness to embrace change and drive innovation, which bodes well for the future of the UK’s financial system as we advance into an increasingly digital age.

Arvin Abraham is an Attorney who leads the UK Fintech practice at McDermott Will & Emery.

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