By Carlos Leon, Director of Financial Market Infrastructures & Digital Currencies Solutions at FNA
In February, Sir John Cunliffe revealed to MPs that there is now more than a 50% chance that a retail, general purpose central bank digital currency (CBDC) – a ‘digital pound’ – will come into existence.
Although he reiterated at the time that a firm decision has not yet been made about the digital pound, the fact that the dedicated Taskforce is moving onto the next stage of detailed policy and technical development is reason enough to be asking the hard-hitting questions about what a state-backed digital currency would mean for the national and global financial and economic system.
Where is the UK on its CBDC journey?
The CBDC debate is well established, and the concerns around what this development means for national and global payment markets is just one of the reasons why no country makes this decision lightly, and indeed why there is no clear first-mover advantage to rushing into a new form of public digital money. The launch of the UK CBDC Taskforce is evidence enough of this fact.
Prior to the announcement in February, CBDC activity remained in the research and theoretical stages; updates included the Bank of England’s release of 70 questions asked by applicants keen to win the contract to create a wallet for its CBDC experiment. What announcements like this have done is raise awareness around the Bank of England’s plans to include the private sector from the get-go. A strong and wise move in my opinion.
In terms of the next stage of CBDC development, the Taskforce has said it will work up a technical blueprint of how the UK CBDC would fit into the current financial ecosystem. The results of this phase will be critical as to whether activity continues, or if the central bank abandons the concept altogether.
It’s obvious that introducing a new form of money and payment instrument would have a significant impact on the nation. The Bank of England needs to find the balance between its incentives (monetary sovereignty and a resilient payment system), the consumer use-case (something people will perceive as useful and easy to use), and financial stability (not threatening the health of the financial system). It is clear that a quantitative approach to research and development, based on extensive and comprehensive simulations and scenario analysis of the retail payment ecosystem, is the right path to finding such a balanced digital pound. On the other hand, recent reports of central banks in the Bahamas and Nigeria struggling with poor adoption rates, highlight the reputational costs related to low and slow adoption–especially for G7 central banks.
Expected changes to the financial ecosystem
If we imagine a reality where a CBDC is made possible within the next 10 years, there are a few core areas of the current ecosystem that would naturally experience the biggest changes. Firstly, the public would be given access to an alternative digital currency. If correctly designed, people would enjoy a new payment instrument that could offer interesting features (e.g., offline payments, programmable payments, lower costs) while spurring innovation and competition in the payment ecosystem. Nevertheless, the mere rollout of a CBDC does not guarantee its adoption. Whether a CBDC will be adopted by the public vis a vis the existing forms of money (i.e., cash, commercial bank money) and payment instruments (e.g., debit and credit cards, cash, transfers) is still uncertain; all in all, the key question is what clear benefit will the public get from using a CBDC.
Another area frequently debated is financial inclusion. The FCA recently estimated that 1.3 million people in the UK do not have access to a bank account. This, combined with the fact that cash transactional use is declining in many countries, means the introduction of a digital pound could fuel further improvements to the financial inclusion situation in the UK. It’s important to point out, however, that a CBDC would complement the use of cash, not replace it – as publicly guaranteed by the Bank of England. Granting the public access to another form of central bank money would also align with the central bank’s incentives of monetary sovereignty and payment system resilience. However, whether a CBDC will reach and entice unbanked or poorly banked people is uncertain. Designing a CBDC with a clear use case is far from trivial. The central bank has to balance its motivations with the people’s perception of usefulness and convenience.
Financial stability is also a major concern. If the CBDC is too attractive to the public, there could be a mass migration from commercial bank deposits to this new form of digital central bank money; for instance, this could happen if the public regards the CBDC as a new store of value. As highlighted by commercial banks and their associations, including UK Finance, this migration may result in undesired effects, such as less stable funding for commercial banks, a reduction in lending to households and firms, and an increase in the cost of funds to the economy.
Are these undesired effects a fair price to pay for having a new form of digital central bank money? It is hard to say, but what is straightforward is that no central bank wants a CBDC to be so successful that this migration jeopardizes financial stability and the efficient functionality of the economy. Therefore, central banks should aim for a sweet spot of CBDC adoption: not too low – to avoid reputational risk–, and not too high – to avoid financial instability. To achieve this, central banks should spend time and resources on research and pilot phases, where simulations, scenario analysis and adoption analytics play key roles, respectively; this is why a CBDC is not coming soon unless the central bank chooses to fast track the process and take some risks.
A final point worth considering is the issue of privacy. Unfortunately, we’re frequently exposed to examples of how governments take advantage of publicly available tools to ‘monitor’ their citizens – China being a commonly discussed example. However, these instances must not be seen as a reality that awaits us. In our view, it is the motivations behind the design and adoption of CBDCs that need to be better understood and clarified. What’s important is championing the responsible and proper design of CBDCs to alleviate the fears associated with the unknown. Consumer protection legislation and the judicious work of all authorities, congress, prime ministers, and society is key to this.
It’s also worth pointing out that existing digital payment methods are already non-anonymous, with cash being the only anonymous form of money and payment instrument. Even so, the central bank could consider a tiered anonymity model, where only high-value transactions require a greater degree of identification and disclosure. Also, as it is widely accepted, it is most likely that a CBDC will be issued by the central bank and distributed by commercial banks. The former will have no direct access to the payments data, whereas the latter would–just as they do today with most digital payment instruments (e.g., debit and credit cards).
Knocking over the first domino
As of the end of 2022, all G7 and 18 of G20 economies have now moved into the advanced development stages of a CBDC – so the UK is far from being alone in its progression. Ultimately, the biggest impacts a sole CBDC would have would be on the country in question. However, when the entire G20 group moves towards the same reality at the same time, the global impacts could become equally as great.
For example, an additional form of digital currency could in theory push out private forms of money, which would have significant impacts on commercial banks and the wider economy. However, as mentioned, central banks – including The Bank of England – are actively working to ensure this doesn’t become a reality.
Equally, a UK CBDC could contribute to the replacement of physical cash. But as mentioned earlier, all conversations and designs are steered away from this possibility.
The next few years will be very telling as to how successful the development stages go for the UK and other countries around the world. All in all, the Bank of England must find a sweet spot between its motivations, the end-users’ needs, and financial stability. This is not a political decision. Rather, it is a technical decision. It is clear the digital pound will become a reality in the years to come, but it remains to be seen exactly how soon.
Finding an adequate balance between the motivations of central banks,the use case for consumers and merchants, and financial stability is the key. Aiming for the sweet spot of adoption requires a quantitative approach to the effects of introducing a CBDC into the retail payment ecosystem. We stand ready to aid all stakeholders by providing the technology to run extensive and comprehensive simulations, scenario analysis and adoption analytics for the CBDC journey.