A Central Bank Digital Currency – a serious consideration or a pipedream?

    By Tom Rich, Business Consultant

    Tom Rich

    Earlier this year, the Bank of England (BoE) released a Discussion Paper with a proposed design for a Central Bank Digital Currency (CBDC), inviting feedback from the Financial Services industry into what would be a seismic and innovative change to the Central Banking landscape.

    The interest in CBDCs arises from developments that started with the 2008 financial crisis: the appearance of cryptocurrencies and the rise of digital transactions; the latter leading to the decreasing role of physical notes and cash. So what is a CBDC and what does it do?

    A CBDC allows households and consumers to make electronic payments in a centralised digital currency that is managed and ran by the BoE. Like a physical banknote, a CBDC would be legal tender and denominated in pound sterling, so £10 of CBDC is equivalent to a £10 note. This electronic money is already available to several large financial institutions, but the Bank of England is now exploring the possibility to expand this to the wider population.

    The Key Drivers of a Digital Currency

    In our view, there are two. And both are being shaped and driven by the consumer’s need for constant change and innovation.

    First is the simple fact that the use of cash is declining; debit and credit card payments are now the norm and surpassed the use of cash several years ago. A CBDC would be a significant step on the way to the cashless society many predict is ahead of us, as the economy continues its digital transformation.

    But could we ever truly become a cashless society?

    There is a complex range of factors driving the transition to a cashless or a less-cash society in countries around the world. There are also key differences across regions that are impacting and driving the need for, and acceleration of, a cashless society.

    In the west, convenience appears to be the main force driving a natural evolution towards a cashless system, supported by lower transaction costs that make contactless payments more competitive than cash transactions.

    In addition, there seems to be little general political interest in removing cash altogether, other than for high denomination notes in the fight against money laundering, terrorism, tax evasion and corruption. The transition also appears to be happening by stealth, without active government intervention in satisfactory transition management.

    But what of other global examples? Africa has become a mobile payments innovation powerhouse, out of a necessity to equip the region’s millions of unbanked with access to a payment infrastructure.

    In Asia, India’s latest demonetisation exercise was aimed at restructuring the economy for a sustainable future, seeking to reduce corruption and improve tax collection.

    In China and elsewhere in Asia, the digital economy and associated investments in infrastructure and payment systems, designed with financial inclusion in mind, drive cashless transactions.

    It is apparent that the innovations that we are witnessing in Africa and Asia are now being exported to the western world and are driving the conversation and interest in digital currencies. This is why the BoE is right to be taking a serious interest in this topic for the UK.

    The Rise in Electronic Currencies

    The other major pressure point comes from the rise in other electronic currencies, either in a decentralised format such as Bitcoin or from privately-owned companies such as Facebook creating their own digital currencies like Libra.

    In their current form, cryptocurrencies are imperfect, but they may play a significant role in increasing global economic participation and protecting against government overreach. Globally, the World Bank estimates that there are 2 billion people without bank accounts of which a third of those are living in Sub-Saharan Africa. Given that cryptocurrencies have low adoption costs and are available online without the need to access a physical bank, cryptocurrencies offer a convenient and safe alternative.

    This is a huge threat to the traditional role that CBs play in monetary policy and so it is little surprise that there is gathering momentum across developed banks to analyse and understand the potential effects of introducing a CBDC.  Interestingly, an increase in the general adoption of either of these would reduce the use of physical currency and thus severely inhibit a Central Bank’s ability to manage the economy through monetary policy. This may sound largely theoretical (Bitcoin usage has never quite taken off to the extent it was once touted too) but it’s a growing risk the BoE cannot take lightly.

    What is clear is that the  BoE must be in control of the money supply to fulfil its most basic and foundational requirements.

    It’s our view that there are also other benefits to a proposed CBDC that allow the BoE to meet and further its objective of supporting financial and monetary stability;

    • Stability. It could give access to those who cannot currently access online payment systems and are excluded from traditional banks. It would also allow the government to supply electronic money directly to people, either in the case of benefits payments or the recent example of the US government’s stimulus checks in response to COVID-19. The introduction of a Universal Basic Income, even if unlikely, would also benefit from direct contact with the Central Bank. However, the introduction of a CBDC could also negatively impact financial stability in the UK by putting the Bank of England in direct competition with retail and commercial banks. A CBDC would likely lead to a reduction in deposits held at banks, thus reducing the size of their balance sheets and weakening their financial positions. To counter a CBDC, banks would have to offer increased rates or improved features to attract and keep customers, all of which would come at a cost to profitability.

      Ultimately, it is consumers and business owners who would be most hurt by this, as banks raise lending rates to compensate for increased costs. This is not an outcome the BoE should remotely want and the design of the CBDC should be firmly rooted in avoiding such consequences.

    • Transparency. A key area of potential benefit is improved transparency, granting the ability to track illegal and fraudulent payments, further strengthening Anti Money Laundering legislation and also cracking down on tax evasion. However, I believe this comes at too great a cost to privacy and that could significantly reduce adoption of a CBDC, thus causing its failure.
    • Having a Central Bank monitor and track all payments is a significant invasion of privacy and will make many very uncomfortable with its use. It’s worth remembering that a large part of Bitcoin’s appeal is that it is decentralised and not subject to the watchful eye of governments. If anything, the CBDC could cause an increase in the adoption of other digitalised currencies as people seek to remove themselves from the scrutiny of government.

    A Winning Formula?

    To stress, the proposal for a CBDC is exactly that, a proposal, and not necessarily an indication of the Bank of England’s future actions, but it’s an interesting conversation to start, nevertheless. In a recent survey, 65% of Central Banks indicated that CBDCs is a topic they are looking at and therefore we are likely to see a number of proposals, designs and experiments in the next few years.

    The BoE would be wise to take detailed note of these and only begin to build and implement a CBDC that has a clear benefit to consumers and businesses alike as well as improvements to financial stability. They well may find such a combination is not attainable.