What would a digital pound mean for UK financial services?

Some experts believe a fundamentally different approach to the pound sterling could help the UK stay internationally competitive. Will McCurdy explores the potential effect of a central bank digital currency (CBDC) on the UK financial services industry, if it could help the City of London stay competitive, and what challenges its introduction might hold.

In 2020, though almost everyone could tell you what a Bitcoin is, and in some circles almost anyone could tell you what a blockchain is, far less could tell you what a central bank digital currency (CBDC) is.

What is a CBDC? Though anyone can hold cash, only banks can hold digital pound sterling. A digital pound would allow citizens and businesses to transfer money to each other without the use of a third-party bank as an intermediary. Which might be a worrying proposition for the UK, a country where the financial services sector is worth £132 billion – the ninth largest in the developed world as a proportion of national economic output in 2019.

CBCDs have already been tested internationally, a digital rouble could be fully launched in Russia by 2023, while China has been working on CBDC related projects since 2014. In fact, the majority - 80 per cent - of central banks are currently exploring CBDCs according to research by the Bank for International Settlements.

Regardless of the lack of current public awareness, CBDCs could soon play a key role in the economy. The potential implementation will depend on the decisions the Bank of England makes in the coming months, following UK chancellor Rishi Sunak’s launch of a government and Bank of England-led CBDC taskforce at UK FinTech week in April.

Unlike a cryptocurrency, a UK CBDC would share data automatically with tax agencies or regulatory authorities and would almost certainly have much less emphasis on data privacy than the peer-to-peer model which is dominant in the crypto space.

“Whereas the original, anarchic vision for bitcoin was to completely remove the need for centralised institutions such as central banks, a CBDC seeks to use the appropriate elements of blockchain technology to deliver the benefits of a digital currency within the secure, regulated environment of the existing financial services ecosystem,” said Rene Pomassl, chief executive at FinTech Salamantex.

Many potential benefits have been attributed to CBDCs: lower payments costs, reduced expenses from not being obliged to produce physical cash, increased protection from the threat of banking failures, as well as facilitating better monitoring of macroeconomic trends due to increased visibility of transactions for central banks.

However, traditional financial institutions have been highlighted as potential losers from the introduction of digital currencies, as consumers could choose to store their money in a CBDC account rather than in a branch of a High Street bank. Greg Baer, chief executive of the US-based Bank Policy Institute, has argued the introduction of CBDCs could diminish established players’ place in the financial system.

However, UK based think tank The City United Project has suggested that a digital pound would enable fractions of a currency to be both spent and traced without high costs and help collect taxes in real-time – which they argued could help the City of London stay internationally competitive.

As cryptocurrencies continue to boom in mainstream popularity and corporate adoption, and cash use continues to diminish rapidly worldwide, finding a suitable alternative to both has pushed the idea of CBDCs to the top of the agenda for governments, banks, and financial services institutions everywhere.

However, the UK differs markedly from some of the smaller countries that have already successfully tested CBDCs, such as the Bahamas, who introduced their “Sand Dollar” in October 2020. The UK is still in the planning phase quite simply because it has a much larger financial system to disrupt.

FStech spoke to several UK financial services companies to find out their view on the potential benefits, risks, and the future of a digital pound in the UK.

How could a digital pound benefit UK financial services?

With something as radical as creating an entirely new form of money, the elephant in the room is whether it could have the potential to destabilize the UK financial system.

However - Ian Gass, chief executive of Agitate, a London-based payment and identity company, believes the introduction of a digital pound could help reduce risk in the banking system, an encouraging prospect with the 2008 crisis still sore in recent memory.

“The main risks of having our payment infrastructure totally dependent on banks is that should there be another credit crisis - and there will be one day - we'll end up back with pressure for 'bank bailouts',” said Gass. “In part this is due to 'normal people' losing money invested, or deposited, with a bank, but mostly it is because if the banking sector falls over so does our ability as a country to conduct commerce.”

He added: “This needs to be corrected.”

Another touted benefit of introducing a digital pound is staying internationally competitive, or rather, not being outpaced by the competition. The City of London’s Whitechapel Think Tank has said that the UK trading internationally using a digital Yuan is not necessarily outside the realms of possibility if China gains a sufficient head start and the necessary level of adoption.

China is relatively advanced in its journey to a CBDC and has announced plans to try and make it possible for athletes and visitors to use its digital Yuan during the upcoming Beijing Winter Olympics in 2022.

“It’s not a matter of a CBDC helping London to stay internationally competitive”, said Paddy Osborn, academic dean and managing director at the London Academy of Trading. “It’s essential for the UK government and the Bank of England to push ahead with their CBDC in order to avoid falling behind the rest of the world.”

“London is number two in the Global Financial Centres Index, but many other countries (led by China) are pushing very hard to become leaders in the crypto space.”

He added: “Like it or not, cryptocurrencies are here to stay, so the UK needs to be proactive in this space to retain its dominant position within the global financial marketplace and to retain regulatory control over the British currency system.”

Some commentators have argued that a CBDC could help post-Brexit Britain keep one step ahead of its EU rivals, as its power to formulate its own regulations could allow a CBDC to be implemented faster.

“A new financial infrastructure would position the UK as a leader in Europe, and while the European Central Bank (ECB) would have to regain approvals from all EU nations, the UK would once again position itself at the forefront of financial innovation,” said Ran Goldi, chief executive of First Digital.

However, in the eyes of some commentators the needed impetus to develop a CBDC is unlikely to come just from other governments, but also from private sector providers who develop so-called stablecoins. Stablecoins are cryptocurrencies where the price is designed to be anchored to fiat money – for example, the US dollar - or to exchange-traded commodities such as gold.
“If the Bank of England does not issue its own CBDC it is very likely that another private sector provider - for example Circle or Paxos - will do so anyway,” said Gass from Agitate.

Improving the transition to a cashless society is another touted benefit of implementing CBDCs. Cash use was rapidly declining in the United Kingdom even before the pandemic, though it is behind some countries such as Sweden in this regard. The use of cash has fallen 54 per cent in the UK during the past ten years according to figures from UK Finance, falling from 58 per cent of payments in 2010 to just 23 per cent in 2020.

CBDCs could potentially help those without a bank account, a credit or debit card, or smart phone to make payments, helping for example tourists, children, or those not considered credit worthy to have access to a means of payment. This could help disadvantaged and vulnerable people to have more access to financial services, boosting the sector’s revenue.

Dr Martin Lukavec, senior lecturer, finance, at the London School of Business & Finance (LSBF) said: “A digital pound would be the logical next step in creating the cashless society that UK businesses and consumers are edging closer towards.”

However, Janis Legler, chief product officer and head of research at UK FinTech Mode, believes that the benefits of a CBDC would be primarily for central banks rather than private institutions, and London’s comparative advantage will likely come from elsewhere.

“A UK CBDC would not have a large impact on the competitiveness of the UK’s financial services industry or the City of London,” said Legler. “Benefits for the Central Bank and HMRC could include faster distribution of stimulus payments or better enforcement of monetary policies like negative interest rates.”

He added: “It is significantly more important for London's international competitiveness to empower innovative FinTechs, cryptocurrency businesses, and decentralised finance protocols through welcoming, definitive, and forward-looking regulation.”

What risks could a UK CBDC hold?

The benefits of a CBDC for the UK might seem to be compelling, but many experts believe its implementation could also hold risks.

If a large volume of the currency supply were held in the form of a CBDC, then there would be fewer consumer deposits - which are the primary asset of banks - to fund bank loans, according to a report by The Bank Policy Institute. Banks’ lending could contract in supply and increase in cost as banks would have to pay higher rates to persuade businesses and consumers to hold conventional deposits rather than CBDC.

The introduction could also cause issues in the event of a potential recession, according to some experts.

“This is what worries economists the most – in a future recession, people might panic and transfer all of their money to the central bank, destabilizing the banking system,” said Lukavec from LSBF. “This idea might be appealing to some.”

Lukavec also believes it may be unwise to overlook the value which traditional banking institutions bring to the financial system more generally.

“Having a central bank that does the job of commercial banks might be a safer setup than what we have right now,” said Lukavec. “But commercial banks are extremely important to the economy – they channel savings to investment and while doing so, they assess how creditworthy individual businesses and individuals are.”

He added: “Leaving this job to a public institution with no competition involved doesn’t seem like a good idea.”

However, competition in the banking sector would only be completely abolished if the most extreme version of a CBDC was implemented: “the [UK] CBDC could also be designed in a similar way to what we have now: a currency with multiple issuers operating under a license by the central bank,” said Lukavec.

Some commentators, such as The Bank Policy Institute, have claimed that a very widely adopted CBDC could increase the chance of payments failure due to concentration risk. The current UK banking system contains a variety of “payment rails”, so if one variety of payment fails, then another, such as the large networks owned by Visa or Mastercard, would be able to serve as a backup. However, CBDCs would need to be sufficiently popular for this to be the case, which is unlikely in the short term.

The centralisation which CBDCs could bring could raise the risk of cyberattacks to the financial system, as the CBDC’s supporting infrastructure would become a significant target for both profiteering criminal gangs and state actors, according to the Bank Policy Institute.
Data privacy concerns are some of the most harrowing potential issues of introducing a UK CBDC, particularly for those who distrust government.

“The central bank knowing about all transactions comes hand-in-hand with major implications for government oversight,” said Lukavec. “This setup gives immense power to the central bank.”
He added: “It’s not surprising, then, that a technologically-savvy but undemocratic regime like China is already pursuing this path.”

The Center for a New American Security, a cross party US think tank believes the Chinese CBDC could: “Enable the Chinese Communist Party to exercise greater control over private transactions, as well as to wield punitive power over Chinese citizens in tandem with the social credit system.”

With such a large amount of the UK workforce employed in financial services – approximately 1.1 million as of Q1 2020 according to Parliament statistics - job losses could also be a factor to consider when discussing whether to implement a CBDC.

“The real risk is for jobs, as digital currencies will take away some of the friction of transactions and payments, it would also take away some of the manual jobs performed by bankers, and other middle and back-office personnel” said Ran Goldi, chief executive of First DAG.

When could we see a CBDC introduced in the UK?

There are certainly potential incentives for the UK to begin exploring CBDCs, and the actions of the current government seem to indicate an open mind to the idea, as it is already fully in the process of hiring for its CBDC taskforce according to online jobs advertisements. The bank has also appointed a director of central bank digital currency.

However, a fully implemented digital pound could be a little time off.

Thomas Cattee, a white-collar crime lawyer at Gherson Solicitors, said the introduction of a CBDC “would take years.”

Though Cattee acknowledged that the pressure of international competition could speed up the roll-out, adding: “it could be spurred on by the fact that China - for example - is taking the lead here.”

“As with any potentially game-changing new technology, the first implementer may claim certain advantages,” he added.

Ossie Amir, chief of staff at payments platform Volt, said: “it may be up to five years before we see any meaningful roll-out plans."

Nilesh Vaidya, retail banking industry leader for Capgemini Financial Services, believes we will see “large pilots in 2024 to 2025” and an “initial rollout in 2026 to 2027” in the UK.

With CBDCs gathering such a large amount momentum worldwide, a key factor the UK financial services industry may need to consider is not whether a UK CBDC will eventually be implemented but the role it will take.

“What really needs to be decided is what mix between the three forms of money is chosen: central bank deposits; bank money; or a form of digital cash,” said Lukavec from LSBF. “There seems to be a preference for some mix of bank money and digital cash.”

He added: “In any case, even more important is to plan carefully how this new form of digital money is introduced and reaches consumers.”

It did not take long for cryptocurrencies to go from being practically unknown in the mainstream media in 2017 to becoming a largely legitimate part of the financial system in 2021.

Coinbase recently posted a record $100 billion initial public offering on the Nasdaq, while a range of major cross-industry players from JP Morgan to Tesla and Visa have been willing to incorporate crypto-currency into their business models.

With the rapid change of pace in 2021, new technologies and concepts can become established practi-cally overnight.

Regardless of whether a CBDC is implemented in the UK, with the amount of interest the concept is seeing internationally, and fierce pressure on the City of London to remain competitive, a digital pound is something which the UK financial services industry needs to start planning for soon.

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