The Bank of England and HM Treasury are exploring the possibility of introducing a central bank digital currency (CBDC) – a so-called ‘digital pound’ – that would be a new form of money issued by the central bank for everyone to use for day-to-day spending. You would be able to use it in-store or online to make payments, just like you use cash or bank deposits today. But how would the digital pound work and what would be the benefits and challenges of such an innovation?
How Would the Digital Pound Work?
The digital pound would be a digital representation of sterling, similar to a digital banknote, that would be backed by the Bank of England and the Government. It is claimed that it would not be a cryptocurrency or a cryptoasset, as those are issued privately and are not backed by any authority. The digital pound would be denominated in pounds and pence and its value would be stable, just like banknotes. £10 in digital pounds would always have the same value as a £10 banknote.
To use the digital pound, you would need a digital wallet, which is a software application that allows you to store, send and receive digital currency. You could have a digital wallet on your smartphone, computer or other device. You could also have a physical device, such as a card or a token, that contains your digital wallet. You could load your digital wallet with digital pounds by transferring money from your bank account or by exchanging cash at a retailer or an ATM. You could then use your digital wallet to make payments to other people or businesses that accept the digital pound, either by scanning a QR code, tapping your device on a terminal, or entering the recipient’s address. You could also receive payments in digital pounds from others into your digital wallet.
The Bank of England and HM Treasury have proposed a model for the digital pound that involves both the public and private sectors. The Bank of England would issue the digital pound and maintain its ledger, which is a record of all transactions in the system. The ledger would ensure that the digital pound is secure, reliable and transparent. The private sector would provide the interface and innovation for users to access the digital pound. This could include banks, payment service providers, fintech companies and other entities that would offer different types of digital wallets and services to customers. These entities would have to comply with certain standards and regulations set by the Bank of England and other authorities.
How is the Digital Pound Different from the Current System of Banking?
The current system of banking relies on two types of money: central bank money and commercial bank money. Central bank money is issued by the Bank of England and consists of banknotes and reserves (deposits that banks hold at the central bank). Commercial bank money is issued by commercial banks and consists of deposits that customers hold at their banks. Both types of money are denominated in pounds and pence and are interchangeable at par.
When you make a payment from your bank account to another person’s bank account, you are not actually transferring physical money from one place to another. You are simply instructing your bank to reduce your balance and increase the recipient’s balance by the same amount. Your bank then communicates with the recipient’s bank through a payment system, such as Faster Payments or CHAPS, to settle the transaction. The payment system uses central bank money (reserves) to transfer funds between banks. This process involves intermediaries, such as payment service providers, clearing houses and settlement agents, that facilitate the communication and settlement of transactions.
When you make a payment with the digital pound, you are actually transferring digital currency units from one digital wallet to another. The transaction is recorded on the ledger maintained by the Bank of England, which acts as the single source of truth for all transactions in the system. The transaction is validated by the Bank of England or by other authorised nodes in the network, using cryptographic techniques that ensure its authenticity and integrity. The transaction is finalised almost instantly, without the need for intermediaries or settlement agents.
What are the Advantages and Challenges of the Digital Pound?
The Bank of England and HM Treasury have identified several potential benefits and risks of introducing a CBDC in the UK. Some of these are:
- Innovation: The digital pound could foster innovation in payments and financial services, by providing a new platform for competition and collaboration between public and private sectors. It could also enable new features and functionalities, such as programmable money, smart contracts and micropayments.
- Choice: The digital pound could offer more choice and convenience to consumers and businesses, by providing an alternative means of payment that is fast, cheap, secure and accessible. It could also enhance financial inclusion, by reaching those who are unbanked or underbanked.
- Efficiency: The digital pound could improve efficiency in payments and financial markets, by reducing costs, frictions and delays associated with intermediaries and settlement processes. It could also enhance resilience, by reducing operational and cyber risks and providing a backup option in case of disruptions.
- Stability: The digital pound could support monetary and financial stability, by providing a safe and trusted form of money that is backed by the central bank and the Government. It could also enhance the transmission of monetary policy, by allowing the central bank to implement negative interest rates or helicopter money if needed.
However, the digital pound could also pose some challenges and risks, such as:
- Privacy: The digital pound could raise privacy concerns, by creating a trade-off between anonymity and traceability. The Bank of England would have to balance the need to protect users’ privacy and data with the need to prevent illicit activities and comply with regulations. The Bank of England would also have to ensure the security of the system and protect it from cyberattacks and fraud.
- Adoption: The digital pound could face adoption barriers, by requiring users to change their behaviour and preferences. The Bank of England would have to ensure that the digital pound is user-friendly, interoperable and compatible with existing payment systems and infrastructures. The Bank of England would also have to manage the transition from the current system to the new system and coordinate with other stakeholders.
- Impact: The digital pound could have a significant impact on the banking sector and the economy, by affecting the demand for bank deposits, the profitability of banks, the intermediation of credit, the creation of money and the allocation of resources. The Bank of England would have to monitor and mitigate these effects and ensure that they do not undermine its objectives.
The Issue of Interoperability with the Digital Pound
One of the key design considerations for the digital pound is interoperability, which means the ability of different systems and platforms to communicate and exchange information with each other. Interoperability is important for ensuring that the digital pound can be used widely and seamlessly across different payment channels, devices and applications. It is also important for enabling innovation and competition in the payments sector, by allowing new entrants and services to access and use the digital pound.
However, interoperability also poses some technical and regulatory challenges, especially if the digital pound is based on blockchain technology. Blockchain is a type of distributed ledger technology (DLT) that records transactions in a secure and transparent way, without the need for a central authority or intermediary. Blockchain can enable faster, cheaper and more efficient transactions, as well as new features such as programmability and smart contracts. However, blockchain also has some limitations, such as scalability, energy consumption and compatibility. The Bank of England has not yet decided whether to use blockchain or another type of technology for the digital pound. However, it has indicated that it is exploring a hybrid model that combines a core ledger maintained by the Bank with an API layer that allows private sector providers to access and offer services on top of the digital pound. This model could potentially enable interoperability between the digital pound and other types of money and platforms, such as bank deposits, e-money, stablecoins, cryptocurrencies and other CBDCs.
However, interoperability also requires some common standards and protocols to ensure consistency, security and compliance across different systems and jurisdictions. For example, there may be different legal and regulatory frameworks for different types of money and platforms, such as anti-money laundering (AML), consumer protection, data protection and privacy laws. There may also be different technical specifications and requirements for different types of devices and applications, such as smartphones, cards, QR codes and biometrics. The Bank of England has stated that it will work with other authorities and stakeholders to develop and implement appropriate standards and protocols for the digital pound.
The Issue of Privacy with the Digital Pound
Another key design consideration for the digital pound is privacy, which means the protection of personal data and information from unauthorized access or use. Privacy is important for ensuring that users can trust and use the digital pound without fear of surveillance or exploitation. It is also important for complying with legal and ethical obligations, such as human rights, data protection and confidentiality laws.
However, privacy also poses some trade-offs and risks, especially if the digital pound is based on blockchain technology. Blockchain can offer some level of privacy by using encryption, pseudonymity and decentralization techniques. However, blockchain can also compromise privacy by creating a permanent and public record of all transactions in the system. This could potentially expose users’ identities, behaviours and preferences to third parties, such as governments, law enforcement agencies, hackers or advertisers.
The Bank of England has not yet decided how much privacy to offer with the digital pound. However, it has indicated that it will balance the need to protect users’ privacy and data with the need to prevent illicit activities and comply with regulations. The Bank has also proposed a model that involves both public and private sectors in providing the digital pound. In this model, the Bank would maintain the core ledger and ensure its security and reliability. The private sector would provide the interface and innovation for users to access the digital pound through different types of digital wallets. The Bank would not have access to personal data or transaction details from these wallets. However, these wallets would have to comply with certain standards and regulations set by the Bank and other authorities.
The Issue of Limits with the Digital Pound
A final design consideration for the digital pound is limits, which means the restrictions or caps on how much digital pounds users can hold or transact. Limits are important for ensuring that the digital pound does not interfere with or undermine the existing monetary and financial system. They are also important for managing the potential risks and impacts of introducing a new form of money.
However, limits also pose some trade-offs and challenges, especially if they are too high or too low. If limits are too high, they could reduce the demand for bank deposits or other forms of money, which could affect the profitability of banks, the intermediation of credit, the creation of money and the allocation of resources in the economy. They could also increase the exposure of users to operational or cyber risks associated with holding large amounts of digital pounds. If limits are too low, they could limit the usefulness and attractiveness of the digital pound for users who want to use it for their everyday payments needs. They could also create inefficiencies or inequalities in accessing or using different types of money.
The Bank of England has not yet decided what limits to impose on the digital pound. However, it has suggested that there may be limits on the size of digital pound holdings, but not on how the digital pound can be spent. The Bank has also estimated that an introductory limit of between £10,000 to £20,000 per individual holding would allow most people to use the digital pound for their day-to-day transactions, while minimizing the impact on the banking sector and the economy. The Bank has stated that it will monitor and adjust these limits over time, depending on the demand and behaviour of users
The digital pound is a potential innovation that could transform the way people pay and transact in the UK. It could offer many benefits, such as fostering innovation, offering choice and convenience, improving efficiency and supporting stability. However, it could also pose many challenges, such as raising privacy concerns, facing adoption barriers and having a significant impact on the banking sector and the economy. The Bank of England and HM Treasury have not yet decided whether to introduce the digital pound, but they are consulting with stakeholders and the public on the case for a CBDC in the UK. They are also preparing for its possible future by exploring different models and technologies for the digital pound.