The Digital Pound

By Ketaki Ingale

Introduction 

Central Bank Digital Currency (CBDC) is an electronic form of retail central bank money,  differing from traditional physical forms such as banknotes. CBDCs serve the same functions as traditional central bank money and hold identical value. The push for CBDCs has gained momentum due to the rapid rise in  digital payments - with roughly nine in ten consumers in the United States and Europe reporting that they have made some form of a digital payment within the past year.

It is important to note that CBDC should not be confused with cryptocurrency or other forms of unbacked crypto assets, which are provided by private firms or individuals, and have volatile purchasing powers due to their extrinsic value. 

Significance 

Before continuing, it is important to acknowledge the significance of the digital pound and other digital currencies. Currently, over 130 countries, representing 98% of the global GDP, are actively developing retail CBDCs. This includes major economies such as the USA, UK, China, Japan and India. Among G20 nations, 19 out of 20 are in the advanced stages of CBDC explorations. The implications of CBDCs for both national and global economies cannot be ignored.

Furthermore, the significance of digital currencies, such as the digital pound, has been underlined by numerous financial institutions. The World Bank has highlighted  the importance of CBDCs to countries with minimal cash use, which aims to ensure that the state’s ability to issue money remains intact.  The International Monetary Fund has commented on the benefits of CBDC with regards to monetary policy implementation. Central bank digital currency has been described as “the safest digital asset available to the general public.” by the Federal Reserve. Similarly, the Bank of England’s 2023 consultation paper on the digital pound emphasises the need for “modern forms of money and payments” to adapt to the changing needs of individuals and businesses. 

It is evident that the impacts of CBDCs will be unavoidable, and will profoundly impact both the global economy, as well as each state’s own economy. 

The Bigger Picture 

Retail CBDCs could be an anchor of economic (financial and monetary) stability. The fundamental purposes of money - serving as a unit of account, a medium of exchange within transactions, and a store of value - depend on monetary uniformity. Uniformity ensures that different forms of money are exchangeable at par (e.g. a bank deposit equaling the value of cash). Without this uniformity, a resulting lack of confidence in the value of the money could lead to a lack of consumer spending, resulting in a reduction of transactions and economic activity, therefore stunting GDP growth.  

 A robust monetary system relies on three pillars to maintain this uniformity: Retail central bank money; wholesale central bank money and regulation and supervision.

Retail central bank money is currently available solely in the form of bank-issued cash, providing direct convertibility with commercial bank money (or “book money”, which is created when banks issue debt). This results in an increase in consumer confidence, due to maintaining financially risk-free money; thereby promoting transactions, even within troubling economic situations.

Wholesale central bank money, often referred to as “reserves,” facilitates interbank transactions across central banks. This allows for uniformity between the deposits made at different commercial banks, as they can be converted to bank deposits at other commercial banks at a rate of one-to-one. This prevents closed loop systems, as consumers can easily make a transaction with another party who holds their money in a different bank. 

Regulation and supervision is mostly targeted towards the wider financial system and  requires commercial banks to be able to meet customer demand when redeeming deposits and converting to central bank money at a rate of one-to-one. 

Today, this uniformity faces challenges. The decline in cash usage and the rise in private digital money, such as “stablecoins,” introduces risks.There is often a lack of clarity if this digital money is issued by technological firms or trustworthy financial institutions. Furthermore, there may be slow or complex convertibility to central bank money, due to the presence of non-bank intermediaries. This may lead to a series of closed looped systems, in which users lack the ability to make transactions outside that particular system (similar to the use of the application “Venmo” that is commonly used within the USA). These issues result in limitations on transactions, due to the lack of uniformity and transferability of money, reducing public confidence in spending and therefore reducing economic activity. 

CBDCs offer a promising solution. By acting as risk-free digital central bank money, they  protect uniformity in digital transactions. The digital pound, for example, could deter reliance on volatile private digital money, strengthen trust in the financial system and support economic growth.The successful implementation of the digital pound could therefore have overall positive impacts on consumer confidence when making digital-based transactions, and promote economic growth.  

Moreover, the digital sterling would increase the efficiency of digital transactions for large firms, allowing them to use the left over resources for investment projects. This would boost investment and increase long term productivity, further stimulating GDP growth.  

Unintended Consequences 

While the benefits of CBDC are considerable, it is essential to remind ourselves that a digital pound could lead to potential issues or unintended consequences which the Bank of England would have to monitor closely.

The ease of transactions caused by CBDC may be used as a tool by money launderers. There is a chance that the transactions may take place on private systems (similar to bitcoin or other crypto currencies) in order to purchase crypto assets and then pass on the assets to other jurisdictions, in order to fund legally grey cross border activities. There could be a possibility that the ease of transactions will aid these schemes. 

However, the negative impacts of the CBDC are not necessarily extreme. 

Traditional central bank currency is already used as a tool within money laundering schemes. Despite the ease of digital transactions due to CBDCs, this does not always  mean that it will be a useful asset to money launderers. The use of blockchain technology within CBDC networks means that there would be an unalterable record of transactions. This, in combination with the knowledge on trends within illegal financial transactions and networks provided by data analytics, could allow for successful monitoring of suspected illegal activity involving the digital sterling. Therefore, it can be argued that the implementation of the digital pound is unlikely to result in an increase of transactions via the black market. 

Another concern is how CBDCs might impact commercial banking and monetary policy. In times of financial instability , banks could experience significant outflows as consumers transfer their bank deposits to digital pounds as a result of an increased demand for non-risk assets. This may lead to banks increasing wholesale funding (banking services that are provided to other banks, financial institutions, large corporations, etc.) as opposed to retail service (banking services targeted towards small businesses and individuals), in order to make up for the loss of individual consumers. Wholesale funding is more expensive, so banks may pass the cost onto consumers in the form of raised prices for services, which may increase bank disintermediation, as some borrowers may switch to non-bank lenders. Private (non-bank) intermediaries are generally less responsive to changes in monetary policy compared to high street banks, which may potentially reduce the effectiveness of monetary policy transmissions and implementations. 

However, bank disintermediation is unlikely to take place in large quantities, so there would not be a significant impact on the cost of banking services, and therefore the transmission of monetary policy. In fact, the use of a CBDC may actually strengthen monetary policy implementations, due to the reduction in the use of private digital money.

Conclusion 

Central Bank Digital Currency has the potential to reshape economic productivity and growth.  By addressing the current limitations on GDP expansion and fostering consumer confidence, CBDCs - if implemented correctly and with caution - could be instrumental in preserving the state’s role in issuing central bank currency in this new digital age. It is difficult to pinpoint the details of how CBDCs, like the digital pound, will affect our economy, but they promise to be both profound and fascinating nonetheless.