What the UK CBDC could look like
Bank of England’s digital currency model for retail payments
By Frankie Elmquist, Eternic
March 2020 — Following its January announcement that they intend to assess the potential of central bank digital currencies, the Bank of England has released a comprehensive 57-page discussion paper summarizing their process so far: Central Bank Digital Currency: opportunities, challenges and design. The paper provides a framework for a retail use CBDC and a model of how it might work. In this article, we’ll give an overview of the proposed UK CBDC and summary of the opportunities and risks presented in the paper.
Objectives for the UK CBDC
The Bank makes clear that in the case of CBDC, as in all cases, its sole objective is to maintain monetary and financial stability. As CBDC has the potential to support that objective, the Bank finds it worthwhile to investigate how it could benefit, or befall, the existing payments landscape.
“The way we pay is changing, with the use of banknotes falling, and the use of privately issued money and alternative payment methods rising. In this context, the Bank is exploring the concept of Central Bank Digital Currency (CBDC), as are central banks across the world.”
What the CBDC would be
For the purposes of creating a working model of a sovereign digital currency, the Bank is taking the following approach — they have established that the United Kingdom issued CBDC, or UK CBDC would have direct 1:1 equivalency to banknotes, e.g., 1 pound sterling = 1 pound CBDC. Unlike electronic central bank money, which only financial institutions can hold as reserves for wholesale purposes of interinstitutional payments and settlement, CBDC would be available to the public for the retail purposes of making payments and storing value, i.e., saving. The potential of wholesale CBDC is also under investigation, but not in this paper.
The paper also states that CBDC would be “fundamentally different” from cryptocurrency and stablecoins because it would be issued by a central governing body, rather than private entities. As such, it would also be backed by the Bank’s reserves just as regular banknotes are making it “a new risk-free form of digital pound sterling.”
With this working definition, they are working to evaluate which design principles a retail-use CBDC could fulfill, what the various trade-offs might be, and how the CBDC would impact already established systems of spending and saving.
Based on these criteria, the Bank is investigating how a general use UK CBDC would function, how it would be powered, and who would play what role in its operation to create a working model.
How the CBDC would work — a working model
In the model presented in the paper, the UK CBDC would not replace existing currency, but rather exist in parallel with it, operating on its own infrastructure. This infrastructure would take the form of a “public-private payments platform” parallel to the RTGS system. The Central Bank would provide and run the core ledger and CBDC payment processes. Verified private sector Payment Interface Providers (not the same as Payment Initiation Service Providers), under the supervision of the Central Bank, would then connect with the core ledger via an API and could provide the overlay CBDC payment services tailored to meet specific use cases for the end-users.
The Bank would charge a small transaction fee to the Payment Interface Providers. The Payment Interface Providers can develop their revenue model based on services provided and competition, which could include but is not limited to monthly fees and transaction fees.
The types of payments that they foresee a CBDC could enable, include:
- Basic one-off push and pull payments, which can be settled instantly.
- Point-of-sale payments for businesses
- Bulk payments such as payroll or bill payments
- Micropayments to support IoT applications and digital media
- Offline payments, if the technology can be developed to eliminate risk
- Programmable payments which could support cross-currency payment-versus-payment (PvP) or asset exchange delivery-versus-payment (DvP)
The Payment Interface Providers would be authorized and overseen by the Bank of England as “critical providers to important payments systems,” and subject to Financial Conduct Authority (FCA) and UK Payment Systems Regulator (PSR) regulations. The paper states that providing this oversight will require updating the existing regulatory framework to cover digital currency.
What technology the Bank will use to power this infrastructure remains to be seen. The paper presents that distributed ledger technology (DLT), the underlying technology that has made digital currency possible, has potential and is being considered possibly as a whole or as a kit of parts that could form “building blocks.” However, it also states that other more “conventional centralized technologies” are also being evaluated.
Opportunities CBDC could present
The paper presents several opportunities that a CBDC could potentially introduce to improve existing payment systems. These opportunities include providing greater resilience, efficiency, and competition by adding a new payment option to the landscape.
The paper explains that as e-commerce and electronic payments have increased, the use of cash has reciprocally decreased. The majority of electronic payments are currently made via credit card or credit card-backed debit cards. As the use of these types of payments increases, so too does our reliance on that one form of payment; this reduces the resilience of the payment system as a whole. Introducing a CBDC could provide a new and equally stable means of payment.
Another opportunity CBDC could provide is improved efficiency. For example, with card payments, the payment appears instant to the payer, but for the provider of the service or goods, the processing of the card payment can take several days. A CBDC payment, however, has the potential to function like cash, providing instant payment as well as receipt, improving the speed and efficiency of the payment system, as well as liquidity.
Providing an alternative to card payments creates competition, which can drive improvements to both cost and services for end-users. The paper states that CBDC would also offer the opportunity for consumers and businesses to hold and make payments in an e-currency, which would be more functional and convenient than cash in a digital economy. Additionally, they see the opportunity for CBDC to an attractive alternative to private digital currency that is stable, reliable, and easy to use.
The proposed model is for domestic retail payments, which are relatively straightforward. The Bank also sees the opportunity for CBDC to support improvements to the cross-border payments system. They propose that central banks can work together to design CBDCs to be interoperable across payment systems, which could support ‘atomic’ transactions between CBDC systems as well as PvP and DvP transactions.
The paper acknowledges that for any of these advantages to be effective, CBDC would have to be designed to encourage widespread use and acceptance.
Risks CBDC could pose
Enhancing the advantage of CBDC to promote adaption, however, also introduces risks. The paper presents how if CBDC were to become the preferred method of transacting, it could have the opposite effect; conversely reducing payment method diversity, resilience, and competition.
Event though CBDC is to be a parallel and independent system, its success could affect the usage of the existing payment systems. The paper cites that cash use in payments has decreased from 60% to 28% over the last decade in the UK, and the concern that CBDC, in conjunction with other electronic payments could reduce this further. Similar to the Nordics, the decline could decrease where cash will still be accepted, thereby reducing diversity and resilience in the system. In response to this risk, the paper assures that “as long as demand for cash remains, the Bank is committed to meeting this demand.”
The more significant concern presented in the paper is that introducing a CBDC could reduce the amount of cash and deposits in banks, affecting their ability to lend; this could result in similar repercussions reducing the availability and competition in lending and, ultimately, market stability. The Banks Deputy Governor raised this concern in his recent speech on the future of money as well. The paper acknowledges that “some degree of disintermediation is an inevitable consequence of a successful CBDC.” And that the demand for CBDC will have to be managed carefully in conjunction with commercial banks and the design of the CBDC because of its potential effect on balance sheets and credit rates.
For a comprehensive overview of the paper, watch this webinar from the Bank of England:
Call for industry input
The document remains noncommittal on whether or not a UK CBDC will come to fruition. However, it does provide a clear and comprehensive look at the pros and cons of under review. What makes it unique in the context of other government papers exploring CBDC is that they conclude with an invitation for input “from the public, technology providers, the payments industry, financial institutions, academics, and other central banks and public authorities.”
We certainly intend to take up their offer for dialog, not only to move our cross-border payments project forward but the overall electronic payments infrastructure as well. The invitation to respond is open through June 12.
Eternic is a new global payments and settlement platform that uses blockchain technology to enable real-time cross-border transactions between banks. To learn more visit www.eternic.io.
