Tentative plans for the introduction of a digital pound have been put forward by HM Treasury and the Bank of England (BoE) as the UK and the City of London looks to retain its position as a global leader in banking and finance.

A consultation just launched will explore the proposals for a central bank digital currency (CBDC) for retail transactions between consumers and businesses. At present, only commercial banks hold accounts directly with the BOE. 

Under this new public-private partnership, consumers would hold CBDC directly with the central bank through third-party wallet providers, providing almost instantaneous settlement times for transactions, lower transaction costs, interoperability with other forms of money (cash and bank deposits) and the prospect of increased security and greater accessibility.

Central banks globally have for some time been considering the potential use case for CBDCs, partly in response to recent technological developments within the crypto sector and the recent consumer shift to digital transaction payment methods.

However, the shift in banking practices away from consumers holding money in cash form or as commercial bank deposits carries potentially seismic risks from a financial stability and monetary policy perspective. As such, the BoE is approaching these proposals with caution.

In particular, the Bank has sought to address privacy concerns through a platform model; wallet providers would hold transaction information in ways similar to existing banking practices, while personal data held by the BOE would be anonymised. However, the implications for real-time settlement require further thought as the absence of a break mechanism in the settlement process could mean that fraudulent payments and errors might be harder to stop and rectify. 

To address some of the financial stability risks of a CBDC due to likely money flows out of commercial banks, deposit limits will be set in the order of £10-£20k. Without a limit, commercial banks might face funding constraints that could increase the cost of borrowing, raise interest rates on lending and reduce access to credit for consumers. The impact would be significant, weighing on the ability of consumers and businesses to borrow and invest.

The BOE has not yet specified the limit that might be set for corporates and businesses, which could be key in determining the extent of any deposit migration out of commercial banks.

The Treasury and BoE have expressed possible risks and opportunities posed by the idea of a digital pound. One of the risks is that widespread use of non-sterling digital money could compromise the UK’s monetary and financial sovereignty. If sterling was no longer the unit of account for a significant portion of UK retail transactions, monetary policy would affect a lower proportion of money in the UK and become less effective at achieving the inflation target.

However, the physical, as opposed to digital, nature of cash means that it is harder to make large payments with, or store large amounts of, cash than it is with digital money, which in itself acts to limit the scale of use in financial crime.

There are also elements that could result in positive or negative outcomes. For example, the UK, as an open economy, could benefit from a digital pound that improves cross-border payments (for example, cheaper or faster payments for international trade or remittances). But a digital pound, or a new form of privately-issued sterling digital money, could also change the structure of the financial system in a way that increases the UK’s exposure to foreign shocks.

A digital currency also raises the prospect of a monetary policy shake-up. Under existing commercial banking arrangements, the BOE’s bank rate is used to set short-term interest rates. By rewarding commercial banks with interest on reserves held on the central bank balance sheet, the BoE is effectively setting the lower bound interest rate for lending in the economy. 

If the demand for the digital pound results in lower deposits held by commercial banks, we may see a reduction in reserves held with the BoE, which could impact the transmission of monetary policy. To keep a check on demand for the digital currency (alongside deposit limits), it will not be rewarded with interest in the same way that commercial banks are on central bank reserves. Commercial banks would then be able to incentivise deposit flows through savings rates on their deposit products.

Undoubtedly, the business models of payments providers, including banks, card schemes and merchant acquirers, will need to adapt to retain market share and insulate against lost revenue. Commercial banks, in particular, currently enjoy a number of benefits through existing means of payment, including transaction data for credit assessments, interest-free funding and cross-sell opportunities to other financial products. 

Gavin Brown, Associate Professor in Financial Technology at The University of Liverpool, says the implementation of a UK CBDC has pivoted from ‘never' through to ‘if’ and now ultimately ‘when’ in just half a decade.

“For an economy led by financial services, the introduction of a CBDC represents a step-change in monetary policy that is so profound that UK policymakers dare not be left behind. For instance, the Chinese equivalent project, the digital yuan (or e-RMB), was released for live public testing in April 2021. The UK is already, therefore, at least five years behind. 

Brown says the prudent and considered approach was to be applauded. “It is better to be right than to be first.” However, the prospect of a digital pound highlights other important issues that would need to be addressed. They include individual cashlessness, financial inclusion, mitigating the shadow economy and tax gap, further potential CBDC deposit limit changes and Financial Conduct Authority deposit protection limits, as well as the potential for running multiple base rates and even CBDC expiry dates. 

“This recent announcement is, on balance, an important milestone in the evolution of British monetary policy and for the UK and the City of London to remain as a global leader in banking and finance,” Brown says. “Nonetheless, it is the thin end of the wedge and it is important that we turn our attention to the many and varied underlying issues that the move to a digital pound could create.” 

• ICAEW will be responding to this consultation and therefore invites members to send their views to ICAEW’s Head of Financial Services, Reuben Wales, at Reuben.Wales@icaew.com