Last week, the Bank of England launched a consultation on a UK central bank digital currency (CBDC) and the regulation of private digital currencies, joining dozens of other central banks around the world who are investigating “digital cash” and some, like the Chinese, who are already trialling it.
Modern digital money that we use for everyday transactions on our credit cards and for online transactions has become increasingly important to the functioning of the economy, accounting for 97% of the circulating money supply. But unlike physical cash and coins, digital money is not created by the central bank or government but by commercial banks. When a bank makes a loan, it creates new, sterling-denominated electronic deposits in your bank account: money. The total “money supply” in the economy is determined by the rate of new loans issued to households and firms and the rate of repayment by those borrowers.
This arrangement is best described as an accident of history. Modern “fractional reserve” money was the product of bankers issuing deposit receipts in return for safekeeping people’s precious metals. It was more convenient to use such notes for payments than the metals themselves, so they took on money-like qualities. Bankers realised they could issue more notes into circulation than they had backed by metals, since people infrequently withdrew their metals, and bank “lending” was born. Today, these deposit receipts are the numbers we see when we look at our digital bank balances.
With the abolition of the gold standard, bank money is no longer backed by anything physical. However, the central bank still has some influence over the money supply since commercial banks must settle payments using “reserves” that they hold in separate deposit accounts held at the central bank. Central banks try to affect the economy through changing the interest rate they charge on lending these reserves.
CBDC would allow households and firms, not just banks, to hold digital money directly at accounts with the central bank. The primary motivation of the Bank of England to examine CBDC appears to be the threat of non-bank digital currencies issued by unregulated entities outside central banks’ purview – the best known are the “crypto-assets” such as bitcoin.
But central banks are more worried about currencies issued by large corporations with billions of users and international reach such as the Diem currency, which is partly backed by Facebook, or redeemable platform tokens that large retail tech companies such as Amazon could issue, backed by the ability to spend on goods the platform sells. As these are generally pegged to one or more state currencies, they are less volatile and have the potential to become “systemic stablecoins”, to use the Bank of England’s terminology, becoming widely used as a trusted form of payment by households and non-financial businesses. The worry is that such stablecoins could draw people’s savings away from the public-private hybrid system we have today and weaken the central bank’s regulatory power.
By creating a CBDC, a central bank would considerably reduce the threat posed by these non-bank currencies. A key advantage would be that public digital cash would never be subject to a risk of a “run” as with commercial bank money and would not require vast taxpayer bailouts for banks at times of crisis or deposit insurance. It would be the safest “store of value” possible, backed by the state itself.
But a well-designed public digital cash could also provide the central bank with a new and potentially highly effective tool for monetary policy. The impact of changes in interest rates would be more direct on households and firms and not reliant on banks making loans, an issue that also came to the fore during the Covid-19 crisis.
Relatedly, during severe economic downturns central banks could directly credit households’ CBDC accounts with new money rather than relying on banks and financial markets passing on the new money created by central banks through quantitative easing (QE) programmes to the real economy. QE has been criticised for pumping up asset prices and contributing to widening inequality. A CBDC could also considerably reduce the costs of implementing a universal basic income-type policy.
A CBDC could also reduce rent extraction by the financial sector and enhance financial inclusion. Currently, banks and payment companies act as middleman in a privatised, cartel-like payments system, charging fees that could be socialised. Public digital cash could be accompanied by the establishment of a public company with the job of providing universally accessible digital cash accounts, and a specific remit to develop payment services to serve those whose needs are unmet by the banking system, including many on low incomes. Digital cash could help to reduce the entry barriers on the payment market and stimulate innovation.
In addition, sterling notes and coins generate so-called seigniorage profits – the difference between the amount central banks receive on issuing money and the much lower cost of printing it. This money ultimately goes to the Treasury as the owner of the central bank. A CBDC would massively scale up these profits, which could help support the public sector balance sheet in the aftermath of Covid.
But a CBDC also has potential drawbacks. It would create direct competition for banks in terms of a place for people to keep their money. This could lead to a loss of funding for banks, affecting their ability to make loans to businesses and households with negative effects on the wider economy. This could be addressed by the Bank of England offering a below-market or zero-rate of interest on CBDC or providing banks with a flexible central bank loan facility that would enable them to expand their lending despite liquidity constraints. The central bank could use this facility to encourage banks to lend to more productive or sustainable sectors of the economy; currently only around £1 in every £10 lent by UK banks supports businesses.
A second concern is privacy. A CBDC would in theory enable the state to monitor digital payments. However, the Bank of England would be subject to the same rules around privacy as any other technology provider, including the General Data Protection Regulation (GDPR). Privacy concerns also need to be counterbalanced by the fact that an increasing amount of illegal activity and money laundering is moving to non-bank digital currencies (notably bitcoin) because of the anonymity they provide.
Public digital cash represents potentially the most profound shift in the monetary system since the introduction of central bank monopoly on notes and coins almost 200 years ago. A well-designed digital cash with appropriate attention to the functioning of the banking system could increase the resilience of the economy, enhance the effectiveness of monetary policy and help reduce unnecessary rent extraction by financial institutions.