Digital pound – revolution or damp squib?

Digital pound – revolution or damp squib?

Money evolves over time. From coins to banknotes, cheques, credit cards, online banking and mobile payments, the search is always for cheaper and more convenient ways of using money. The computer age has turned the bulk of money issued by central banks into digital form. In the UK the share of transactions accounted for by cash has fallen from 55% to 15% over the last decade.

• In their early days cryptocurrencies appeared to offer a potential alternative to central bank money. But wildly fluctuating values and uncertainties about governance mean that they are mainly used for speculation than transactions.

• A simple innovation aims to crack these problems. The value of stablecoins is linked to a benchmark asset, generally an existing currency or a commodity. In 2019 Meta (then Facebook) caused a stir when it announced a plan to create its own stablecoin, Libra, linked to the dollar and other currencies. The prospect that Meta could create a credible, mass-use private currency unnerved central banks and prompted intense scrutiny from regulators. The backlash led to many of the original founder companies leaving the Libra Association. Renamed Diem, the project was wound down last year, and then sold to a Californian bank due to regulatory obstacles.

• Diem may have failed, but the threat it posed to traditional money has acted as a wake-up call to central banks. Their fear was that a successful private currency, issued by one of the world’s biggest tech companies, would undermine the power of central banks and weaken their influence over monetary policy. 

• Central banks around the world have stepped up planning for their own central bank digital currencies (CBDCs). 114 countries, representing over 95% of global GDP, are currently exploring CBDCs. All G7 countries are in the development stage and 11 countries have launched digital currencies. China’s, the largest, reaches quarter of a billion people and is scheduled to expand to the whole country this year. The governor of the European Central Bank, Christine Lagarde, has said that they would like to see a euro CBDC in operation within two years.

• Last month, the Bank of England released its proposal for a digital pound. The document illustrates the potential and the perils of CBDCs.

• The proposed pound would be a token-like digital instrument that would need to be held in a digital wallet provided by banks and other approved institutions. It could be spent or transferred online, through smartphones or cards, as is the case today with conventional bank deposits. The Bank of England would provide the central digital infrastructure to facilitate transactions in digital pounds.

• Every digital pound would be a direct claim on the Bank of England, unlike the current system in which money put into a bank can be used by the bank to create more money to lend on. Under the Bank of England’s proposal, the wallet provider would merely record and facilitate the holder’s use of the CBDC - the provider would not be able to use the deposit to create credit.

• Imagine then a world in which digital pound existed. Since central banks cannot go bust – they have the magical capacity to create money without limit – many people would shift money from riskier banks to the safety of the Bank of England. That would leave the commercial banks with fewer deposits to create credit. Unless they borrowed on wholesale money markets, which is expensive, banks’ ability to lend would be eroded. The traditional fractional banking system would be at risk, especially in times of uncertainty when deposits would flow away from the commercial banks to the digital pound.

• To avoid such an outcome, the Bank of England proposes limiting holdings of digital pounds at £10,000 to £20,000. In addition, households’ and corporates’ holding of digital pounds at the Bank of England, unlike those of the commercial banks, would receive no interest. With the base rate at 4.0%, and some banks offering instant access accounts with rates of over 3.0%, that would blunt the appeal of the digital pound. As the Economist notes, to protect the existing banking system, “these changes would, by design, make CBDCs an inferior form of money”.

• Since they would operate alongside the current banking system, be similar to how we use digital money now and wouldn’t pay interest, what are the benefit for consumers of a CBDC?

• Probably the most compelling is that it could help reduce transaction costs. The UK Payment Systems Regulator has estimated that the average transaction service cost charged to merchants is at about 0.6%, rising to around 1.9% for small businesses. CBDCs would reduce counter-party risk and would be transferred instantly and securely without the need for intermediaries such as banks or payment processors. This could reduce the transaction costs involved in digital payments, especially for small businesses. The creation of a digital pound could help spur innovation and competition among existing payment providers, driving down costs. Set against this, central banks would need to create and run a major new payments system, a very costly and complex ventures.

• To their advocates CBDCs will also improve access to digital payments for the 4% of the population without bank accounts. Sceptics respond that CBDCs do not solve the problems of financial and IT literacy and stop some people from opening bank accounts.

• A House of Lords Economic Affairs Committee Report published in January identified four potential risks from the introduction of a CDBC: state surveillance of people’s spending; a risk of financial instability if people flee bank deposits for the safety of CBDCs in times of stress; an increase in central bank power without commensurate scrutiny and a centralised point of failure that would become a target for hostile nations and criminals. The Committee concluded that it had “yet to hear a convincing case” for why the UK needs a retail CBDC.

• Yet a head of steam is building behind CBDCs around the world. More countries will follow the lead of the 11 that have so far introduced them. The rest of the world will be watching their experience closely. Digital central bank currencies could be the next great step forward in the history of money – or a footnote to it.

PS: If you would like to read more on the Bank of England’s digital pound proposal, my colleagues at Deloitte have produced a neat summary, which you can find here:  https://emearegulatorystrategy.deloitte.com/post/102i7iv/the-digital-pound-one-step-at-a-time

For the latest charts and data on health and economics, visit our Economics Monitor:
https://www2.deloitte.com/uk/en/pages/finance/articles/covid-19-economics-monitor.html

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week down 2.5% at 7,748. Financial stocks came under pressure as concerns grew about the fallout from the failure of Silicon Valley Bank (SVB) in the US.

 Economics

• SVB was taken over by regulators following losses of $1.8bn on the sale of approximately $21bn in securities that it sold to raise cash. The bank’s failure, the second largest in US history, spooked investors who worried that other banks may face similar headwinds. Bank stocks sold off on both sides of the Atlantic 
• Over the weekend US regulators and policymakers worked to avoid a wider economic and financial fallout from the failure of SVB. Regulators said on Sunday that they would auction the bank
• The UK Treasury said on Sunday that it was planning to help technology firms exposed to SVB with short-term operational and cash flow needs  
• US Fed chair Jay Powell said that the Fed would be prepared to return to larger interest rate hikes to control inflation, adding that “the ultimate level of interest rates is likely to be higher than previously anticipated” due to recent strong economic data
• The US economy added a greater than expected 311,000 jobs in February although the unemployment rate rose marginally to 3.6%. Wage growth slowed, leading investors to moderate their expectations for additional interest rate hikes by the Fed
• The UK economy grew by 0.3% in January following a contraction of 0.5% in December
• The UK government announced that it would delay the construction of the Birmingham to Crewe and central London sections of the HS2 railway to save costs. A number of road schemes were also delayed
• UK chancellor Jeremy Hunt is reportedly considering tax breaks for business investment in this week’s Budget. Rates of corporation tax are set to increase sharply
• UK regulator the Financial Conduct Authority estimated that 356,00 mortgage borrowers could face payment difficulties over the next year, lower than an estimate of 570,000 last September
• The government of South Korea has faced a backlash over its proposals to increase the maximum length of the working week from 52 to 69 hours
• Chinese exports and imports were sharply down in the first two months of the year, reflecting lingering COVID disruption and slowing in the global economy

 Business

• Carmaker Volkswagen is prioritising a new battery plant in North America over one in eastern Europe due to subsidies under the US Inflation Reduction Act, the FT reports
• The UK is set to design Australia’s first generation of nuclear-powered submarine under the ‘AUKUS’ deal, the Telegraph reports
• The UK rail union RMT called off strike action planned for this week following a new offer from Network Rail
• Research by Citigroup found that UK shares trade at a 40% discount to US shares based on price-to-forward-earnings ratios, a record Anglo-American valuation gap
• UK baker Greggs reported 23% sales growth last year despite cost of living pressures

 Global and political developments

• Russia launched fresh waves of missiles at targets across Ukraine. The attacks included hypersonic missiles that Ukraine’s air defences struggle to counter
• The EU and US conducted talks over a possible free-trade style agreement in a bid to ease European concerns over the impact of subsidies for green technology in the US Inflation Reduction Act
• The US imposed sanctions on five Chinese companies that it accused of supplying parts to Iran to make drones that are being used by Russia in Ukraine
• US Republican speaker of the House of Representatives Kevin McCarthy will meet with Taiwanese president Tsai Ing-wen in the US. Mr McCarthy denied that the choice of venue reflected whether he would travel to Taiwan
• Chinese president Xi Jinping was sworn in for an unprecedented third term
• The country of Georgia dropped legislative proposals that would monitor ‘foreign agents’ following widespread protests

 And finally… last week NASA announced that it was monitoring an asteroid that has a small chance of hitting the earth on Valentine’s Day 2046 – scared of comet-ment