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A New Era for Digital Money the Bank of Englands Discussion Paper

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    On 7 June 2021, the Bank of England ("BoE") published a discussion paper on new forms of digital money (the "Discussion Paper"). The Discussion Paper develops the BoE's views on the future regulation of central bank digital currencies ("CBDCs") and other systemic currencies, which it defines as "those that have the potential to scale up and become widely used as a trusted form of sterling-based retail payments". Last week, on 5 and 8 July, the BoE hosted two webinars on the Discussion Paper, one on systemic currencies and one on CBDC, that discussed the BoE's thinking.

    The proposals in this Discussion Paper build on the framework provided by HM Treasury’s proposals, in its consultation paper on stablecoins (the "Consultation Paper") in January 2021 (see our briefing here). In summary, the Consultation Paper considered that, if appropriate standards and regulation could be satisfied, certain stablecoins would have the potential to play an important role in retail and cross-border payments (including settlement), and proposed introducing a regulatory regime for stable tokens used as a means of payment. This regime would cover firms issuing stable tokens and firms providing services in relation to them. The Discussion Paper develops these proposals in application to the areas of financial regulation over which the BoE has regulatory jurisdiction, in particular monetary policy and the regulation of payment systems.

    What will the impact be for cryptoasset service providers?

    As HM Treasury and the BoE are not the primary regulators of financial instruments and payment services providers, both the Discussion Paper and the HM Treasury consultation paper are focused on the regulation of the small proportion of cryptoassets in circulation which most closely resemble, or have the potential to closely resemble, money. The Discussion Paper notes that its proposed regulatory approach to both systemic and non-systemic stablecoins would incorporate aspects of current regimes of the BoE, the FCA and the Payment Systems Regulator (subject to some amendments where necessary).The intermediaries regime would involve an FCA authorisation framework based on payments regulation and would also consist of enhanced requirements where systemic thresholds were met, However, this is not considered in detail as it is outside the scope of the BoE's regulatory jurisdiction.

    Cryptoassets that are treated primarily as non-financial assets or commodities of a sort (i.e. unregulated tokens such as Bitcoin) are outside the scope of these proposals, and so cryptoasset businesses that trade primarily or only in unregulated tokens will not be directly affected by the regulatory scope of these proposals. This approach diverges from the EU's proposals for sweeping cryptoasset regulation through MiCA (see our briefing here), which operates on the basic assumption that cryptoassets are a form of a financial asset or product.

    As a result, the papers are unlikely to directly affect cryptoasset businesses in the UK at present, where their business is primarily focused on offering unregulated cryptoasset trading. Moreover, the papers consider a hypothetical future situation in which a cryptoasset becomes or has the potential to become a systemic currency. This situation has not yet occurred, and so the regulatory considerations in the papers are essentially preparatory in nature. Notwithstanding, both papers demonstrate substantial steps in the development of digital money in the UK and are laying foundations for concrete policy formulation and implementation..

    What does the Discussion Paper propose for stablecoins?

    The Discussion Paper focuses on systemic stablecoins denominated in sterling, which are not created by lending like commercial bank money and which has a retail focus – in other words, mass use on by the public for day-to-day payments and possibly as a store of value. The Discussion Paper does not deal with wholesale focussed digital money or digital money denominated in other currencies.

    The BoE states that any new form of digital money will need to be trusted, similar to commercial bank money, before it is widely used. It considers private stablecoins will only be trusted as both a store of value and an accepted means of payment if they are subject to appropriate safeguards. HM Treasury proposes to bring systemic stablecoins into the BoE’s remit, in line with the BoE's responsibilities for systemic payments systems.

    The Discussion Paper explores the potential models by which it would be possible to regulate systemic forms of digital currency in a way that would meet the following two expectations of monetary systems, developed by the BoE's Financial Policy Committee:

    • First Expectation (Payments): regulation of payment chains should reflect the financial stability risk, rather than the legal form, of payment activities. Regulation should ensure end-to-end operational and financial resilience across systemic payment chains that are critical for the smooth functioning of the economy, including where payment chains are unbundled resulting in a range of firms providing various services to support the resilience and continuity of the entire payment chain. Sufficient information from payments firms should allow monitoring of emerging risks to financial stability, and a stablecoin-based payment chain should be regulated to standards equivalent to those applied to traditional payment chains.
    • Second Expectation (Money Creation and Storage): Where stablecoins are used in systemic payment chains as money-like instruments, they should meet standards equivalent to those expected of commercial bank money in relation to:
      • the legal claim of holders that allows them to redeem their deposits for fiat currency promptly, both in normal times and in stress, for the original amount deposited and at no loss of value to the depositor;
      • the capital requirements on the issuer, imposed to lower the risk of insolvency and to protect the claim of the holders in the case of such an insolvency;
      • the liquidity requirements on the issuer, imposed to ensure that it can meet redemptions of deposits in most circumstances; and
      • a backstop to compensate depositors and ensure that vital payment services are maintained, such as through the FSCS.

    The cautious approach adopted by the BoE is somewhat understandable and consistent with global policy reaction to the rise of the stablecoin business model. The reality is that an ambitious global stablecoin project mixes the characteristics of being a deposit institution and a cross-border payment settlement system in a single concept. Each of these functions is subject to elaborate domestic regimes that are designed to ensure the safety and soundness of the institution and its counterparties/customers, as well as critical services to the wider macro economy. It is clear and obvious that a well thought through stablecoin project offers significant potential efficiencies and progress for the way in which we exchange value and buy goods and services domestically and cross-border. We strongly believe however that the best way to achieve progress in this area is to approve domestic projects that over time may be able to connect and be interoperable with domestic projects of a similar nature developed in other countries.

    The purists would argue that incremental adoption will significantly curtail the benefits of the distributed ledger technology underpinning stablecoin models and the idea that transformative stablecoins will develop their own 'monetary policy' such as is associated with recognised fiat currencies. However, the harsh reality is that this makes an ambitious stablecoin project making claim for some sort of monetary sovereignty whilst lacking any recognition, legitimacy or appropriate governance and stature that is normally associated with a body able to assert meaningful monetary policy. And this is the precise 'pinch point' and the 'holy grail' of the debate.

    Somewhat controversially and a little counterintuitively, the Discussion Paper is good news for banks. The reason for this is that a stablecoin proposal by an existing bank looks a great deal more likely to be endorsed and receive the green light to be launched. The BoE has substantial experience with supervising its existing bank subjects and would be more confident in one or a few of them having the ability to spearhead this transformation. This would be a surprising outcome given the major efforts done at all policy levels to increase the competitiveness of the banking and payment sectors for the very noble reason of reducing systemic risk.

    What is a little surprising is the lack of a coherent statement from the BoE about experimentation with stablecoins in the inter-bank market. We view these projects as a potentially helpful prelude to the roll out of a mass retail product where systemic nerves are much more pronounced.

    Significantly, the BoE has played the 'public benefit' card. The argument is that no matter the size and shape of the potential benefit of a stablecoin proposal, there must be a convincing case that the public benefit outweighs the potential for harming confidence in money and financial intermediation. This is the first articulation of how this principle works for both stablecoin and CBDC and makes for a sober read.

    It is no doubt conceivable that a stablecoin project can be authorised and be made a reality within parameters that will not undermine the ability of the BoE to effectively manage monetary policy and without disrupting money markets and or lending capacity/economic activity. This will surely be greeted with disappointment in certain quarters of the innovation community, though it ought to be the right path to adoption.

    What does the Discussion Paper say about CBDCs?

    The Discussion Paper treats CBDCs as a form of potential future digital money, and so the key proposals of the Discussion Paper apply equally to any future CBDCs as to any systemic stablecoin.

    In addition, the BoE has also published a response to its 2020 paper on CBDC. Its key takeaway is that financial inclusion and creating a competitive CBDC ecosystem with a diverse set of participants will support innovation and offer the best chance to deliver the benefits of a CBDC. However, the BoE did not confirm any certain plans to develop a CBDC at this point, noting that it will need to assess whether non-CBDC payment innovations could deliver the same benefits, more broadly, if the adoption of a CBDC would align with and progress its core objectives of maintaining monetary and financial stability.

    We don't believe it wise for CBDC to create a direct relationship between the BoE as a central bank and the general public. Apart from potentially causing havoc with conventional banking business models that rely on reasonably cheap and plentiful supply of funding from private customers and companies, it will (given widespread adoption) undermine traditional systemic financial infrastructure that would on the face of it be rendered redundant.

    It seems to us that a CBDC ecosystem which enables only a select number of financial intermediaries including banks and eligible Payment Service Providers to directly interact with the BoE as issuer should be the preferred model. In other words, the technological network that will underpin CBDC will be a closed one in the first instance, accessible only through an eligible intermediary. In this regard, we envisage a form of 'sponsored access' system at least in the first phase of roll out of CBDC. Once this phase of the CBDC is successfully accomplished and ramifications for flow of funds and impact on the money market are better understood, attention can turn to the prospects and benefits of further disintermediation. Given the similarities this model has to the existing ecosystem, it should in theory be quicker to launch to market, simpler to adapt and easier to mitigate risks among a closed network of already-regulated participants. Given the progress other nations are making on CBDC and the bold statements the UK is making on the global stage about its commitment to innovation and fintech, now is the time for action.