The Digital Pound A penny for your thoughts

On 7 February 2023, the Bank of England (Bank) and HM Treasury (HMT) issued a consultation paper (Consultation Paper) and a technology working paper (Working Paper) on a proposed model for a digital pound. This follows earlier publications in this area, including a March 2020 discussion paper on a central bank digital currency (CBDC), as well as a June 2021 discussion paper on new forms of digital money (see our briefing here). This is against the backdrop of increasing activity in relation to CBDCs globally in light of the emergence of new forms of digital money (such as stablecoins).

Approaches and motives for CBDCs vary from country to country. The focus of the Consultation Paper and Working Paper is a retail CBDC. An intermediated or partnership approach between the Bank and the private sector - employing a platform model - is also favoured. For firms operating in the payments sector, the Consultation Paper and Working Paper provide useful information in relation to next steps and possible involvement. However, development of a digital pound is still in the early stages and it will not be until the second half of this decade that we would see a digital pound emerge.

What is a CBDC?

CBDCs are a type of digital money that are issued and backed by a central bank. They are an entirely digital form of the coins and banknotes we use in physical form today and represent a direct claim on (or liability of) the central bank – unlike commercial bank money which is a liability of that commercial bank. A retail CBDC is a digital form of central bank money, denominated in the national unit of account, distinct from electronic reserves (which cannot currently be accessed by individuals), and physical cash. CBDCs are also different from privately issued digital currencies, such as stablecoins, which are a liability of private entities.

A CBDC is often thought of in two parts: (1) the CBDC itself, that is an instrument issued by the central bank that can be transferred as a means of payment or held as a store of value; and (2) the broader ecosystem in which a CBDC operates, including the supporting infrastructure that allows CBDC balances to be managed and payments made.

So, what's the big deal?

In recent years, the emergence of new forms of digital money (both private and state-backed), developments in technology (Web3.0 and the metaverse, the Internet of Things and programmable money etc) and increasing reliance on digital payments have encouraged central banks to consider issuing their own digital currencies. Over 90% of the world's central banks are working on CBDCs. For example, in January 2022, the Federal Reserve (i.e. the central bank of the United States) published a policy framing paper exploring the implications of, and options for, issuing a U.S. CBDC.

Under the UK presidency of the G7 in 2021, a set of public policy principles for CBDCs were agreed. These principles emphasise that any CBDC:

• must not compromise financial and monetary stability;
•  should coexist with, and complement, existing forms of money; and
• should promote innovation and efficiency in payments.

At the EU level, the European Central Bank Governing Council is expected to conclude its investigation phase in relation to a retail digital euro that would complement cash in autumn 2023. The European Commission is expected to publish a legislative proposal in relation to a digital euro in 2023. Alongside a CDBC, the EU is looking at enhancing digital infrastructures for the settlement of transactions between banks in central bank money.

Other states, including most notably China, have launched CBDCs already.

The Financial Stability Board is also looking at the use of CBDCs to enhance cross-border payments and interlinking CBDCs.

What has the UK being doing, then?

Quite a bit. In addition to the public policy principles on CBDCs referred to above, the Bank has issued several papers in relation to digital money and CBDCs. It also set up a CBDC Engagement Forum with HMT (further details are available here), meeting periodically with key stakeholders to discuss key issues in relation to the design of a digital pound.

Why is the UK considering introducing a digital pound?

Due to ongoing trends in money and payments (e.g. declining cash use and new forms of private digital money), the Bank and HMT consider it likely that there will be a future need for, and benefits from, a digital pound and state the following primary motivations for exploration of a digital pound:

1. to sustain access to, and promote the usefulness of, central bank money thereby ensuring its role as an anchor for confidence and safety in the UK's monetary system; and
2. to promote innovation, choice and efficiency in domestic payments.

Other motivations cited in the Consultation Paper include supporting financial inclusion and improving domestic resilience and cross-border payments.

It has also been expressed by others that central banks need to plan for and consider a CBDC as a defensive mechanism. States need to be prepared to compete in the CBDC arena if local and global trade and customs move that way, which is expected in some industries sooner rather than later. Failure to have a compatible CBDC could lead to a loss of sovereignty over monetary policy, the potential to be shut out of global market infrastructures in times of conflict or geopolitical events and a potential shift in world orders.

What stage are we at now in the UK ?

The Consultation Paper and Working Paper represent the end of the research and exploration stage of the work on a digital pound (Phase 1). The Bank is now intending to move to Phase 2 (the design phase) and this will involve developing the model (in technology and policy terms) of the digital pound. The Consultation Paper and Working Paper set out the proposed model for the digital pound and seek views on the model.

What is the Bank aiming to achieve in Phase 2 (the design phase)?

The Bank will develop a comprehensive architecture for a digital pound and associated experimentation and proofs of concept in partnership with the private sector.

The Bank is hoping to:

• lessen lead times on development and gain knowledge and capabilities to move into the build phase should there be a decision to introduce a digital pound;

• work out the technological feasibility and investment needed to build a digital pound;
• set out in detail what technology and operational architecture for a digital pound would look like;
• assess and evaluate the benefits and costs of the digital pound architecture;
• broaden/deepen the Bank's knowledge of CBDC technology and the private sector's understanding of its technology approach;
• support the development of the broader UK digital currency technology industry through experimentation and proofs of concept; and
• provide the basis for a future decision on whether to introduce a digital pound.

The legal basis for the digital pound would be determined alongside consideration of its design.

What would happen in the build phase of the digital pound?

If the Bank decides to move into the build phase, it would involve developing a prototype digital pound technology in a simulated environment and then moving into live pilot tests. A digital pound would only be launched if it fitted the Bank's exacting standards concerning security, resilience and performance.

What is the proposed model for the digital pound?

Based on the Bank's primary motivations for potentially introducing a digital pound as summarised above, the Bank has identified the following key criteria for a digital pound model:

• to ensure that central bank money acts as the anchor of monetary and financial stability, the model should ensure access to financially risk-free central bank money, a direct end-user claim on the Bank and settlement finality for any transactions. The CBDC should be interoperable with other forms of money, particularly cash and bank deposits; and
• to support innovation, choice and efficiency, the model should be extensible and flexible, reflecting the fact that the future payments landscape is innovative and dynamic. The model should ensure a standard of operational resilience necessary for major national infrastructure.

The Bank is proposing a platform model consisting of the following components which it considers meets its key criteria:

• Bank core ledger and infrastructure: the Bank would provide a fast, highly secure platform which provides payments functionality (but which would crucially not provide the Bank with access to users' personal data) and which enables payments made between users to be processed and settled by a transfer on the Bank's core ledger.
• Private sector intermediaries (Payment Interface Providers (PIPs) and External Service Interface Providers (ESIPs)): authorised and regulated firms would provide user-friendly interfaces between the user and the Bank's core ledger (PIPs would initiate payments and provide interactions relating to payments while ESIPs would provide non-payment related value-add services).

The intermediaries would be responsible for interacting directly with users and would be responsible for recording the identity of digital pound users and carrying out any relevant Know Your Customer (KYC) and Anti-Money Laundering (AML) checks. They would provide digital pass-through wallets (that is, wallets that simply pass instructions from the user to the Bank's core ledger – see below for further details) and would never be in possession of users' digital pounds so would not pose counterparty or credit risk to users.

PIPS and ESIPs would be robustly but proportionately regulated to ensure resilience, continuity of operations and protection of customers but they are unlikely to need extensive prudential regulation. In addition to regulatory requirements, the Bank is likely to impose principles for operation for PIPs and ESIPs, including technical standards (for example, the digital pound infrastructure would be required to be operational on a 24/7 basis).

• Application Programming Interface (API) layer: this would enable PIPs and ESIPs to access the Bank's core ledger functionality in order to allow them to integrate their current and future payment services with the digital pound and build overlay services that would make the digital pound more usable and useful
• Users: end-users would register with PIPs in order to access the digital pound.

What are digital pass-through wallets?

Digital pass-through wallets would allow users to hold and use the digital pound, which would always be a direct liability of the Bank. This contrasts with other types of wallet where the user's funds are held as a claim on the wallet provider/held in custody by the wallet provider. Under the proposed framework, wallet providers (i.e. PIPs) would need to provide a certain minimum functionality:

• customers must be able to register on the digital pound ledger and open a wallet;
• wallets would need to allow users to easily make and accept payments from merchants to other users, and commercial bank accounts, as well as switch digital pounds into cash;
• users must be able to view their activity; and
• customers must be able to switch easily between wallet providers and, if desired, close their wallet.

What about a wholesale CBDC for the UK?

As stated above, the Consultation Paper and Working Paper relate to a retail CBDC. This contrasts with a "wholesale CBDC" which would be used to settle high-value payments, typically between financial institutions. Innovation in UK wholesale payments is primarily being progressed through the Bank's Real-Time Gross Settlement (RTGS) Renewal Programme (pursuant to which the Bank is renewing its RTGS system – which is the infrastructure that holds accounts for financial institutions - to support more efficient wholesale settlement in central bank money). The Consultation Paper notes that the digital pound's support for greater efficiency in retail payments would complement the Bank's efforts to enhance wholesale payments through RTGS renewal.

The Bank currently allows for wholesale settlement through the Clearing House Automated Payment System (CHAPS) and its RTGS service. The balances held within the RTGS service constitute a form of wholesale central bank money. The Bank and other bodies have been looking into enhancing wholesale settlement in central bank money and the Bank considers that a wholesale CBDC would enhance innovation and experimentation that is occurring through initiatives such as distributed ledger technology (DLT) based exchanges and settlement systems involving the issuance and trading of tokenised financial securities. Three approaches are discussed in the Consultation Paper: (i) enhancing existing systems; (ii) enabling private sector innovation; and (iii) establishing a wholesale CBDC platform. So far as enhancing existing systems is concerned, the Bank's renewal of its RTGS service would see the delivery in 2024 of a modular core settlement engine based on open standards (including ISO 20022 for messages). It has published a consultation response paper in relation to developing a roadmap for RTGS beyond 2024 to enable greater digitisation of wholesale settlement.

For the time being, the Bank has committed to an investment plan for renewing RTGS that will take it up to the middle of this decade; there is no shifting away from this. It is hoped the existing work will be able to bridge into digital asset platforms either directly, through new payment systems or through other forms of digital money, such as private stablecoins or digital deposits. There is little prospect of the Bank spending money on a completely new infrastructure for wCBDC while the current RTGS renewal and New Payment Architecture work is ongoing, but that is not to say how these plans may evolve in the future.

Are there any other key considerations relevant to a digital pound?

The Consultation Paper states that rigorous standards of privacy and data protection would accompany the digital pound and sets out the following design objectives for the digital pound:

• neither the Government nor the Bank would have access to the digital pound users' data, except for law enforcement agencies under limited circumstances prescribed in law;

• a digital pound would not be anonymous because the ability to identify and verify users is needed to prevent financial crime;
• users would be able to choose from a range of wallet services and varying levels of identification would be accepted;
• users should be able to vary their privacy preferences to suit their needs; and
• enhanced privacy functionality could result in users of the digital pound securing greater benefits from sharing their personal data.

Under the proposed framework, all UK residents would be able to hold and use the digital pound and non-UK residents would be able to hold and use the digital pound when visiting the UK and when outside the UK for payments with either a UK or a non-UK resident. Non-resident access would involve: (i) a recognition regime to determine which non-UK PIPs and ESIPs could offer the digital pound wallet and services; and (ii) UK authorities reserving the right not to grant access to the digital pound for non-residents from high-risk jurisdictions (e.g. by looking at the Financial Action Task Force's list of countries judged as having weak regimes to combat AML and the financing of terrorism).

The Consultation Paper notes that payments in digital pounds may involve a variety of devices including smart devices, smart cards, e-commerce and point of sale. Users would likely make digital pound payments using smartphones or cards. Although in-store online and person-to-person payments would be the initial focus of the digital pound, this may broaden in the future. The Bank would place some limits on holdings of digital pounds during the introductory period, with a limit of between £10,000 and £20,000 per user. There may also need to be restrictions on corporates' holdings of digital pounds but such limits are subject to further research. These limits are to monitor and mitigate any negative effects on the broader financial system.

How would a digital pound fit in with stablecoins?

In contrast to CBDCs such as the potential digital pound, a stablecoin would not be a claim on a central bank and sometimes is not even a claim on the issuer. They constitute private money. Stablecoins aim to maintain a stable value, typically against fiat currencies, by holding assets to back liabilities.

The Consultation Paper states that the risks of new types of money such as stablecoins need to be managed robustly. It states that stablecoins could play an increasingly important role in retail payments, noting that the Financial Policy Committee has already set out two expectations for stablecoins that are to be used as money-like instruments in systemic payment chains: (1) that payment chains that use stablecoins should be regulated to standards equivalent to those applied to traditional payment chains; and (2) that stablecoins should have standards equivalent to those that apply for commercial bank money in relation to stability of value, robustness of legal claim and the ability to redeem at par in fiat currency.

The Bank is working with the Financial Conduct Authority and HMT to introduce a regulatory framework for systemic and non-systemic stablecoins via the regulation of digital settlement assets in the Financial Services and Markets Bill 2022-23 (see our briefing here).

It is argued that in a mixed payments economy, a digital pound could coexist with and complement a systemic stablecoin. The Consultation Paper argues that stablecoin regulation would need to consider the implications of any similarities and differences between stablecoins and the digital pound in order to ensure coherence in the approach to monetary and financial stability risks and to prevent regulatory arbitrage.

What about the Working Paper?

Whereas the Consultation Paper is consulting on the policy objectives and high-level design for a UK CBDC, the Working Paper considers the technology implications of the policy objectives and the economic and functional design choices set out in the Consultation Paper. The Working Paper is not a consultative document as no decision is being made on a specific proposition. Instead, it sets out the Bank's early stage thinking on CBDC technology and seeks feedback on the potential approaches to important technology considerations. The technology implications discussed are not exhaustive and will be tested and developed further in the design phase of work.

The Working Paper explores the following six technology design considerations which organise and guide the Bank's work on CBDC technology:

1. Privacy: the CBDC system should be designed to protect user privacy while allowing PIPs and ESIPs the minimum necessary access to transaction data to provide CBDC services and to fulfil their legal and regulatory obligations.
2. Security: the CBDC system should identify and guard against security risks. For example, a CBDC may be a potential target for cyber threats. Security risks could also increase due to additional functionality of a CBDC and the number of ecosystem participants. The Bank would be responsible for managing the security of the core ledger and API layer and PIPs and ESIPs would be responsible for managing the security of their own components.
3. Resilience: the CBDC system should be resilient to disruption. The Bank has established preliminary resilience requirements for a CBDC including operating 24/7 and a target uptime of at least 99.95%.
4. Performance: the CBDC system should be able to handle a high number of transactions and confirm and settle transactions as quickly as possible. The Bank estimates that throughput of approximately 30,000 transactions per second, and confirmation and settlement in under one second, might be needed. However, as innovation occurs and potential CBDC use cases develop, demands on CBDC throughput may increase so the Bank intends to explore capabilities of up to approximately 100,000 transactions per second.
5. Extensibility: the CBDC system should have an extensible design (i.e. the ability to add new functionality to the system and modify existing functionality) which allows PIPs and ESIPs to implement additional functionality without affecting user services.
6. Energy Usage: the CBDC system should be energy efficient and designed in a way which minimises any impact on the environment. The Working Paper states that a UK CBDC would not use the energy-intensive technologies used by some cryptoassets and that it would need to make use of renewable energy.

Although there are other technology considerations to take into account, the Bank considers that these six are priorities and they will therefore provide a basis for testing architectures and solutions, and evaluating design trade-offs. The considerations raised in the Working Paper will be examined further in the design phase.

The Consultation Paper states that the platform model is agnostic to many technology decisions. For example, the core ledger might be centralised or might use DLT. The Working Paper notes that use of centrally governed, distributed database technologies might be a more efficient and appropriate approach than use of DLT solutions but the Bank will continue to assess a range of different approaches and will closely monitor ongoing developments in ledger technology.

Concluding thoughts

Despite the publication of the Consultation Paper and the Working Paper, it will be a long time before a digital pound is introduced. The Consultation Paper explicitly states that the earliest a digital pound would be introduced is in the second half of this decade. It is also clear there is still a vast amount of work to be undertaken to inform any decisions about the introduction of a digital pound and the appropriate form, function and infrastructure that should be adopted for its use. For example, throughout the Consultation Paper and the Working Paper there are frequent references to further work, research, input, discussion, consultation, consideration, analysis, evaluation, examination, exploration, investigation, assessment, experimentation and testing that will need to be undertaken in relation to a wide range of areas (including substantial areas such as law, regulation and operational requirements) prior to any decision being taken on whether or not to introduce a digital pound.

The cost of introducing a digital pound and the scale of disruption that could be caused to payments systems and the financial markets is also not clear and it is possible that there may not be the appetite to pursue a digital pound once these and related factors are known, especially if such costs and disruption do not outweigh the benefits of a digital pound which are also yet to be established. For example, in contrast to some other countries (including countries that explore CBDCs for financial inclusion purposes), the UK financial services sector and payments infrastructure is well-established, accessible, stable and functions smoothly so there may ultimately need to be a compelling reason for the introduction of a digital pound in order to justify the significant, costly and lengthy disruption to payments systems and the financial markets that would likely be caused.

Although there are examples of CBDCs which are already being used in some countries, there are no examples of a CBDC that has been used at scale. It is therefore difficult to predict whether a digital pound would be warranted and the potential practical benefits it could provide. Even if there were examples of CBDCs being used at scale, the read-across from such examples to the digital pound would likely be limited. This is because the design of CBDCs can vary considerably and will be informed by policy decisions and the markets in which they are intended to be used within. The UK has a leading payments and financial markets infrastructure, which is already undergoing significant investment and modernisation. It is entirely feasible that this work will be more than sufficient to enable the UK to keep pace with developments and innovations in this area, with the digital pound ready to emerge if and when needed. In this context, it makes sense that the Bank and HMT are effectively hedging their bets by adopting a "wait and see" approach in respect of how the payments industry and the broader digital assets and digital money industry evolves in coming years whilst simultaneously undertaking extensive further work into the introduction of a digital pound so that operational readiness is present if and when it makes sense to implement a digital pound system.