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The Bank of England’s proposed Central Bank Digital Currency: a step in the right direction for banking innovation?

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The Bank of England is considering introducing a retail Central Bank Digital Currency (CBDC) in order to stay relevant in a rapidly changing digital landscape. A CBDC would present a number of opportunities for the Bank to maintain an open and innovative monetary system while upholding financial stability. However, the Bank faces competition from private digital money, in the form of cryptocurrency. Cryptocurrencies have rapidly gained popularity in recent years and have a number of advantages over a CBDC. These include being more efficient and userfriendly, as well as being decentralized and not subject to government control. Given the competition from cryptocurrency, the Bank of England must carefully consider whether or not to introduce a CBDC. It should weigh the pros and cons of doing so, in order to decide whether a CBDC would be in the best interests of the public.

A Central Bank Digital Currency (CBDC) would be an electronic form of central bank money that could be more widely used by households and businesses to make payments and store value. CBDC is sometimes thought of as equivalent to a digital banknote, although in practice it may have other features that will depend on its final design.

The Bank of England have explored how a CBDC could provide improved settlement and payments in financial markets known aswholesale CBDC, however, their 2020 report The Central Bank Digital Currency ReportOpportunities, Challenges and Design focused exclusively on aretail CBDC; which is the key focus of this review paper. A retail CBDC, the bank claims wouldbe designed to meet the payments needs of households and businesses outside the financial sector(Bank of England, 2020: 7).

The BoE have consequently attempted to create an illustrative retail model in which they have made considerations for 1. a CBDCs economic characteristics (as a new form of central bank money), 2. the functionality and technology used to power a CBDC payment system, and 3. the possible roles of the central bank and private sector in providing parts of the CBDC ecosystem.

Design and implementation of a CBDC by the Bank of England will not only stand as an intervention tool but also secure the central banks sovereignty over monetary policy within the UK. This market power could work to legitimise attempts at financial reform, post the 2008 financial crisis, and in an increasingly unstable economic environment. In the banks main role as monetary policy maker, who are a publicly accountable institution, this puts them in the ideal position to maintain financial stability and confidence in the UK banking system, which is a pivotal responsibility of the Bank of England.

The stability of the financial system is dependent upon the operational resilience of the systems ability to absorb and adapt to economic shocks and disruptions (Financial Stability Board, 2020). The extent to which a CBDC can fulfil financial and economic stability will therefore rest on the success of it as an intervention policy tool for reform providing conditions such as settlement finality, liquidity and integrity (Bank for International Settlements, 2021a). The design of a CBDC is then paramount to its success.

A CBDC could have many benefits including increased efficiency and transparency of payments, as well as increased access to financial services for those who currently lack it. It could also provide a more level playing field for competition in the payments sector. However, there are also potential risks associated with a CBDC, such as cyber security risks and the potential for money laundering and other illicit activities.

The Bank of England is currently working on a CBDC proofofconcept, which is expected to be completed by the end of 2021. This will be an important step in determining whether a CBDC could be viable in the UK.

What role will a retail CBDC play in the UK payments landscape and wider global
financial system?

  • CBDCs would be a new form of money that would exist alongside cash and bank deposits rather than replacing them.
  • CBDCs would require the creation of infrastructure so that it can be used to make payments.
  • A CBDC would offer users another way to pay, which might ultimately be faster and more efficient, with new added functionality.
  • The ultimate benefits of adopting a new payment technology will depend on the competitive structure of the underlying payment system and data governance arrangements.
  • Encouraging greater competition can reduce barriers to entry and boost access to global markets through increased interoperability.
  • Coordinating interoperability is particularly essential in the payments sector.
  • The growth of crossborder payments has been influenced by factors including; manufacturers expanding their supply chains across borders; crossborder asset management and global investment flows; international trade and ecommerce; and migrants sending money via international remittances.
  • However cross border payments can be complex. They can provide more challenges than domestic ones involving various intermediaries, time zones and jurisdictions limiting operating hours, capital control regulations, resulting in long transaction times associated with high fees.
  • CBDCs built on digital identification present the opportunity to improve crossborder payments, and limit the risks of currency substitution.
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Should the UK implement a CBDC and what are the benefits, challenges and risks
involved?

  • A CBDC can help coordinate interoperability among cross border payment structures.
  • A CBDC can promote financial inclusion by increasing access to financial services for unbanked and under banked populations.
  • A CBDC can help address the needs of those at the bottom of the pyramid in financial inclusion strategies.
  • A CBDC can offer interoperability with open payment platforms.
  • A CBDC can provide financial inclusion measures for the public good.
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The Bank of England's proposed Central Bank Digital Currency: a step in the right direction for banking innovation? 5

What are Cryptocurrency’s Competencies, and the Benefits and Risks?

  • Cryptocurrencies offer a host of economic benefits, including low transaction costs, a low level of entry, worldwide speed, and pseudo-anonymity of the transactions.
  • Cryptocurrencies can be used as an alternative currency option, particularly in South American countries to avoid rising hyperinflation.
  • The most popular cryptocurrency by market capital Bitcoin, has been reportedly used as an alternative currency option, particularly in South American countries to avoid rising hyperinflation.
  • Cryptocurrencies are not governed by a traditional central authority, and subsequently not legally enforced by the UK government as a currency, or legal tender.
  • Cryptocurrencies can offer their users many economic benefits such as low fees, and social benefits including power over control and privacy of their transactions, but such benefits come at a legal and social cost for the user.
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The Bank of England's proposed Central Bank Digital Currency: a step in the right direction for banking innovation? 6

A CBDC or Cryptocurrency for users?

  • The Bank of England is working on a CBDC infrastructure that will be interoperable with private money and cryptocurrency.
  • The main advantage of the CBDC network will be that it can offer super-fast, secure, and low-cost transactions.
  • If this is the case that cryptocurrency will be interoperable with the CBDC layer 1 infrastructure, this will bring a host of opportunities for users to leverage the benefits of both a CBDC and cryptocurrency.
  • Challenger banks have innovated to respond to user needs by recognising changing consumer habits and offering more flexible services options.
  • Offering features such as these, as well as extensive mobile and online services, in response to adapting consumer habits, has put challenger banks in a strong position to serve those who are underserved by the incumbent banks.
  • The UK market for alternative banking therefore appears strong and signals an appetite among users for financial diversification, which could be beneficial for user adoption of a CBDC.

The UK case for a CBDC

  • The UK is seeing a rising shift toward consumer-centred needs that sit outside (or at least on the periphery) of the traditional financial system.
  • There is a gap in the market for growing interoperability of financial services within the UK.
  • The BoE needs to acknowledge the gap in the market and the potential risks associated with it.
  • Regulation is a key component to any CBDC design if cryptocurrencies are to be integrated onto a common layer 1 network.
  • The UK has started to regulate cryptocurrencies to some extent, with the FCA regulating crypto businesses and the PSR regulating payment systems.
  • A BoE blockchain based CBDC could benefit from this risk-based approach to regulation if it can be developed with stability at the heart of its design.

Conclusion

  • The Bank of England should introduce a retail CBDC in order to take advantage of the benefits it would offer.
  • A retail CBDC would be an electronic form of central bank money that could be more widely used by households and businesses.
  • The Bank of England’s 2020 report ‘The Central Bank Digital Currency Report – Opportunities, Challenges and Design’ outlines design principles for a retail CBDC.
  • One important factor for CBDC design is its proposed level of decentralisation for resilience purposes.
  • Concerns have been raised regarding third party intermediaries who would have access to the ‘decentralised’ platform.
  • Cryptocurrencies can offer advantages such as low transaction costs, a low level of entry, worldwide speed, and pseudo-anonymity of transactions.
  • If a retail CBDC is introduced, it should be interoperable with innovative payment platforms including blockchains (and those which support smart contracts).

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