Payments View - A Digital Pound for your thoughts?

Ahead of the February edition of Payments View, we wanted to quickly reach out on the developments surrounding the proposed Digital Pound. Last week, HM Treasury ("HMT") and the Bank of England ("BoE") have published an extensive consultation paper on the potential for a central bank digital currency or "Digital Pound". The paper itself is a hefty 116 pages so we have picked out the key points below. Please do reach out if it would be interesting to discuss this in any more detail.

The current proposal is that the Digital Pound would be issued by the BoE for retail use (i.e. for everyday payments in-store and online) to sit somewhere between physical cash and card payments. A platform model is proposed; the real-time ledger would be held and updated by the BoE. Users' wallets, which facilitate payment instructions and account information, would access the ledger through an API and be operated by private providers such as banks. Importantly, 'never the twain shall meet' - the government will receive anonymised payment instructions and the private providers would not hold user assets. Functionality would also allow auxiliary, non-payment services to be provided by third parties with lower regulatory requirements.

The consultation makes clear that whilst the BoE and HMT consider that a Digital Pound will be needed in the future, "no decision has been taken at this stage to introduce a digital currency". The earliest that a launch decision could be made is 2025. The current consultation runs until 7 June 2023 and is accompanied by a Technical Working Paper.

Jon Cunliffe (BoE Deputy Governor, Financial Stability) has also given a speech on the consultation where he sets out some of the thinking behind the consultation paper and the next steps proposed for the Digital Pound.

Our view is that, taking the proposals together with the fact that (i) the core ledger will not necessarily be based on DLT or blockchain technology, (ii) that users will not hold a tokenised form of money, and (iii) the lack of any interest payments/charges are not being considered, the Digital Pound essentially looks like e-money in its current form, albeit issued by the BoE instead of by commercial issuers (banks and EMIs).

Overview: What would a Digital Pound look like?

A Digital Pound would "replicate the role of cash in a digital world, so that it is risk-free, highly trusted and accessible" and would be: (i) issued by the BoE and (ii) always redeemable at par. The consultation stresses that access to, and settlement of, Digital Pounds would be subject to rigorous standards of privacy and data protection and that holders would have the "same level of privacy as a bank account" but importantly, this means that unlike cash and some stablecoins, use of the Digital Pound would not be anonymous.

The Digital Pound would be accessed through digital wallets offered to consumers by the private sector and available through smartphones or smartcards (the latter, at least initially, intended to replicate contactless card payments for financial inclusion purposes). Key functionalities that HMT is aiming for the Digital Pound to be able to accommodate are: embedded finance, blockchain, smart contracts, DeFi, atomic swaps and cryptography but, as indicated in the Technical Working Paper, no decision has been made on the technology underpinning the core ledger.

A number of features integral to the operation of normal cash are excluded - the consultation specifically does not accommodate proposals for: (i) interest payments/charges (removing saving functionality and some of the BoE's ability to dictate monetary policy), (ii) the use of the Digital Pound in wholesale markets (due in part to the RTGS Renewal), and (iii) unlimited user holdings (with initial restrictions proposed of up to £20,000 for individual users).

Key Elements of the Consultation

• Platform model: The BoE has confirmed that their preferred model is providing the central public infrastructure in the form of a 'core ledger' which would provide the "minimum necessary functionality". Regulated private firms (described as 'banks and approved non-banks') would then be invited to use this infrastructure to design services that provide all customer-facing interactions. These firms, Payment Interface Providers ("PIPs") and External Service Interface Providers ("ESIPs", which would be less regulated and provide non-payment services) - could then access the core infrastructure via an application programming interface ("API"). User-facing interactions would include handling customers' information and the functionality to develop and offer all services using the Digital Pound. At this point a decision on whether the ledger is centralised or decentralised has not been made.

• Pass-through wallets: These core services in relation to the Digital Pound would be offered through digital 'pass-through' wallets to end users which could be integrated into other services by a PIP. The term 'pass-through' refers to the user's holdings of Digital Pounds being recorded anonymously on the BoE's core ledger, in order to safeguard their privacy, and the wallet simply passing instructions from the user to the core ledger. End-users would interact with these wallets (via app or smart card) rather than directly with the BoE. The private sector would never hold users' funds and the BoE would never know the identity of payers or payees (subject to law enforcement caveats similar to the current position on bank accounts, as noted below).

• Payment Interface Provider requirements: PIPs, and the wallets they provide, would "never be in possession of end-users' Digital Pound funds so do not pose counterparty or credit risk to their customers". Therefore, the consultation notes that PIPs are unlikely to need extensive prudential regulation which is currently typical of other types of financial institution. PIPs participating in the Digital Pound system would, however, be held to "at least the same standards" as those to which regulated payment services providers are held today - particularly relating to financial crime, including to prevent money laundering, terrorist financing, and fraud. Some detail is provided on how PIPs would be allowed to monetise their engagement, but the consultation broadly welcomes views on revenue models for access to the Digital Pound as well as HMT and BoE's initial concerns regarding the negative effects of cross-subsidisation by PIPs.

• Other interface providers: ESIPs might also participate in the Digital Pound ecosystem. These are described as firms whose business is not payments but who provide services that augment wallets and are of value to users and merchants. Examples of services include business analytics, budgeting tools and fraud monitoring. ESIPs might be granted 'read' access to specific data on the Digital Pound ledger. As a default, it is proposed that all PIPs would also be able to also undertake ESIP activities.

• Data protection and privacy: As noted above, a key theme of the consultation is addressing concerns over the security of the Digital Pound (as well as the privacy of its users). The Digital Pound would be "subject to rigorous standards of privacy and data protection" and PIPs would anonymise personal data before any data was shared with the BoE. The identity of users would only be known to their PIP, and neither the Government nor the BoE would have access to Digital Pound users' personal data, except for law enforcement agencies under limited circumstances prescribed in law and on the same basis as with other digital payments. It is also proposed that users should be able to choose from a range of wallet services with varying levels of identification accepted to cater to different preferences and ensure that the Digital Pound is accessible for all.

• User experience: The proposed digital wallets are envisioned as allowing users to seamlessly manage their holdings and would be used in the same way as current contactless payments. Initially their use would need to be designed to work with existing online and in-store payments technology, such as card readers - which doesn't represent a particularly innovative leap. Throughout the consultation, mobile devices are quite clearly positioned as the centre of a user's engagement with the Digital Pound - in terms of accessing account information and making payments. The consultation also addresses concerns over governments' ability to restrict where the Digital Pound could be spent, but aim to assuage these concerns with a note that "subject to a payment being lawful, the BoE would be neutral in processing it, and does not envisage applying any limitations on payments on ethical grounds". Although a Digital Pound would be designed with UK users in mind, it would be available to non-UK residents too.

• No interest: As mentioned above, the consultation initially proposes that the Digital Pound would not pay (nor charge) an interest rate. This is on the grounds that (i) it is not intended as a savings product, so it does not need to be remunerated, and (ii) using the Digital Pound for monetary policy reasons is not a motivation for its introduction by the BoE and HMT. Appropriate room is left, however, with the consultation noting that, "were the approach to remuneration change after the Digital Pound was introduced, it would follow consultation and the BoE would provide adequate lead time".

• Holding limit: A limit on individuals' holdings would apply at least in the introductory phase. This would strike a balance between both encouraging use and managing risks, such as the potential for large and rapid outflows from banking deposits into Digital Pounds. It is clearly envisioned that these limits would be amended in the future, however, following any successful implementation. An individual limit of between £10,000 and £20,000 has been proposed. The consultation also welcomes views on a lower £5,000 limit.

• Retail not wholesale: the proposal is for a 'retail CBDC', designed for "everyday payments by households and businesses". That contrasts with a 'wholesale CBDC', which would be used to settle high-value payments between financial firms and where the BoE is focusing on improvements through its "transformational programme of RTGS Renewal". Corporate access to (and maximum holdings of) the Digital Pound is still under review, but is important in understanding how corporates (including of course merchants) will be allowed to accept payments from individuals. No definitive option is proposed, but possibilities include a significantly higher limit to the user limit, a much lower limit with automatic sweeping into a nominated bank account, or a restriction on some corporates holding Digital Pounds entirely.

Alternative Approaches

The 'platform approach' is noted as the current, preferred option, but other approaches are raised. The consultation notes that none of these appear suitable, but they include:

• A 'delegated' model where PIPs would have their own ledgers recording customer holdings. Transactions between users with the same PIP would occur on that PIP's ledger. For users of different PIPs, the transaction between them would be facilitated on the BoE's core ledger. The concern here is primarily that of creating a fractured payments landscape, that it could undermine how clear and direct the user's claim on the BoE is, and that it introduces too high a technical requirement for smaller private firms.

•  A 'bearer instrument' model, where ownership of Digital Pounds is recorded on individual user devices, and transactions take place between users, with no interaction with the central bank. This is close to the way cash works at present, but raises concerns over double-spend and totally anonymous payments.

• A non-bank stablecoin that has backing assets held entirely with the BoE. While this would be economically similar to the Digital Pound, such a stablecoin would be a liability of the private-sector issuer rather than a claim on the central bank and so does not fall under the BoE or HMT's proposed review.

Stablecoins

Non-BoE stablecoins are, however, discussed at reasonable length throughout the consultation and integration of them into a Digital Pound eco-system seems to be a consideration. The consultation notes a requirement that "if new, non-bank forms of payment such as stablecoins emerge, they would be required to be exchangeable with the digital pound".

The consultation also notes that the Financial Policy Committee has set out two expectations that stablecoins must meet to be used as money-like instruments in systemic payments chains. The first is that payment chains that use stablecoins should be regulated to standards equivalent to those applied to traditional payments chains. The second expectation is that stablecoins used as a money-like instrument 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.

The framework for fiat backed stablecoins used for payments is already being developed around the existing structure in place for e-money.

Financial Stability and Monetary Policy

Here, the consultation is very keen to stress that the Digital Pound does not need to be a dominant form of money in order to meet its public policy objectives and could exist alongside other forms of money, including stablecoins, to be regarded as a success. Specifically on monetary policy, the consultation makes clear that remunerating the Digital Pound, either positively or negatively, to make monetary policy more effective is not a motivation for its possible issuance.

The main concern on financial stability that the consultation raises is that the speed and scale of uptake by households and businesses, could affect some bank business models. The consultation suggests that banks which lose 'traditional' deposits may replace them by borrowing in wholesale funding markets to maintain the same level of lending. As a result and, to the extent that wholesale funding is more costly than deposits, banks might then pass this on in their lending, by increasing the price of credit to households and businesses or reducing the quantity of credit they are willing to supply. HMT and the BoE have provided analysis of this concern and note that, "assuming around 20% of commercial bank retail deposits migrated to new forms of digital money (equivalent to the total amount of non-interest-bearing deposits in the UK), bank lending rates were estimated to rise by around 20 basis points in steady state."

Financial Inclusion

Financial inclusion and the needs of vulnerable people are also being considered by HMT and the BoE as part of the development of the Digital Pound. Their aim is that any end-product should be "designed, developed and implemented carefully so it contributes to financial inclusion to the extent it can". Key concerns over the ease of budgeting and digital sophistication are raised, with continuing consultation with stakeholders noted.

The main suggestion to improve inclusion is that of using 'tiered wallets' to allow users with limited forms of ID or digital sophistication to open basic wallets that permit low-value payments. This is seen by the consultation as providing a more accessible gateway into digital payments, but we note that there are likely to be concerns over whether this alone would go far enough and that there would be interesting tensions between the approach and the wider context of the industry's adoption of the Consumer Duty.

Next Steps

The BoE is undertaking further research and development work to "investigate what is possible first, whilst always making sure we protect financial stability". A decision about whether to implement a Digital Pound will be taken "around the middle of the decade" and will depend on whether the payments landscape evolves in line with current trends in the UK and abroad. The key trends that the BoE and HMT are looking to are:

• the continuing decline in the use of cash;

• the emergence of new forms of private digital money issued by new payment entities (such as the growing use of e-money and stablecoins across the market);

• how easily new forms of money can be converted into existing (and other new) forms; and

• international developments in CBDCs and private digital money.

Also to note is that the "legal basis for the Digital Pound will be determined alongside consideration of its design" and we will update on this when further details are released.

The consultation invites views on their 12 questions (which we have also listed below for ease). Respondents should provide answers by 7 June 2023. Of course, if you had any questions ahead of this deadline, please do of course reach out.

Consultation Questions

• Do you have comments on how trends in payments may evolve and the opportunities and risks that they may entail?

• Do you have comments on our proposition for the roles and responsibilities of private sector digital wallets as set out in the platform model? Do you agree that private sector digital wallet providers should not hold end users' funds directly on their balance sheets?

• Do you agree that the Bank should not have access to users' personal data, but instead see anonymised transaction data and aggregated system-wide data for the running of the core ledger? What views do you have on a privacy-enhancing digital pound?

• What are your views on the provision and utility of tiered access to the digital pound that is linked to user identity information?

• What views do you have on the embedding of privacy-enhancing techniques to give users more control of the level of privacy that they can ascribe to their personal transactions data?

• Do you have comments on our proposal that in-store, online and person-to-person payments should be highest priority payments in scope? Are any other payments in scope which need further work?

• What do you consider to be the appropriate level of limits on individual's holdings in transition? Do you agree with our proposed limits within the £10,000-£20,000 range? Do you have views on the benefits and risks of a lower limit, such as £5,000?

• Considering our proposal for limits on individual holdings, what views do you have on how corporates' use of digital pounds should be managed in transition? Should all corporates be able to hold digital pounds, or should some corporates be restricted?

• Do you have comments on our proposal that non-UK residents should have access to the digital pound, on the same basis as UK residents?

• Given our primary motivations, does our proposed design for the digital pound meet its objectives?

• Which design choices should we consider in order to support financial inclusion?

• The Bank and HM Treasury will have due regard to the public sector equality duty, including considering the impact of proposals for the design of the digital pound on those who share protected characteristics, as provided by the Equality Act 2010. Please indicate if you believe any of the proposals in this Consultation Paper are likely to impact persons who share such protected characteristics and, if so, please explain which groups of persons, what the impact on such groups might be and if you have any views on how impact could be mitigated.