Digital currency in the UK

Ganesh Viswanath Natraj at the Gillmore Centre for Financial Technology outlines five ways a digital pound could change our world

 

Towards the end of this decade, it is possible that UK consumers and businesses will adopt a central bank digital currency (CBDC) for transactions and money transfers.

 

The Bank of England initiated a consultation on the concept of a ’digital pound’ in February last year, and while we are still waiting to see if the responses will influence its decision, Governor Andrew Bailey acknowledged that this new currency will hold great significance in shaping the way the country uses money.

 

This shift towards a digital currency is partly driven by the declining use of cash, as online business and payment platforms like Apple Pay and Google Wallet gain popularity, reducing the reliance on physical notes and coins. Cash accounted for over half of payment transactions in 2012, and decreased to just 15 per cent in 2021, according to a Bank of England and HM Treasury paper on the digital pound.

 

This trend is not exclusive to the UK, as central banks worldwide are exploring the idea of CBDCs, with a Bank for International Settlements (BIS) survey in 2021 revealing that 90 per cent of central banks were actively looking into CBDCs. However, only a few countries, like China with its e-CNY, have implemented CBDC schemes thus far.

 

While a CBDC aligns well with the digital age, its success is not guaranteed. If introduced, the digital pound would be pegged to the existing sterling currency and interchangeable with physical cash, but many details remain to be determined. Key factors influencing the CBDC’s relevance to consumers include interest rates on the currency and potential limits on holdings.

 

However, if it proves successful, it could have major impacts on the position of banks in the financial system and the way the overall UK economy operates.

 

Here are five potential ways a CBDC could change our world, presenting both opportunities and challenges.

 

1. Improving financial inclusion

A CBDC had the potential to foster a more financially inclusive ecosystem, benefiting the estimated 1.2 million unbanked individuals in the UK. 

 

A recent paper co-authored with Ivan Shchapov, of the Institut Polytechnique de Paris, and David Murakami, of the University of Milan, found a CBDC was a more effective savings vehicle for unbanked households as it can be used to smooth out consumption and buffer against economic fluctuations.

 

However, such effects are only most apparent if the central bank pays interest on the currency – something the Bank of England does not plan to do.  

 

Authorities could also use a CBDC digital wallet to efficiently distribute social welfare payments and other supports or subsidies. 

 

If everyone was automatically given a CBDC account, this would be most effective, and could be done similarly to anyone receiving an NHS number. 

 

2. Making monetary policy more effective

A CBDC could enhance the Bank of England’s ability to influence the economy through monetary policy. This includes efforts toward controlling inflation, although this would be dependent on whether interest is paid on the currency.

 

By adjusting interest rates paid on CBDC balances, the central bank could directly pass any changes in rates into the wider economy rather than having to rely on retail banks, and potentially use negative interest rates to encourage spending during periods of low demand.

 

3. Cheaper cross-border payments

CBDCs could significantly reduce the cost and improve the efficiency of remittances and cross-border transactions, replacing the current expensive and slow correspondent banking system. 

 

However, this requires digital currencies to be easily exchangeable, and thus cooperation and common usage among central banks worldwide.

 

4. Increased competition for deposits

A user-friendly and well-designed CBDC could provide an alternative to traditional banks, motivating them to compete more for retail deposits. 

 

Even without interest payments, efficiency gains in payment systems could also attract consumers to keep assets in their CBDC wallets rather than their normal bank account.

 

5. Higher risks of financial instability

Offering interest rates on CBDCs may lead to financial instability if depositors move large sums from traditional banks to their digital wallets. To mitigate this, the Bank of England will likely and essentially impose limits on individual holdings, although finding the right balance will be essential for effective transmission of monetary policy.

 

Ensuring the success of a CBDC

Interest rates come into play as they key issue. If a CBDC pays a high rate of return, then consumers will be more likely to move more of their assets to take advantage of that, but if set too low, then there will be less of a reason for consumers to pay attention.  

 

The potential adoption of a central bank digital currency in the UK hosts significant impacts upon various aspects of the economy and financial system. However, careful planning and consideration of several factors are required in order to ensure its successful integration and operation.

 

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Ganesh Viswanath Natraj is Assistant Professor of Finance in the Gillmore Centre for Financial Technology

 

Main image courtesy of iStockPhoto.com