‘Digital pound’ proposals imagine new wave of disruption in UK payments

The Bank of England and UK Treasury said recently that they think it is “likely that a digital pound will be needed in the future” in response to the way money and payments are changing. Based on the proposals on which they are consulting, the UK payments market could be set for a significant shake-up.

What has happened?

The Bank and Treasury have opened a consultation on proposals for a digital pound (116-page / 2.8MB PDF), which, if implemented, would see a new retail central bank digital currency operated in the UK. The digital pound would have the same value as a banknote – i.e. 10 digital pounds would hold the same value as a £10 banknote – and its purpose would be as a new form of payment, not as a savings product, which is reflected in the fact that there are no plans to pay or charge interest on the digital pound.

Businesses and consumers should not expect the digital pound to be introduced imminently. Whilst the Bank and Treasury are progressing the preparatory work on how the infrastructure underpinning the digital pound may be designed (Phase 2 – the design stage), they believe it is “too early to decide whether to build the infrastructure” for the digital pound. A decision on build will not be made until 2025 at the very earliest.  Even then, the Bank and Treasury have plans to run prototypes and pilot initiatives before the digital pound would come into mainstream operation (Phase 3 – the build stage).

Their consultation paper examines the possible model for supporting the digital pound, the need for and possible benefits of the digital pound, and monetary and financial stability considerations.

The Bank has also published a separate technology working paper (86-page / 1.43MB PDF) that gives insight into various factors that will shape the technology model and how the Bank envisages the model integrating with existing payments infrastructure.

The Bank and Treasury have promised to work in tandem with the private sector when developing their proposals – there will be opportunities for financial institutions, financial market infrastructure operators, fintech companies and technology providers, consumer groups, academics and others to shape the plans. Stakeholders are first encouraged to respond to questions posed in the consultation paper concerning the digital pound proposals – feedback can be submitted until 7 June 2023.

Monetary and financial stability and the impact on business models

It is clear from the consultation paper that the Bank and Treasury believe that inaction in relation to a central bank digital currency could pose monetary and financial stability risk in the years ahead, but that the introduction of such a digital currency would bring its own risks in respect of monetary and financial stability.

They highlighted the trend away from use of cash to spending becoming more digital and warned that if this continues “the monetary system could become fragmented, posing a risk to monetary and financial stability”. They said that if “a new form of non-sterling digital money were used for a significant amount of retail transactions in the UK, it could compromise the UK’s monetary and financial sovereignty”.

According to the Bank and Treasury, a digital pound would ensure central bank money remains available as “an anchor for confidence and safety in money”. However, they acknowledged that the digital pound would need to be “usable and sufficiently adopted by households and businesses” to achieve that status. To this end, they envisage that digital pound payments would be similar to digital banknotes used on smartphones or through payment cards.

The Bank and Treasury are also concerned about how take-up of the digital pound could impact on bank business models and the knock-on impact that could have on the cost and availability of credit in the economy and on the transmission of monetary policy. They said they would seek an “orderly” introduction of the digital pound into circulation and have proposed some design features that aim to limit those financial stability and monetary policy risks.

For example, the Bank and Treasury propose to apply a limit on the amount of digital pound that individuals and businesses could hold, at least in the period following its introduction. The limit would be applied to “[constrain] the degree to which deposits could flow out of the banking system”.

A specific limit for businesses has not been put out for consultation, but the Bank and Treasury said it would “need to be significantly larger” than the limit of between £10,000 and £20,000 that they have proposed for individuals. They judge that limit as being “likely to strike an appropriate balance between managing risks and supporting wide usability of the digital pound” and see a need for “technical solutions” to ensure that the limit is not breached so that, for example, additional funds above the limit are automatically ‘swept’ into another nominated account in the name of the user where they would be held in another form of money.

However, while consideration of monetary and financial stability will shape the digital pound project, there was a clear warning that the Bank would not “seek to preserve the status quo structure of the financial system or to protect any business model within the commercial banking sector from the impact of technological innovation and competition”.

Competition and innovation in retail payments

Beyond preserving monetary and financial stability, promoting “innovation, choice, and efficiency in payments” is another primary motivating factor behind the Bank and Treasury’s digital pound proposals.

In an evolving payments landscape where the proportion of digital payments is increasing, they are concerned that a small number of money issuers using new technologies could begin to dominate the market. If that were to happen, it would “pose a risk to competition and diminish the incentives for longer-term innovation”.

The Bank and Treasury see a role for the digital pound in mitigating that risk. They believe introducing the digital pound “would support the safety and interchangeability of money, as well as encourage choice, competition and innovation”. They envisage it coexisting with cash and other forms of private digital money and believe its introduction can help boost the economy, support growth, and promote financial inclusion.

The model and technology design

The technology working paper provides a good insight into the potential functionality of a new digital pound ecosystem and how that system would be structured and operate. It is clear from the paper that the Bank and Treasury intend for the digital pound to provide a public platform for private sector innovation.

Under this platform model, the Bank would provide the digital pound and the central infrastructure, including the ‘core ledger’ on which transactions are recorded. A separate Application Programming Interface (API) layer would allow private sector intermediaries to connect to the core ledger.

Through APIs, authorised and regulated intermediaries such as payment interface providers (PIPs) and external service interface providers (ESIPs) would offer a user-friendly interface between the user and the core ledger. PIPs would provide payment interactional services whereas ESIPs would provide non-payment related value-added services. The final users would then register with those intermediaries to access digital pounds.

The ability for banks and other authorised and regulated firms to integrate into that infrastructure with their own user interfaces thereby enabling consumers to hold their digital pounds in digital wallets, would support a whole range of payment and other value-add solutions – from supporting in-store and online consumer transactions to payments between friends, and business analytics, budgeting tools and fraud monitoring services – with an even broader range of solutions expected to follow thereafter.

The Bank has also stated that as the operator of the digital pound system, it “would likely impose principles for operation for PIPs and ESIPs, including technical standards, alongside regulatory requirements”.

Whilst the Bank has not stated what those principles will be – it envisages they will be developed as the “design and of the digital pound system matures and as likely business models become clearer” – it has proposed they would facilitate availability, security and resilience, fast and convenient operation, interoperability, user friendly access, inclusion, diversity and innovation, and privacy.

As part of ensuring interoperability, the Bank and Treasury want the wallets to have “aliases”, such as a consumer’s mobile phone number. This would enable the consumer to make payments in digital pounds via messaging apps on their device. Interoperability with existing payments infrastructure is envisaged to enable digital pounds to be converted to other forms of money via payment systems such as the Faster Payments System and LINK – as well as new retail payments infrastructure emerging via the new payments architecture programme.

They are also exploring the potential for the system to support ‘offline’ payments. That “would not involve immediate interaction with the core ledger, theoretically allowing higher payment volumes to occur locally without any computational resource” and could make the system more resilient to network disruption.

Whether the infrastructure could be used to improve cross-border payments is also being examined – though it has acknowledged that this would “take time and require international co-operation to deliver”.

Eventually, the Bank and Treasury believe the digital pound infrastructure could support wage payments and foreign exchange and that it may need to accommodate around 100,000 transactions per second.

On privacy, the Bank said that a new central bank digital currency would not be anonymous since “the ability to identify and verify users is needed to prevent financial crime and to meet applicable legal and regulatory obligations”. However, it said neither it nor the UK government would have access to users’ personal data – this is because under its proposed model users would interact with banks and other intermediaries rather than directly with it. They see a potential role for “privacy-enhancing technologies” to be used by intermediaries to address user privacy concerns in a manner that also enables their legal and regulatory compliance. In any event, the Bank has stated that the digital pound “would be subject to rigorous standards of privacy and data protection”.

On security and resilience, the Bank appears to be concerned to ensure the digital pound is designed in such a way so as to mitigate the risk of payment fraud. The Bank has stated that “all entities in any digital pound ecosystem would have a responsibility to protect consumers from fraud and uphold robust financial crime controls”.

Whatever technical standards and regulatory principles the Bank does implement, it has promised that PIPs and ESIPs would “operate within a robust legal and regulatory framework to protect users and ensure the resilience and integrity of the system”.

The technology working paper also reveals the Bank and Treasury’s views on potential infrastructure for the core ledger They see some advantages in distributed ledger technologies and blockchain-based solutions in terms of guaranteeing consistency and resilience but flagged privacy, scalability and security challenges. They appear to favour using centrally governed distributed database technologies instead, though they are keeping their options open for now. In particular, the Bank has emphasised that the infrastructure should be designed in a way that “minimises any impact on the environment”. In this regard the Bank has said the digital pound “would not use the energy-intensive technologies uses by some crypto assets”.

A nod to wholesale payments

The focus of the digital pound proposals is on retail payments, with the Bank and Treasury wary of enabling financial institutions from settling high-value wholesale transactions in digital pounds “given the disruptive impact this could have on core financial markets”.

However, they said they are considering establishing a new wholesale central bank digital currency platform to support wholesale settlement in the long-term. The Bank already provides central bank money in electronic form for wholesale settlement through its Real-Time Gross Settlement (RTGS) service. It has committed to delivering an improved RTGS service in 2024.

Co-written by Tom Aries and Hinesh Shah of Pinsent Masons.