The Bank of England has published a discussion paper which sets out its thoughts on new forms of digital money, including on the potential impact of introducing a Central Bank Digital Currency (CBDC) and systemic stablecoins on the current monetary system.
This post is not intended to set out a summary of the conclusions reached in the Paper, which are very well summarised in the accompanying news release.
Instead, we focus here on the illustrative example modelled by the Bank, which considers the potential implications of demand for new forms of digital money based upon certain assumptions, including that new forms of digital money would be provided for retail use only and would be systemic, that commercial banks will seek to broadly maintain their current lending levels and liquidity positions and that any stablecoin would meet the FPC’s expectations, which are set out in the Paper.
How is money created?
For those who are familiar with how money is created, please feel free to skip past this section. For those that would like a refresher, here is a very broad overview of the two forms of money which are widely used in the UK:
- Central bank money. Central bank money is available to the public in the form of cash, and available to commercial banks in the form of central bank reserves, which anchor the monetary system by establishing and maintaining sterling as the unit of account for virtually all transactions in the UK; and
- Commercial bank money created through the intermediation of credit. Put simply, this money is created by banks lending to their customers to create deposits, which are in turn used to purchase goods and services (or in some cases for saving or transactional purposes) and which is then typically deposited back at a bank.
The illustrative example
The Bank has produced an illustrative scenario in its paper setting out the potential implications of a migration from commercial bank deposits to a new form of digital money, be that a CBDC or systemic stablecoin.
Consumers may prefer digital money over traditional money for any number of reasons including both financial and non-financial. Under the scenario, it is assumed that around a fifth of all commercial bank retail deposits will migrate to new forms of digital money owing to non-financial factors such as its convenience and an increase in the current levels of trust and perceived safety.
The Bank identifies three implications of a migration to digital money of 20% of deposits including the impact on (i) banks’ balance sheets; (ii) lending rates; and (iii) monetary policy. We consider each of these below.
Any migration of depositors to a new form of digital money would have an unavoidable impact on the deposits held with commercial banks. It is assumed in the example that banks would need to compete for deposits by offering higher interest rates, but that they would also need to adapt their balance sheets to deal with the resulting outflows. Banks are also assumed to seek to maintain (i) levels of lending, through mortgages, corporate loans and credit facilities, and (ii) liquidity positions, which will depend on their short-term liabilities and the high-quality liquid assets which they hold to meet their liabilities.
The Bank’s modelling illustrates money being recycled through the financial system, leaving the amount of central bank reserves for the banking system largely unchanged. However, there are a number of variables that need to be taken into account when considering how commercial banks can maintain their liquidity ratios, which would likely still be impacted. The issue of long-term wholesale debt and investment in gilts from non-banks is assumed to play a significant part in this.
Lending rates and credit provision
As long-term wholesale funding is likely to form a more significant part of a bank’s management of its balance sheet, the cost of funding is assumed to rise. This is likely to have an onward impact on funding costs and lending rates of around 20 basis points, which the Bank expects could be dealt with through a loosening of monetary policy.
The increase in costs and lending rates may push consumers towards non-bank lenders who may be able to compete more effectively in lending to both households and consumers. Lending rates to those borrowers unable to obtain other sources of financing would likely be more volatile. However, the overall impact on lending rates is thought to be modest, with credit provision to the wider economy expected to fall by a little over 1%. There are, however, uncertainties around the substitutability of long-term bank debt and gilts and the availability of non-bank credit which could have a further impact on credit provision and rates.
Monetary policy and financial stability
Monetary policy aims to maintain stability of prices for the goods and services consumed, and financial stability to avoid interruptions in the provision of financial services. Any new form of digital money which becomes widely used has the potential to impact both monetary policy and financial stability, as commercial banks, which are an important part of the economy, are themselves affected.
An impact on the cost and availability of borrowing from banks may make it more difficult to effectively implement monetary policy to ease financial conditions. Conversely, depending on how new forms of digital money are structured, and in particular whether interest rates on digital money track ‘Bank Rate’, they could also potentially enhance the transmission of monetary policy to bank lending rates.
One of the risks set out in the illustrative example arises from the potential for stablecoins to undermine confidence in money and payments, and therefore in the wider financial system. The FPC’s stablecoin expectations, set out in the Paper, are designed to mitigate the risks by ensuring that stablecoin issuers are subjected to appropriate regulatory oversight and standards, in order to ensure public confidence at a level which is equivalent to that which is held in commercial bank money. HM Treasury has recently published a consultation paper in which it proposes to bring stablecoins within the scope of the regulatory perimeter which, if implemented, would go some way towards ensuring that the FPC’s expectations are met. We consider this consultation in our recent blog post, The UK consults on cryptoassets: are stablecoins the future of money?
As the Bank explains in its paper, new forms of digital money are not yet widely used, and so there are challenges in forecasting the potential uptake and any impact on the commercial banking system and real economy with any real certainty. However, whilst there are clearly lots of “ifs” and “buts”, the illustration modelled by the Bank is useful as it gives a tangible indication of the possible impact, along with the potential variables, of a new and systemic form of digital money on the UK financial system.
As we start to see new forms of digital money emerge, both in the UK and elsewhere, we may be in a position to further refine some of the variables and experience the real world impact to further inform current expectations within the financial sector.