Bank of England publishes discussion paper on stablecoins

Earlier this month, the Bank of England (BoE) published its discussion paper ‘New forms of digital money’ (the Paper) setting out its approach to stablecoins and digital currencies.

The Paper summarises the BoE’s current thoughts on stablecoins and the possibility of a central bank digital currency (CBDC) for the UK. The BoE hopes to open a dialogue with those involved in the finance sector and payments industry, and invites stakeholders to respond to the questions and issues raised in the Paper.

Stakeholders who wish to have their views heard have the opportunity to respond to the questions raised. Responses must be submitted by 7 September 2021, so interested parties have time to consider and prepare their submissions.

The Paper is organised into four topics and includes an illustrative scenario, which models the demand for new forms of digital money, how banks would respond and the impact this would have on credit conditions. The topics explored are:

  • The role of money in the economy
  • Public policy objectives
  • Implications for macroeconomic stability
  • The regulatory environment

The BoE sets out its current understanding of each of these asks a number of questions related to each of these key areas of concern, as well as in relation to the accuracy of the model described in the illustrative scenario. It will use the responses it receives to these questions to inform further research and discussions, as well as to help shape policy on stablecoins and digital currencies more generally. We look at each topic in more detail below.

The role of money in the economy

The BoE describes the three main purposes of money, namely a unit of account, a means of payment and a store of value. The benefits offered by digital currencies are recognised, but it is also noted that in order to be preferred to existing forms of money, they would need to become a widely accepted means of payment and trusted as a store of value.

The Paper also considers how issuers of stablecoins – which it defines as “cryptoassets that aim to reduce volatility by pegging their value to government-sponsored – or ‘fiat’ – currencies” – might back their deposit liabilities. It suggests that commercial banks would be more likely to back such deposits with liquid assets, rather than loans. The reason for this is that deposits of digital currencies are considered to be more likely to be withdrawn at short notice and thus cannot be backed by illiquid loans. It is suggested that therefore non-banks could be relied more heavily upon for the provision of credit, with a potential rise in the cost of bank lending as a result.

The BoE wants interested parties to share their views as to how they believe new forms of digital money affect money and credit creation, and whether its analysis misses any key considerations.

Public policy objectives

The BoE’s mission to maintain monetary and financial stability might be affected by the introduction of stablecoins and other digital currencies. It aims to achieve price stability by ensuring inflation is low and stable, and it achieves this by exercising control over the cost of borrowing and reward from saving, by setting its base rate. As the value of digital currencies can be highly volatile, the BoE’s Financial Policy Committee has already indicated that payment chains using stablecoins should be regulated to the same standards as traditional payment chains.

The Paper suggests that a CBDC, backed by Sterling might be an important factor in ensuring continued access for consumers to central bank money. Although no decision has been made in relation to the UK issuing a state-backed digital currency, the BoE notes in this Paper that, were it not to do so, its ability to maintain monetary and financial stability might be impacted negatively. It also lists an array of benefits offered by digital currencies, including widening financial access, privacy and protection, and cheaper and faster transactions.

The Paper asks for views on the importance access to central bank money in a digital world, whether its thoughts on protections and privacy are sensible, and how competition could be bolstered through the promotion of interoperability of new forms of digital money with other payment systems.

Implications for macroeconomic stability

This section of the Paper identifies the risks to the economic stability of the UK associated with a wider adoption of digital currencies. The first and most important is the potential for such innovations to undermine confidence in the financial system. Trust in forms of payments is considered essential to the proper functioning of the economy, and the novelty and likely lack of public understanding could mean that digital currencies are not viewed with the same confidence that traditional payment methods are.

One of the other considerations is the wider resilience of banking sector liquidity. As mentioned above, it is thoughts that digital currencies are likely to be withdrawn at higher rates than existing currencies. The Paper suggests that existing liquidity resources and requirements, the banking system should be able to withstand sudden deposit outflows.

The cost and availability of credit is considered likely to be impacted by the introduction of a stablecoin. This is because of how banks are predicted to respond, namely that they will migrate to long-term debt, which reduces the vulnerability of those banks in relation to deposit runs.

The questions for discussion on this topic are whether there are other significant risks that the BoE has not considered, the positive and negative implications of a shift to market-based financing and what concerns the BoE should have over the ability of banks and markets to adjust to new forms of digital money.

The regulatory environment

The BoE makes clear that the regulatory framework for stablecoins should be established prior to their introduction to the UK. Four distinct models for how digital money should be backed are considered: the existing bank model, the high-quality liquid assets model, the central bank liability model and the deposit-backed model. Each is explored in some detail, and the BoE identifies the risks and rewards without coming to a firm conclusion as to which is most appropriate.
The final consideration in relation to the regulatory environment is the potential for a set of transitional arrangements while digital money is being introduced. Limits on aggregate holdings, transactions, access eligibility and remuneration are explored as potential methods of restricting consumer’s exposure to potential risk and to allow banks, markets and non-banks time to adjust.

The BoE seeks answers to questions concerning features of the banking regime that it has not addressed, the appropriateness of the models it describes and suggestions for alternatives, as well as inviting thoughts on the use of limits during any transition phase.

Next Steps

As described above, this paper will form the basis for the BoE’s approach to stablecoins and digital currencies more generally. Digital money and other innovations in the payments and financial services industry directly impacts how businesses and consumers interact. The COVID-19 pandemic has sped up the adoption of new technologies and the demise of cash in the economy. An agile and informed response by the BoE, government and other regulators to such innovations is crucial to ensure a competitive, productive and ultimately safe environment for those operating in the financial and payments industries, as well as their users.

Should you have any questions about the above, please do not hesitate to contact one of the members of the Bird & Bird global payments team.

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