Central Bank Digital Currency for the UK

Question 1: How beneficial would it be to the UK economy for the Bank of England to introduce a central bank digital currency in some form in the upcoming decade?

 

Question 2: What effect will the introduction of a CBDC have on UK banks?

Summary

The CfM panel of experts on the UK economy is nearly unanimous in agreeing that a Bank of England-issued digital currency would benefit the British economy. Half of the panel also believes that a digital currency would have limited impact on the UK banking system.

Background

The June 2021 CfM survey asked the members of its UK panel to assess the benefits of a Central Bank Digital Currency (CBDC) to the UK economy and its potential risks to the UK banking sector. 

Central Bank Digital Currencies

Central banks across the world are starting to experiment with digital currencies. A 2021 BIS Survey of central banks “has found that 86% are actively researching the potential for CBDCs, 60% were experimenting with the technology and 14% were deploying pilot projects” (BIS 2021). Just last year, the Bahamas have become the first country to introduce a CBDC nationwide (the Sand Dollar) and in April, the Eastern Caribbean became the first currency union central bank to issue digital cash. Overall, the BIS reports that at least 46 central banks are currently actively designing or planning for the possible introduction of digital currencies (Auer, Cornelli and Frost, 2020). This year, the Bank of England and the Treasury announced the joint creation of a Central Bank Digital Currency (CBDC) Taskforce to explore a potential UK CBDC.

Most transactions in the UK are already conducted “digitally,” and cash comprises only a small fraction of the money base issued by central banks. However, digital money is currently mostly in the form of private bank deposits. Furthermore, only few households and non-financial corporations have direct access to central bank liabilities, except through physical bills and coins. The introduction of a CBDC can be seen simultaneously as a way to replace cash with a digital alternative and a way to give households less intermediated access to central bank liabilities.

Auer and Böhme (2021) provide a useful summary of current proposals regarding the implementation of CBDCs. These differ primarily in the extent to which the non-financial private sector is granted direct access to central bank liabilities. Current suggestions range from direct CBDC, where households have direct claims on the central bank,  with the latter handling retail payments directly, through hybrid or intermediated solutions where private firms execute and keep track of payments (but with the CBDC remaining  a direct household or firm claim on the central bank); to indirect architectures, where private financial institutions (including banks) provide payment services using liabilities that are fully backed by central bank reserves.

Walker (2020) enumerates the benefits a CDBC could bring. These include bringing “smart contracts” and distributed ledger (blockchain) technologies to conventional units of account, expanding financial inclusion, reducing disease transmission linked to the use of bank notes and coins, and curtailing illegal uses of cash. It has also been argued that central banks’ seigniorage and ability to conduct countercyclical monetary policy would both increase with CBDCs. Barrdear and Kumhoff (2016) evaluate these last two economic benefits to the UK at 3 percent of GDP. The BIS (Annual Report, 2021) qualifies that “The ultimate benefits of adopting a new payment technology will depend on the competitive structure of the underlying payment system and data governance arrangements. The same technology that can encourage a virtuous circle of greater access, lower costs and better services might equally induce a vicious circle of data silos, market power and anti-competitive practices. CBDCs and open platforms are the most conducive to a virtuous circle.”

The main concern voiced regarding CBDCs is the harm they might cause to the banking system, and therefore potentially to the entire economy. The risk is that CBDCs could fully replace bank deposits, removing banks’ primary funding source. Banks will no longer intermediate savings to investment, which may deprive the non-financial sector of a major financing source. Fernández-Villaverde et al (2020) formalize this argument with a theoretical model of CBDCs in which private banks are still necessary because of their investment expertise. The model predicts that the central bank will become a monopolist depositary institution because of its capacity to deter bank runs. In contrast, Andolfato (2020) develops a model of CBDCs which shows that digital currencies need not reduce banks’ profitability or monopoly power and may even serve to increase them. Andy Haldane posits that “a widely-used digital currency could change the topology of banking fundamentally… the traditional model of banking familiar for over 800 years could be disrupted.” But Haldane sees opportunities, not only risks in this disruption: “This radically different topology, while not costless, would reduce at source the fragilities in the banking model that have been causing financial crises for over 800 years.”  Lastly, Walker (2020) argues against CBDCs, stating that their benefits are limited and that the main motivation for their creation is a vague fear that the private sector will usurp central banks’ money-creation monopoly.

This month’s survey asks its members about the desirability and risk of a Bank of England CBDC.

Question 1: How beneficial would it be to the UK economy for the Bank of England to introduce a central bank digital currency in some form in the upcoming decade?

Nineteen panel members responded to this question. 84% of panel members think a CBDC would benefit the UK economy, although none viewed a CBDC as “very beneficial”. The remainder of the panel thought a CBDC would neither be beneficial or harmful.

Roger Farmer (University of Warwick) sees CBDCs as the “logical” response to the threat posed to national currencies by private crypto-currencies. He believes that “National digital currencies, and the state monopolization of this function, are the logical next step in the evolution of money.” To Jagjit Chada (National Institute of Economic and Social Research), a CBDC would be helpful “to the extent that it increases participation in the financial system, efficiency in transactions and reduces illegal uses of cash.” Jumana Saleheen (CRU Group) similarly points towards a potential improvement in terms of monetary policy transmission. “At present”, she states, “monetary policy is implemented through repo transactions between the central bank and major high street banks, [… which can create] frictions in the transmission of monetary policy. CBDC removes those frictions.” Lastly, she claims that CBDCs may facilitate the implementation of negative interest rates and could increase the UK economy’s productivity.

On the other hand, some panelists believe that a CBDC would disrupt the UK banking sector but view this disruption favorably. Nicolas Oulton (London School of Economics) views greater competition in (and with) the UK banking sector as a good thing: “As far as retail customers are concerned banks only innovate when really pushed by forces outside the banking sector.” David Miles (Imperial College London) adds: “Substantially reducing the risk of bank runs by providing a safe means of payment and a default free home for funds for the risk averse would remove the need to have deposit protection schemes. It would also remove the need for so much bank regulation and supervision designed to stop banks with retail deposits owned by very risk averse households taking inappropriate risks.”

Some panelists think that the hype around CBDCs overstates the impact—positive or negative—they will have on the economy.  In the likelihood that a British CBDC would operate under indirect infrastructures, David Cobham (Heriot Watt University) posits that its economic effects are likely to remain “marginal”. In a similar vein, Martin Ellison (University of Oxford) argues that “digital currencies will only be a sideshow in the next decade. Debit cards became available in the 1980s and 1990s, but it was not until 2018 that payments by debit card exceeded those by cash in the UK. Even if the Bank of England introduces a central bank digital currency in the next decade, it will take time before it becomes an accepted part of the financial market landscape.”

Finally, a few panel members stated that the devil is in the details of CBDC design. To Costas Milas (University of Liverpool), CBDCs are “beneficial provided that we do not rush into the project for the sake of it. Currently, the whole idea is more like a shot in the dark as there are too many unknowns. concerns regarding the ifs and hows of CBDC interest rate determination and its impact on “the value of the traditional sterling exchange rate.” Ricardo Reis (LSE) adds that “Given the current state of knowledge, [the] pros outweigh the cons. But we are still learning about it.” In turn, Panicos Demetriades (University of Leicester) lays a series of ground rules for optimal CBDC operation: “If CBDC is introduced by [the] BoE, […] it will likely be through financial intermediaries providing the interface, as central banks in general should not be aiming to displace intermediaries by taking deposits directly from the public. It will also likely come with relatively low limits, e.g. no higher than deposit insurance limits to prevent unfair competition with commercial banks. Additionally, there will have to be strict anti-money laundering (AML) checks […] at least at every entry point.” Ultimately, Demetriades concludes that CBDCs will only be introduced if the BoE finds ways to ensure effective regulation.

The panel was also asked about the potential effects of a Bank of England CBDC on the UK banking system.

Question 2: What effect will the introduction of a CBDC have on UK banks?

Twenty members of the panel answered this question. Half of the respondents think a CBDC would have no or little effect on the UK banking system. This share increases to 62% when weighting responses by the experts’ self-assessed confidence levels. The remainder of the panel is roughly equally divided between those thinking a CBDC would harm the British banking system (20% of respondents viewing the harm as moderate and 5% as great) and those thinking a CBDC would yield benefits, with 20% viewing these as moderate.

Respondents identified various potential adverse effects the introduction of a CBDC could have on the UK’s financial system. According to Salaheen, “central bank digital currencies will be the next big disrupter to the financial system”, and disruption levels will depend on the CBDC’s functioning. “At one extreme, if [one] can hold a central bank digital currency account, and undertake all transactions through that account, [one does] not need a high street bank account. This CBDC innovation has the potential to be the final nail in the coffin with respect to banks' traditional role as an intermediary between borrowers and savers. Some of that disruption is already underway with the growth of challenger banks (such as the Monzo app) and the availability of loans from non-bank financial institutions.” David Miles further argues that the introduction of a CBDC would potentially remove commercial banks’ insurance of their retail deposits. Finally, Nicolas Oulton predicts that “A CBDC would move the banks towards a greater reliance on equity financing.” He argues that while this would improve bank safety at the systemic level, this “is something they have resisted fiercely since the global financial crisis,” because it will erode banks’ profits.

 

Others noted that CBDCs are merely a sideshow to the greater upheavals in financial and payment technologies. Ricardo Reis writes: “banks in the last few years have already suffered [from] great competition from fin-techs in the operation of payments. The counterfactual of no CBDC is not the status quo of ten years ago. Also, as the BIS excellent research output in this area has shown, the ultimate impact depends on which type of CBDC comes to life, and in some of them banks benefit greatly.”

Finally, some respondents pointed to the resilience of the banking system, its adaptability, and the likelihood that CBDCs will be designed to contain damages to banks. Roger Farmer suggests that “private banks will evolve, as they always have, to provide intermediation services in different ways. It is fallacious to believe that commercial banks need deposits to function. There are many other ways of providing the maturity transformation and risk intermediation services that characterize the activities of modern banks.” Martin Ellison adds that “outside of a financial crisis, there is limited appetite to “rock the boat” with financial innovation. This means that the role of a newly-launched central bank digital currency will, by design, likely to be limited. Radical proposals are unlikely to fly, so it is difficult to see sufficient disruption to upend 800 years of traditional banking.” For similar reasons, Panicos Demetriades believes that CBDCs may well benefit private banks: “CBDC will not displace but complement financial intermediation and will not be a major source of competition for funds. CBDC could benefit banks, if they end up providing the infrastructure and clearing system of this new form of payment.”

References

Auer, R. G. Cornelli and J. Frost, “Rise of the Central Bank Digital Currencies: Drivers, Approaches and Technologies”, BIS Working Papers No 880, August 2020. Available at: https://www.bis.org/publ/work880.pdf

Auer, R. and R. Böhme, “Central Bank Digital Currency: the Quest for Minimally Invasive Technology”, BIS Working Papers No 948, June 2021. Available at: https://www.bis.org/publ/work948.pdf

Bank of England, “Bank of England Statement on Central Bank Digital Currency”, April 19th, 2021. Available at: https://www.bankofengland.co.uk/news/2021/april/bank-of-england-statement-on-central-bank-digital-currency

Bank of International Settlements, Annual Report, June 2021. Available at: https://www.bis.org/publ/arpdf/ar2021e3.htm 

Barrdear, J. and M. Kumhoff, “The Macroeconomics of Central Bank Issued Digital Currencies”, Bank of England Working Paper No. 605, July 18, 2016. Available at: https://www.bankofengland.co.uk/working-paper/2016/the-macroeconomics-of-central-bank-issued-digital-currencies

Boar, C. and A. Wehrli, “Ready, steady, go? - Results of the Third BIS Survey on Central Bank Digital Currency”, Bank for International Settlements, January 27th, 2021.

Kiff, J. et al. “A Survey of Research on Retail Central Bank Digital Currency”, IMF Working Paper, Volume 2020, Issue 104. June 26th, 2020.

Walker, M. C. “Central Bank Digital Currency – Nine Key Questions Answered”, in LSE Blogs, December 15th, 2020. Available at: https://blogs.lse.ac.uk/businessreview/2020/12/15/central-bank-digital-currency-nine-key-questions-answered/

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How the experts responded

Question 1

Participant Answer Confidence level Comment
Ethan Ilzetzki's picture Ethan Ilzetzki London School of Economics Beneficial Not confident at all
Times will require the Bank to introduce a CBDC. Its cost and benefits will depend greatly on design.
Jagjit Chadha's picture Jagjit Chadha National Institute of Economic and Social Research Beneficial Confident
It is not so much the adoption of a central bank digital currency per se but how it works within the structure of the financial system and what changes it forces. To the extent that it increases participation in the financial system, efficiency in transactions and reduces illegal uses of cash it will be helpful. But we need to think carefully about how to prevent it hampering the the funding or deposit base of the private banking system.
Hande Kucuk Beneficial Confident
Sir Charles Bean's picture Sir Charles Bean London School of Economics Beneficial Confident
Jumana Saleheen's picture Jumana Saleheen CRU Group Beneficial Extremely confident
CBDC is likely to be beneficial to the UK economy as a whole. It will be a plus when it comes to improving the speed of transmission of monetary policy. At present monetary policy is implemented through repo transactions between the central bank and major high street banks. When interest rates are cut, banks can decide how much of that to pass through to borrowers and lenders. Sometimes the cut is fully passed through to borrowers and savers immediately, sometimes it is only partial. Sometimes the pass-through is asymmetric between borrowers and savers. The high street bank creates frictions in the transmission of monetary policy. CBDC removes those frictions. CBDC has the potential to make the implementation of negative interest rates easier. CBDC has the potential to raise the productivity of the UK economy.
David Cobham's picture David Cobham Heriot Watt University Neither beneficial nor harmful Not confident
It all depends on the form in which the CBDC is introduced and operated, but I'm assuming an 'indirect architecture', in which case the effects would seem marginal in either direction.
Martin Ellison's picture Martin Ellison University of Oxford Neither beneficial nor harmful Very confident
Digital currencies will only be a sideshow in the next decade. Debit cards became available in the 1980s and 1990s, but it was not until 2018 that payments by debit card exceeded those by cash in the UK. Even if the Bank of England introduces a central bank digital currency in the next decade, it will take time before it becomes an accepted part of the financial market landscape.
Roger Farmer's picture Roger Farmer University of Warwick Beneficial Confident
Digital currencies are here to stay. If private crypto currencies begin to supersede the use of national currencies they will erode the ability of central banks to fulfill their twin roles of price stability and maximum sustainable employment. National digital currencies, and the state monopolization of this function, are the logical next step in the evolution of money.
John VanReenen's picture John VanReenen London School of Economics Beneficial Not confident
David Miles's picture David Miles Imperial College Beneficial Confident
Substantially reducing the risk of bank runs by providing a safe means of payment and a default free home for funds for the risk averse would remove the need to have deposit protection schemes. It would also remove the need for so much bank regulation and supervision designed to stop banks with retail deposits owned by very risk averse households taking inappropriate risks.
Nicholas Oulton's picture Nicholas Oulton London School of Economics Beneficial Very confident
Greater competition for UK banks would be a good thing. As far as retail customers are concerned banks only innovate when really pushed by forces outside the banking sector.
Panicos Demetriades's picture Panicos Demetriades University of Leicester Beneficial Very confident
It can be both beneficial and harmful for the reasons alluded to in the literature that you cite. It is hard to imagine a topology in which central banks displace financial intermediaries, although I agree with Haldane that in that world banking crises can be avoided. The reason is that without fractional reserve banking, we lose the inherent instability due to bank runs, but we also lose financial intermediation provided by the banks, which helps address all kinds of imperfect information problems in finance. Thus, it is not at all obvious that abandoning fractional reserve banking is in the public interest - indeed the Diamond Dubvig model shows that financial intermediation can help achieve the Pareto optimal allocation, as long as we can prevent bank runs from occurring (which explains lender of last resort and deposit insurance). If CBDC is introduced by BoE and indeed other CBs, it will likely be through financial intermediaries providing the interface, as central banks in general should not be aiming to displace intermediaries by taking deposits directly from the public. It will also likely come with relatively low limits, e.g. no higher than deposit insurance limits to prevent unfair competition with commercial banks. Additionally, there will have to be strict anti money laundering (AML) checks - something that the economic literature has not addressed. It is inconceivable that CBDC end up facilitating money laundering - which unregulated digital currencies often do.the reputation risks are so high that central banks should do everything possible to prevent it - which means there have to be identity checks at least at the entry point. A lot of work needs to be done to study CDBC by central banks considering introducing them, given the opportunities, challenges and risks. The outcome of this process in my view is that B digital currencies, if and when introduced, will be well regulated and will not constitute a AJ or source of competition to commercial banks. As such, their impact will be limited but on balance somewhat beneficial. Otherwise, they will not be introduced!
Ricardo Reis's picture Ricardo Reis London School of Economics Beneficial Very confident
Given current state of knowledge, pros outweigh the cons. But we are still learning about it.
Linda Yueh's picture Linda Yueh London Business School Beneficial Confident
Gino A. Gancia's picture Gino A. Gancia Queen Mary University of London Beneficial Confident
Costas Milas's picture Costas Milas University of Liverpool Beneficial Confident
Beneficial provided that we do not rush into the project for the sake of it. Currently, the whole idea is more like a shot in the dark as there are too many unknowns. So I would like to see a proper discussion and preparation before the digital currency is implemented. The digital currency is an asset which will be priced in the market. I assume it will offer an interest rate, which in turn, will provide the BoE with another powerful monetary policy tool. Will this interest rate be determined by a a so called "policy rule" and how will it be linked to the Bank's base rate? If, indeed, this digital currency offers an interest rate, how will this affect the value of the (traditiona)l sterling exchange rate?
Wouter Den Haan's picture Wouter Den Haan London School of Economics Beneficial Not confident
Natalie Chen's picture Natalie Chen University of Warwick Neither beneficial nor harmful Not confident
Lucio Sarno's picture Lucio Sarno Cambridge University Beneficial Not confident

Question 2

Participant Answer Confidence level Comment
Ethan Ilzetzki's picture Ethan Ilzetzki London School of Economics Moderate harm Not confident at all
I doubt CBDCs will be designed in such a way that they usurp banks' traditional role. If banks are "disrupted" it will be due to private sector developments and I expect banks will evolve to face these new challenges.
Jagjit Chadha's picture Jagjit Chadha National Institute of Economic and Social Research Moderate benefits Not confident
As with my previous answer, it all depends on the details of the introduction of the CBDC. Specifically, who can hold, what it can be used to buy and in what quantities. And whether cash, as we know it, will run in parallel. The ability of the private sector to provide financial intermediation must be protected.
Hande Kucuk No or little effect Not confident
Sir Charles Bean's picture Sir Charles Bean London School of Economics Moderate benefits Confident
Jumana Saleheen's picture Jumana Saleheen CRU Group Great harm Not confident at all
Central bank digital currencies will be the next big disrupter to the financial system. The devil is in the detail. The level of disruption will depend on how the CBDC will work in practice. At one extreme, if I can hold a central bank digital currency account, and undertake all my transactions through that account, I do not need a high street bank account. This CBDC innovation has the potential to be the final nail in the coffin with respect to banks' traditional role as an intermediary between borrowers and savers. Some of that disruption is already underway with the growth of challenger banks (such as the Monzo app) and the availability of loans from non-bank financial institutions.
David Cobham's picture David Cobham Heriot Watt University No or little effect Not confident
Again, this assumes an 'indirect architecture'.
Martin Ellison's picture Martin Ellison University of Oxford No or little effect Confident
Outside of a financial crisis, there is limited appetite to “rock the boat” with financial innovation. This means that the role of a newly-launched central bank digital currency will, by design, likely to be limited. Radical proposals are unlikely to fly, so it is difficult to see sufficient disruption to upend 800 years of traditional banking.
Roger Farmer's picture Roger Farmer University of Warwick No or little effect Confident
I see no merit in the argument that access of private individuals to digital state money would harm the existence of the private banking system. Private banks will evolve, as they always have, to provide intermediation services in different ways. It is fallacious to believe that commercial banks need deposits to function. There are many other ways of providing the maturity transformation and risk intermediation services that characterize the activities of modern banks.
John VanReenen's picture John VanReenen London School of Economics No or little effect Not confident
David Miles's picture David Miles Imperial College Moderate harm Not confident
Banks benefit from implicit and explicit insurance of bank retail deposits; this is probably not fully priced which helps them. Removing that insurance is made more feasible by CBDC and while banks might be net losers, overall there are net benefits.
Paul De Grauwe's picture Paul De Grauwe London School of Economics No or little effect Confident
Nicholas Oulton's picture Nicholas Oulton London School of Economics Moderate harm Confident
The whole point of greater competition is that it does harm incumbents whose monopoly profits are reduced. They are then forced either to innovate to keep up or shrink. A CBDC would move the banks towards a greater reliance on equity financing which would improve bank safety and is something they have resisted fiercely since the global financial crisis. If banks do indeed have expertise in allocating funds to borrowers then they can still exercise this to make profits even if they are largely equity-financed.
Panicos Demetriades's picture Panicos Demetriades University of Leicester No or little effect Very confident
For the reasons, alluded to above CBDC will not displace but complement financial intermediation and will not be a major source of competition for funds. CBDC could benefit banks, if they end up providing the infrastructure and clearing system of this new form of payment.
Ricardo Reis's picture Ricardo Reis London School of Economics No or little effect Very confident
Banks in the last few years have already suffered great competition from fin-techs in the operation of payments. The counterfactual of no CBDC is not the status quo of ten years ago. Also, as the BIS excellent research output in this area has shown, the ultimate impact depends on which type of CBDC comes to life, and in some of them banks benefit greatly.
Linda Yueh's picture Linda Yueh London Business School Other or no opinion Not confident
Gino A. Gancia's picture Gino A. Gancia Queen Mary University of London No or little effect Confident
Costas Milas's picture Costas Milas University of Liverpool Moderate benefits Confident
In the medium to long run, I assume banks will adjust to the challenge.
Wouter Den Haan's picture Wouter Den Haan London School of Economics No or little effect Not confident
The transition towards a system in which banks rely less deposits will have some costs, but surely it will be a better system with less distortions when banks' lending occurs less with funding like deposits that seem cheap to banks but that come with a nontrivial social cost in the form of financial instability.
Natalie Chen's picture Natalie Chen University of Warwick Moderate benefits Not confident
Lucio Sarno's picture Lucio Sarno Cambridge University Moderate harm Confident