The UK needs a CBDC, but why impose a £20k limit?

Representatives of the BoE and Treasury made announcements on the 7th February 2023 regarding the progress towards creating a digital version of the UK’s fiat currency (Pound Sterling).

Along with several public statements, the announcement included opening a consultation and sharing an architectural working paper produced by the Bank.

Since then, there have been numerous articles and conversations surrounding the Bank’s approach to creating a CBDC. However, two questions above all seem to be of greatest concern.

1)    What does a Pound CBDC give us that we don’t already enjoy with GBP fiat?

2)    Why has the announcement accompanied an expectation of an imposed £20k limit?

This thinking and these challenges are discussed in Bad Money: FinTech as an Instrument in the Battle for Global Dominance.

The first question may be addressed with a large variety of answers. However, I will restrict mine to the most salient.

Most importantly, the principal rationale for creating a digital pound is that although several minor players have released them, when China did so, it changed the competitive landscape. As the world’s second largest economy, China creating a digital form of its fiat currency, the e-CNY and its payment system - Digital Currency / Electronic Payment (DC / EP) in early 2020 has meaningfully altered the fiat spectrum. Since then, there has been a significant acceleration in exploring how to achieve parity amongst emerging as well as advanced economies worldwide.

The natural response to the above explanation is ‘well, so what? Isn’t our money mostly digital already?’

The vast majority of the British money supply (M1, M2 & M3) is already digital. It resides as account-based money on the balance sheets of financial institutions. This includes depositors’ funds which can easily be stored, saved, invested, and spent from a smartphone app or via a website. Furthermore, only a proportion of the ‘M0’ money supply comprising physical banknotes and coinage isn’t presently digital.

Thus, it begs the question as to what benefit is there to digitising a subset of the M0 money supply.

Firstly, the various entities that play a role in the end-to-end process of facilitating payments between two counterparties are not necessarily doing so efficiently and each exacts a proportion of a transaction fee to do so. Thus, the introduction of a convertible virtual currency by a central bank which is transferable between counterparties digitally is an opportunity to mitigate counterparty risk as well as reduce the excessive costs, friction, and inefficiency of doing so.

Secondly, with the recent volatility experienced in extra-systemic cryptocurrencies, regulating these digital asset classes will gain broader acceptance by displacing their utility with a legitimate fiat equivalent.

Thirdly, human beings are not the only economic actors that will benefit from a truly digital medium of exchange. It is no secret that we’ve embarked on a digital journey and entered a novel epoch dominated by technology-enabled commerce. As this Web3 journey progresses, the need for digital media of exchange will only amplify. Furthermore, as the Web4 ecosystem matures, facilitating commerce amongst smart devices will require digital media of exchange in order to do so.

The latter is the world of Machine-to-machine (M2M) commerce. Without a digital fiat equivalent, this emerging business paradigm will be dominated by a minority of payment intermediaries, which will inhibit consumer choice, impede innovation, and ultimately relegate control within the economy to monopoly power. In reinforcing this perspective, it would be worth noting that CarIQ, a US company developing a seamless car-to-pump payment mechanism for refuelling vehicles, closed its $15m funding round on the same day as the BoE’s and Treasury’s consultation announcement.

The UK is an advanced economy famous for thought leadership, innovation, and is a buoyant centre of excellence for all things financial. Not having a ‘sovereign digital currency’ is simply an unrealistic proposition. Particularly over the longer term.

This now brings us to the second question. The £20k limit.

From the outset, there are foreseeable challenges with imposing a limit on holding a digital version of Pound Sterling. Practically, how would two counterparties transact if the payee has reached his/her limit? Remember, this isn’t a form of private e-money. This is a digital version of Pound Sterling fiat currency. Thus, it is legal tender and is required by law to be acceptable as a means of payment within the UK. If the payer is attempting to pay the payee with Pound Sterling, the payee must accept it. So, imposing a £20k limit is already set up for failure in certain situations. The Treasury and the BoE are likely forecasting that few such circumstances will manifest themselves. However, the very principle that such a limit exists, regardless of how high or low such a limit may be, by extension undermines the credibility of Pound Sterling as a whole.

This conjures parallels with ‘soft currencies’ which face convertibility challenges in some developing and emerging market economies. These jurisdictions often impose capital account controls, which limits the convertibility of their national currency. Consequently, confidence in the jurisdiction and its money is perceived to be lower and riskier than that of an advanced economy. This affects exchange rates, liquidity, investment into the jurisdiction (FDI), and has a cascading effect on its economy.

Pound Sterling’s (and by extension the UK’s financial centre) status relies on confidence in its stature as a bedrock unit of account and a prized reserve asset held ubiquitously by central banks worldwide. Albeit typically held in smaller quantities than that of US Dollars and Euros.

So, if imposing a limit on the quantity that may be held, why would the Treasury and the BoE risk Sterling’s credibility by doing so?

The most obvious reason is fear of what may transpire during the next liquidity crisis. In periods of financial stress, liquidity is sought as actors divest themselves of asset classes, they deem to be risky. In 2007, for the first time since the failure of Overend Gurney in 1866, queues formed outside a British Bank for the purpose of mass withdrawal. Northern Rock’s depositors sought to withdraw funds en masse. This is known as a ‘run on the bank’.

With a £20k limit imposed, depositors would not be able to transfer their account balances into cash digitally beyond this limit. Thus, the limit prevents a digital run on the banks for sums exceeding this threshold. This in turn serves as a measure to safeguard the banking sector in lieu of the public. As H.M. Treasury and the Bank of England are effectively the sponsors of the British Pound, I should imagine these institutions may wish to rethink this limitation. Afterall, this is effectively what the Bank of England’s monetary policy committee have the reserve ratio for. The reserve ratio could be increased to act as a counterweight to banks’ liquidity stress. The Financial Service Compensation Scheme limit of £85k per depositor could be raised. There are numerous remedies, which could be employed before resorting to this limit. None of the aforementioned alternatives, would negatively impact the stature of the Pound.

Returning to the legal tender status of a digital Pound and the necessity to accept this digital medium as a form of payment, this presents yet another sobering thought. In our present consumer payments ecosystem, merchants may receive payment via cards, cheques and private e-money at their discretion. They are however, compelled to accept legal tender.

This means once the BoE begins issuing a digital form of Pound Sterling, it implies that all merchants in the UK will be compelled to invest in the infrastructure to accept it whether they presently accept electronic forms of payment or not. In such circumstances small domestic merchants will likely be unreceptive and a degree of resistance may be evident once the small business community come to this realisation. Furthermore, public pressure from business may in turn prompt a differentiated status for digital Sterling from that of fiat. Thus, the digital Pound may be relegated to a ‘stablecoin’ status in lieu of a genuine form of public money / legal tender.

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