The Bank of England has published its latest thinking on new forms of digital money, a.k.a. Central Bank Digital Currencies and stablecoins. Notably, the BoE’s latest modelling on the potential impact on credit conditions has not deterred the Bank from continuing to support digital money innovation. In the case of systemic stablecoins, it expects such arrangements to be subject to standards “equivalent to commercial bank money” and outlines four potential models for achieving that. The paper is open for feedback until 7 September 2021.

A busy month for the BoE’s innovation department

The Bank of England has had a busy month in matters of innovation. It recently published a discussion paper on new forms of digital money and a summary of responses to its March 2020 CBDC discussion paper (along with a number of related speeches). It has also, together with the Bank for International Settlements, launched the BIS Innovation Hub London.

So, what have we learnt from its latest messaging? A few key takeaways below.

The Bank’s modelling on the potential impact on credit conditions has not deterred the Bank from continuing to support digital money innovation

The potential risks that stablecoins and, in some cases, CBDCs pose to monetary and financial stability have been widely discussed. They include, among other things, the potential impact on commercial banks and the knock-on effect on funding the real economy. Whilst heavily caveated, the digital money paper reveals some BoE modelling which suggests that the long-term impact of new forms of digital money on lending rates and credit provision may be modest (though the impact on banks themselves, particularly in the short term, may be more significant).

More broadly, the papers suggest that the Bank’s current thinking is that it should be possible to manage risks to monetary and financial stability through well-designed measures. In the case of stablecoins, this includes (i) an appropriate regulatory framework that aligns with the Bank’s expectations; (ii) the use of transitional periods to assess the impact of any launch after the event; and (iii) initiatives to encourage more institutions to access the Bank’s liquidity facilities (as discussed further below).

CBDCs – no firm decisions yet, but commitment to deeper exploration driven by five key principles

The responses to the BoE’s March 2020 CBDC discussion paper revealed a broad range of views on most substantive issues concerning CBDC, including whether or not to issue one. Many felt that the BoE needed to set out the use case more clearly, and that this would ultimately drive answers to other questions. This is something that the Bank has clearly taken on board.

The Bank now plans to “deepen its exploration” into CBDC through a number of fora, including a Joint Taskforce with the government; a CBDC Engagement Forum; a CBDC Technology Forum; and its work with the Bank for International Settlements.

In doing so, it plans to follow five principles, which it has formulated based on areas of consensus in the responses.

1. Principle 1: Financial inclusion should be a prominent consideration in the design of any CBDC. For example, it should be broadly accessible and not replace cash.

2. Principle 2: A competitive CBDC ecosystem with a diverse set of participants will support innovation and offer the best chance to deliver the benefits of CBDC. Consistent with the “platform-model” proposed in the BoE’s original discussion paper, the BoE should provide only a minimum level of infrastructure, with the private sector taking a leading role in responding to the needs of end users. Interoperability between CBDC and other forms of money will likely be a key concern.

3. Principle 3: Due recognition should be given to the value of other payments innovations and their ability to deliver the benefits the BoE seeks. Notably, the BoE has to consider whether improvements to existing architecture as well as privately issued stablecoins (which may in some cases be implemented much faster than a CBDC) could negate the need for a CBDC.

4. Principle 4: CBDC should seek to protect users’ privacy. The BoE has confirmed that, subject to meeting objectives in relation to financial crime, CBDC should ensure a strong level of privacy.

5. Principle 5: While CBDC should “do no harm” to the BoE’s ability to deliver monetary and financial stability, opportunities to better meet the Bank’s objectives should also be considered. In other words, the BoE should consider what opportunities CBDC offers to support monetary and financial stability (for example, in implementing negative interest rates or quantitative easing) as well as for payments.

Systemic stablecoin arrangements – broadly welcomed but need to meet standards equivalent to commercial bank money and traditional payment chains

Focus on systemic stablecoins

The digital money paper is primarily focused on stablecoins which are issued by private companies, denominated in sterling and have the potential to become widely used by households and non-financial businesses (i.e. gain systemic status). This is reflective of the government proposal to bring systemic stablecoins into the BoE’s regulatory remit.

The paper does acknowledge some of the potential challenges with developing different regimes for systemic and non-systemic stablecoins, including in relation to how firms might smoothly transition from one regime to the other as they grow (which is likely to be a key concern).

Stablecoins as a source of opportunity

Rather than discussing stablecoins purely in terms of risk-management, the BoE is quick to acknowledge the potential benefits that stablecoins could offer (eg in relation to efficiencies, competition, financial inclusion, data protection, resilience and enhanced functionality). Although it discusses the additional benefits that CBDCs could offer which privately-issued stablecoins could not (for example, in terms of public interest objectives), it does not seem to have reached any firm view as to whether a CBDC would necessarily be the preferable alternative.

Stablecoins as a store of wealth

The digital money paper highlights that stablecoins have the potential to offer both a new means of payment and a new way of storing wealth, and that the regulatory framework needs to support both functions. This is notable because the government’s recent consultation on stablecoins focused solely on payments. Likewise, the existing e-money regime (which the government has been considering for application to stablecoins) seeks to deter users from using e-money as a store of wealth by prohibiting interest payments.

Standards equivalent to those applied in traditional payment chains

The paper reiterates two expectations previously set out by the Bank’s Financial Policy Committee (FPC). The first expectation requires that payment chains that use stablecoins are regulated to standards equivalent to those applied to traditional payment chains and that firms in stablecoin-based systemic payment chains that are critical to their functioning are regulated accordingly.

Adding more colour to this, the BoE highlights that stablecoin arrangements can involve a fragmentation of functions (such as governance, issuance, redemption, reserve management, stabilisation, transfer of coins and interaction with users) across different entities, some of which may currently fall outside the regulatory perimeter. Given that any firm in the payment process could ultimately become a critical link in a systemically important payment chain, the Bank considers that it may be necessary to bring other entities within the scope of its regulation.

Standards equivalent to commercial bank money

The second FPC expectation requires that where stablecoins are used in systemic payment chains as money-like instruments they meet standards equivalent to those expected of commercial bank money. The BoE highlights four key features of the commercial bank regime for which equivalent protections would be needed:

1. A robust legal claim that allows for prompt redemption of the amount deposited

2. Capital requirements to lower the risk of insolvency

3. Liquidity requirements and support to ensure liquidity problems do not result in failure

4. A backstop to compensate depositors akin to the Financial Services Compensation Scheme and bank resolution arrangements

It also stresses that, unless a stablecoin is operating as a bank, the backing assets for stablecoins will need to cover the outstanding coin issuance at all times and robust reserve management will be a key requirement.

E-money not equivalent to commercial bank money

The paper echoes statements previously made by the Governor of the BoE in highlighting that the requirements applicable to e-money do not currently meet the FPC’s expectations. Whilst the use of e-money currently remains low, the BoE suggests that enhancements to the regime may be needed to address the potential for systemic risks arising in the future. Likewise, it indicates that this regime would not, as it currently stands, be suitable for regulating the types of systemic stablecoins it is concerned with.

Four potential regulatory models

The paper outlines four potential regulatory models which could be used to reflect the key features of the commercial bank regime. The differences centre around the assets that would be used to back the stablecoin issuer’s liabilities. In short, these are:

1. Bank model – i.e. the stablecoin issuer is subject to the current banking regime. Banks can choose to back their liabilities with (i) non-liquid assets like loans; (ii) liquid assets such as government bonds and certain corporate securities; and/or (iii) reserves held with a central bank.

2. HQLA model – the bank model is adapted so that the issuer is restricted to backing its liabilities with assets described in limbs (ii) and (iii) of the bank model. Capital, liquidity and backstop requirements could be calibrated to reflect the lower risks associated with these categories of backing assets.

3. Central bank liability reserve backing model – the bank model is adapted so that the issuer is restricted to backing its liabilities with assets described in limb (iii) of the bank model. This would be economically similar to a CBDC (but, importantly, not a direct central bank liability). Capital, liquidity and backstop requirements could be adjusted accordingly.

4. Deposit-backed model – liabilities are backed with deposits placed with commercial banks (acting as custodians). The custodian holds the deposits on trust for stablecoin customers in its reserve account or other highly liquid assets. The stablecoin issuer has no direct relationship with the central bank. This would share features with the current e-money regime, but with enhanced protections including a public backstop and appropriate capital and liquidity requirements.

Access to the Bank’s balance sheet

The model used would have implications for the use of the BoE’s balance sheet – for example, it may be appropriate for stablecoin issuers under the HQLA model to draw on central bank lending in order to access contingency liquidity in the event of severe market disruption, whereas this should not be necessary if the stablecoin issuer’s only assets are central bank liabilities.

Transitional periods and limits

As noted above, the BoE considers that transitional arrangements may be a useful tool in managing the potential impact of new stablecoins on monetary and financial stability risks. This includes, for example, the risk that the banking sector proves unprepared to withstand large outflows of deposits or that markets and non-banks are unable to fill any funding gaps that arise. Transitional arrangements could, for example, include limits on the use of, or access to, stablecoins during the transitional period. Such arrangements could also be maintained on a more long-term basis if necessary.

Next steps

The Bank’s discussion paper invites feedback on most of the issued raised, including the appropriate regulatory framework for stablecoins. Responses must be submitted by 7 September 2021.

As ever, please get in touch if you would like to discuss.