Response to Crypto & Digital Assets APPG: Crypto Inquiry 2022

Share this!

The Digital Pound Foundation takes pleasure in responding to the Crypto & Digital Assets APPG – CRYPTO INQUIRY 2022.

The DPF is supportive of the UK government’s commitment to place the UK’s financial services sector at the forefront of cryptoasset technology and innovation, and to take a staged and proportionate approach to cryptoasset regulation, which is sensitive to risks posed and responsive to new developments in the market.

With respect to this response, we will focus our attention on the questions most relevant to the DPF’s remit:

  • The role and current approach of UK regulators including the Bank of England, the FCA and the ASA in relation to new forms of digital money, including stablecoins:
    • Views on the current approach by UK regulators, specifically the Financial Conduct Authority, the Bank of England, and the Advertising Standards Authority.
  • Central Bank Digital Currencies:
    • Views on what any UK CBDC should look like;
    • Views on the potential use case for a UK CBDC;
    • Views on the opportunities and risks associated with a UK CBDC.

General Comments

The introduction of new forms of digital money – whether public or private in form – is irreversible. And, given that money touches everyone and everything, its implications are enormous. A global race has therefore developed between private and public protagonists – the issuers of these new forms of digital money. The ability to maintain the stability, safety, and security of financial markets and access to money and payments infrastructure is therefore of profound social and political significance for all central banks and governments. These new forms of digital money create opportunities for radical transformation of the ways in which business is done, value is exchanged, and services are provided and received. They also give rise to risks and challenges, which must be recognised and addressed.

The DPF sees a clear distinction between digital forms of fiat currency (including fiat-pegged stablecoins and central bank digital currencies) and other forms of digital currencies, such as cryptocurrencies and those stablecoins that are pegged to multiple currencies or to one or more other types of asset. Digital forms of fiat currency – which can be thought of as new forms of digital money – are likely to play a growing role given the functionality, opportunities and potential benefits that they bring to the way in which consumers, businesses and governments transact with each other.

The introduction of new forms of digital money will lead to the coexistence of three forms of fiat currency: cash, commercial bank money, and new forms of digital money (which may be further subdivided into CBDC and privately issued systemically important stablecoins, should a CBDC be introduced). In the DPF’s view, public interest will likely be less in the potential utility of a central bank-backed form of digital money, and more in the potential anonymous (or otherwise) aspects of such a development.  Since the Bank has already said that any form of digital money will not be anonymous, digital money is likely to be more of an alternative to commercial bank e-money than to cash, with the exception of financial inclusion requirements (bearing in mind that people do not necessarily transact in cash out of choice, but also due to exclusion from the banking system for whatever reason). Its primary appeal to the public will therefore lie in fact that it is smart (programmable etc) e-money, much like a smarter form of commercial bank or EMI-issued e-money, and that it is fully backed by the central bank with no FSCS limit.

We do not see digital money as supplanting other forms of money, but rather as coexisting alongside them, for the foreseeable future. Furthermore, over time the lines between these forms of money may become blurred, as commercial bank money itself becomes issued in a digital-native form akin to stablecoins (or “tokenised” commercial bank money) and if a retail CBDC that is implemented with cash-like features becomes used in a similar way to cash.

The role and current approach of UK regulators to new forms of digital money, including stablecoins

We support the general decision of policymakers and regulators to focus on stablecoins in the first instance given their potential to develop into a widespread means of payment.

The DPF also agrees that the introduction of such regulation will help create the conditions for issuers and service providers of stablecoins and e-money tokens used as a means of payment to operate and grow safely in the UK, driving consumer choice and efficiency. However, we recognise that the government also considers it necessary to ensure appropriate and proportionate  tools are in place to mitigate the financial stability issues that could materialise by the failure of a firm of systemic scale. To date, no firm in the UK has yet launched a stablecoin capable of being used as a means of payment to such an extent. Globally, stablecoins such as Tether’s USDT and Circle’s USDC are primarily used for transacting in cryptocurrencies; that said, their potential benefits in both wholesale and retail payment and settlement use cases are well documented. It is only a matter of time until they are more widely adopted. We are also mindful of the efforts by private entities to introduce stablecoins whose use would, by virtue of the user base and platform on which they are offered, rapidly become systemic in nature (the now-defunct Libra and Diem proposals being a prime example of this phenomenon).

In this response, we are mindful of a number of recent HMT and Government publications that reference the future regulatory treatment of stablecoins, including:

The DPF is also mindful that privately-issued new forms of digital money remain a nascent sector at present, and that many discussions – including those between the Digital Pound Foundation, its Members and Partners, and the wider financial community – are taking place about the form of digital money in the future, and the market structures and ecosystems that  may evolve and rise.

Whilst it is true that recent events in the cryptoasset markets have highlighted the need for appropriate regulation to mitigate consumer, market integrity and financial stability risks, it is also notable that the stablecoin regulatory perimeter currently envisaged by HMT would not have prevented the collapse of TerraUSD, a so-called algorithmic stablecoin.  We are mindful  of the potential for this emerging sector to evolve unexpectedly, and for the risks of potential contagion and systemic impact to manifest itself in ways difficult to envisage at present. In this context, regulators and policymakers should remain vigilant and mindful of the need for appropriate risk management not only on the part of the issuers of those stablecoins that may become systemic in scale, but also on the part of systemically important users of such stablecoins (specifically, regulated financial institutions).

Whilst we acknowledge the principle that systemically important payment systems  (loosely defined as those whose failure could imperil the proper functioning of the UK economy) should fall within the Bank of England remit, we would also wish to clarify that, in the case of those firms that are solely consumer-facing and do not operate a payment system of systemic importance, these remain under the sole purview of the FCA in line with the current e-money and payments regulatory regimes.  Clarity is required to ensure that these remain appropriately supervised by the relevant regulator and that the principle of “same risk, same regulation” is followed; in short, that certain firms are not treated differently purely due to their underlying technological operating model.

We acknowledge the Bank of England’s remit for oversight of payment system  operators and suggest that HMT await the outcome of the pending consultation by the FCA and the Bank of England that will set the regulatory perimeter before making a final decision on the mandate of the Bank of England with regard to consumer-facing firms.

We observe that at present, a bank issuing a stablecoin (or any other new form of digital money, such as a tokenised form of commercial bank deposits) may not be captured by some of the proposed regulation (where it applies exclusively to non-banks), as they are catered for by separate pre-established regimes. From a consumer perspective, this could lead to differing outcomes in the event of the failure of a bank stablecoin issuer vs a non-bank stablecoin issuer, most significant of which is the extent to which deposits are protected.

There is also at present little mention of the proposed roles of the PRA and the PSR in the new regulatory ecosystem for stablecoins, and given their own respective role for e-money firms and payment systems, this means that it is not possible to determine current proposals fully address the risks that HMT seeks to mitigate, or whether this will be achieved through the most appropriate regulatory bodies.

Introduction of a UK Central Bank Digital Currency

As the Bank of England itself has noted, in its 2021 Discussion Paper on New Forms of Digital Money, the introduction of a CBDC would likely result – to at least some extent in a shift away from commercial bank money deposits. This in turn could represent a potential challenge to the existing fractional reserve banking system, on which the UK is highly dependent (particularly as an economy that is reliant on higher levels of household debt). Nevertheless, it is also possible that innovative forms of financing could arise as a result of the introduction of CBDC and the technological opportunities to which it gives rise.

The DPF sees five key areas in which a CBDC could deliver benefits for the UK:

Central bank and monetary policy

  • As a meaningful and potentially safer public money alternative to the use of private stablecoins and cryptocurrencies for payments and settlements, by providing a central bank-backed alternative digital currency that preserves consumer protections whilst also enabling the benefits associated with programmable money.
  • With the decline in cash usage and acceptance, the creation of a CBDC would enable the continuation of the wider general public’s ability to hold public (or “central bank money”) as opposed to exclusively relying on private money – whether in the form of commercial bank money, e-money or privately-issued stablecoins – for digital account holdings and digital transactions.
  • Improvements in monetary policy transmission, and the potential to allow central banks to deploy highly reactive monetary policy measures. In the event that a CBDC is designed to be interest-bearing, it could directly enable interest rate policies to be transmitted more rapidly and efficiently to end-users.
  • CBDCs can be used as a tool in implementing programmes such as digital borders, for example in enabling the digitisation and automation of customs paperwork and associated payments.

Domestic and cross-border payments infrastructure

  • More efficient cross-border payments infrastructure (for both wholesale and retail/commercial payments), and a more efficient domestic payments infrastructure through developments such as programmability of money.
  • Underpinning a digital-native, comprehensive payments service for government, individual and business users, enabling the legal and regulatory requirements arising from any given payment or transaction to be met in real time.

Transition to a digital economy

  • Enabling the transition to a digital economy and helping to drive innovation. Introduction of a CBDC can drive greater adoption and innovation of transformative technology paradigms such as artificial intelligence (AI), decentralised systems and applications implemented via distributed ledger technology, and the internet of things (IoT). Combining the power of AI and DLT can give rise to a diverse set of new business models and applications associated with internet-enabled, networked hardware devices that can act as digital agents for their owners.

Financial/Digital inclusion and social policy delivery

  • As we have seen, the use cases and benefits associated with CBDC have gained significant traction in the wake of the COVID-19 pandemic, particularly with respect to the potential applications around financial inclusion – including improved capabilities around government distributions, and the achievement of existing and future public policy.
  • A well-designed CBDC that encompasses principles of universal account access has the potential to enable greater financial inclusion. Payment service providers in a CBDC ecosystem could be incentivised to offer accounts or wallets to those customers that are excluded from conventional banking services. Greater financial inclusion, and more universal access to accounts, can generate wider social benefits, including improved credit ratings, lower costs of transactions (to the users of the services) and access to cheaper credit.
  • The introduction of a retail CBDC in the UK will need to be accompanied by careful consideration of the UK’s specific needs with respect to digital inclusion, and how these can be addressed and accommodated through a combination of design alongside the accompanying payments market structure and the roles of participants such as wallet providers and payment interface providers.

Financial Crime

  • As highlighted in UK Finance’s half-yearly Fraud Report (22nd September 2021), the level of digital payment fraud through existing payment channels continues to be substantial. Authorised Push Payment Fraud increased by 60% in volume and 71% in value (to £353m) in the first half of 2021 compared to 2020.  The intrinsic characteristics of CBDCs (e.g. their traceability and programmability) provides a strong opportunity for such fraud to be significantly reduced. These same characteristics could also greatly assist in reducing the ability to process proceeds of crime, terrorism financing and money laundering.

One of the most exciting features of CBDC is the potential for introducing programmable money –  a form of digital money that, by design, allows for the execution of certain software code in the course of a transaction using that money.  Programmable money can offer users – be they individuals, businesses, local authorities or government departments – a means of transacting in which all the consequences and obligations arising as a result of their transaction are managed seamlessly. For example, this could include automated tax reporting and tax deductions at the transaction level, greatly simplifying company accounting procedures and improving the real-time flow of tax receipts to HMRC. For government and local authorities, this could mean better policy delivery, in real time, and for individuals and families it could mean cheaper, easier and more secure access to benefits and entitlements, via digital money, than is currently available. There are indeed risks associated with the introduction of a CBDC, although we note that, given the benefits of introducing one – and indeed the importance of introducing a UK CBDC, given global developments in this space – these can all be managed and mitigated given appropriate planning and resources. Risks include:

Systemic and structural challenges

  • As the Bank of England has noted in its Discussion Paper on New Forms of Digital Money, the introduction of a CBDC could lead to outflows from commercial bank deposits into CBDC holdings, resulting in lower deposit balances being held with commercial banks and hence posing challenges to the ability of commercial banks to maintain their lending abilities, all other things being equal. The same Discussion Paper observes that similar effects could in any case be experienced should the public shift significant holdings and transactions to privately issued systemically important stablecoins. In the DPF’s view, such risks to financial incumbents should not outweigh the potential benefits of digital money for the UK, although we agree that these risks will require management. The Bank has proposed options such as the imposition of limits on holdings in any new forms of digital money, in order to manage the transition towards their adoption at scale, with which we would concur.
    • In a recent speech, Fabio Panetta, member of the Executive Board of the ECB, noted that the ECB’s “preliminary analyses indicate that keeping total digital euro holdings between one trillion and one and a half trillion euro would avoid negative effects for the financial system and monetary policy. This amount would be comparable with the current holdings of banknotes in circulation.”   
  • Opponents of CBDCs often argue that their introduction would force a central bank into becoming a consumer service provider, or would lead to the disintermediation of commercial banks. We would dispel these myths at the outset, noting that the Bank of England itself, in its 2020 Discussion Paper on central bank digital currency, has explicitly rejected any model that would require the Bank itself to provide accounts to the general public, instead seeking to maintain direct access only to certain service providers (in keeping with the current wholesale payments and accounts model). The DPF – like the Bank – envisages a continued role for commercial banks as well as a broader and diverse range of regulated service providers in the role of Payment Interface Providers in a CBDC system. Additionally, to the extent development of a CBDC results in greater competition from non-bank providers to fill the roles traditionally played by commercial banks, consumers could benefit as well.

Operational challenges

  • Introduction of a CBDC will require financial institutions to assess the impact on all of their front-to-back technology and operational infrastructure and processes. The impact is not limited to payments and settlements systems- introduction of a CBDC, and the associated changes to payments processing, can potentially impact the systems of every function in a financial institution (e.g. sales and trading, trade finance, treasury and lending). When viewed in the context of the wider wholesale review, re-engineering, modernisation and digitisation required for a successful transition to a digital economy, this is not necessarily a negative development. Nevertheless, the challenges associated with loss of data, sunk investment costs due to CBDC making previous or planned changes redundant, and general re-engineering challenges are all challenges that must be managed.
  • Customers of these institutions, including corporates and buy-side financial institutions such as asset managers, will be impacted too, in particular where they have direct interfaces to the bank.
  • In order for implementation and roll-out to be successful, the Bank of England will require intensive cross-industry engagement and collaboration, and a detailed implementation roadmap that will cover the impact on and risks posed to every part of the financial markets ecosystem.

We anticipate that CBDC will co-exist with other existing forms of public money for some time, if not indefinitely. Accordingly, CBDC infrastructure should also be designed such that it is interoperable with existing and planned payment infrastructure within the UK and globally, and also with respect to some in-flight upgrades to existing payment infrastructure (such as the UK’s New Payments Architecture), so that these expensive initiatives do not become throwaway efforts.

Reputational and commercial challenges

  • Public trust in a CBDC is vital, in order for successful commercial uptake. Public trust can be negatively impacted, for example, by a perception that the design of the CBDC does not adequately address privacy concerns, that there are insufficient legal safeguards for privacy and autonomous control of personal finances and transactions, and that the use of features such as programmability may violate an individual’s autonomy over their own finances. Such concerns can be addressed in the design of the CBDC as well as the legislative framework around it. The cost of failing to gain sufficient public trust in a CBDC, and hence sufficient uptake, would likely be a gravitation towards private forms of digital money (e.g. stablecoins) or to cryptocurrency-based payment systems and accounts.
  • There is also a cost associated with adopting new forms of money and payments systems, on the part of businesses and consumers. Such costs can be addressed in design choices, for example via mechanisms such as interoperability of CBDC with existing payment systems, and by requirements (or subsidies) for payments intermediaries in a CBDC ecosystem to make the on-ramps and off-ramps to CBDC affordable and easily integrated with existing B2B and B2C payments applications.

Submit your feedback

Claim a FREE Subscription

Receive our monthly newsletter, PLUS invitations to our webinars and events.