It’s unlikely journalists at the Financial Times will have to worry about redundancy any time soon. From narrowly avoiding a recession in 2022 (albeit on 0% GDP growth in the last quarter) to being the only major economy forecast to shrink in 2023 according to the IMF, the UK economy has provided headline after headline. Amidst the chaos, it’s hard to blame the Bank of England for wanting some positive press. Enter the digital pound: the Bank’s radical proposal to shake up the banknote.
What is the digital pound?
It must be stressed at the outset that the digital pound is not a cryptocurrency. Cryptocurrencies are decentralised currencies that anyone with a knack for coding can create, such as the joke-coin 'Dogecoin'. Conversely, the digital pound is the same as any physical banknote or coin, simply transported into the digital sphere. The consultation indicates this is likely to be accomplished through blockchain-based encryption, making the digital coin very similar to cryptocurrencies. This would ensure that every pound could only be spent once – important because a historic issue with digital currencies is the ‘double-spend’ problem. The crucial difference with cryptos is that the digital pound would be centralised, meaning controlled by the government.
The coin would be issued by the Bank of England, who would be its guarantors, but precisely where it would be stored is up for debate. It could be on a "smart-card", or perhaps just a smartphone app. These would be provided by private companies, who would receive access to the Bank of England’s infrastructure.
What's clear is that any regulation surrounding the storing of customer data and payments will be extremely complex. For law firms with a strong history in FinTech and regulation, such as Allen & Overy (ranked Band 1 for their London FinTech offering by Chambers UK), this could provide a vital opportunity to generate revenue in an increasingly competitive market. Considering A&O can offer Magic Circle expertise coupled with strategy consulting, it is possible to imagine them being front and centre in navigating this new digital world. Slaughter and May, too, are likely to play a key role in developing these regulations, having been the historic legal adviser of the government following the 2008 financial crisis.
Why does the Bank of England want the digital pound?
In a post-Covid world, cash is no longer king. In 2020, cash use fell 35% while contactless rose 12%. The trend towards contactless is hardly surprising. More people than ever own a smartphone, and compared to five years ago, cards with contactless capabilities are the norm rather than the exception. Cash is also expensive to mint. A 2020 Freedom of Information request revealed that the price to produce a single note is between seven and eight pence. That may not sound like a lot, but when you consider that there were 4656 million bank notes in circulation in 2022, it adds up fast. Faced with plummeting demand and high prices, then, the Bank of England decided to act.
The paper also argues that access to the public pound is essential for the economy. As a safe liquid asset backed by the state, and one which will always be accepted, cash underpins households and businesses' confidence in the value and uniformity of money. For the Bank, the decline in cash use and the rise of forms of 'private digital money' such as stablecoins, with the potential for convertibility to cash to become harder, threaten that uniformity.
How might the digital pound affect the wider economy?
Despite assertions that a digital pound would be identical to a physical banknote, it could radically affect the economy. I identify four key ways.
First, there is compelling evidence to suggest that consumers spend more when they do not have to physically hand over cash. When the contactless limit was increased from £45 to £100, the average payment surged by almost 30%. If contactless payments become more available, it’s easy to imagine this number will continue to rise. Research from Switzerland also found that when contactless is available, debit cards are used more frequently. Contactless has also been found to increase consumer spending and, assuming this trend holds true, a digital pound should do the same.
Moreover, cash going digital could reduce the rate of retail account holder deposits in commercial banking. This is my own speculation, but I don’t think it’s a particularly radical point to make. We put money in retail bank accounts because hoarding thousands of pounds in cash is both inconvenient and risky (we could lose it, have it stolen, etc.). If our cash is now stored digitally and can be used in the same way, there is no longer this incentive.
This is important because for banks such as JP Morgan and Bank of America, customer deposits are a key source of generating income. They do this by loaning out customer deposits, profiting from the difference between the interest they receive from debtors and the interest they pay out to depositors. That difference is known as net interest income (NII). Shrinking deposits, however, would mean less capital to make the initial loans.
For example, falling deposits meant that JP Morgan recently reported a NII significantly lower than analyst expectations. NII has been a key hedge for banks like JP Morgan, allowing them to come out relatively unscathed during the downturn in dealmaking. With reduced NII, banks could end up overly reliant on their advisory businesses like Goldman Sachs, whose profits have plunged two-thirds as a result of the M&A slowdown (recently covered on this Blog by Jenny Petch).
Thirdly, a digital pound could increase the risk of bank runs. A bank run occurs, as Investopedia helpfully outlines, when significant number of depositors seek to withdraw their deposits simultaneously, threatening the solvency of the bank. Consequently, Sir Jon Cuncliffe, the deputy governor of the Bank of England, has proposed there would be an individual limit on how much cash could be held digitally. A precise figure has not yet been decided, but current ranges put it in the low single digit thousands.
Finally, the digital pound could take us one step closer to widespread ‘smart contracts’ (see page 19 of the consultation paper). This could have a radical effect on the legal industry, as these contracts streamline the process of a transaction. Rather than requiring a solicitor to manually release funds, these permissionless contracts can do so when a specified checklist is met. However, with the proposed low limit on the digital pound, this is unlikely to have a significant impact on commercial law firms in the short-term.
What else do we need to know?
The most important question that needs to be answered is the extent of anonymity the digital pound will provide. Many people, perhaps sceptical of the government or otherwise, prefer physical banknotes for the anonymity they provide. Will the digital pound maintain this anonymity? The answer to this question could be key for the extent of people that are prepared to use it – and even then, true sceptics may refuse to believe it.
The digital pound is an interesting proposal. It could pave the way for a whole new industry with smart cards and apps facilitating the transfers, providing vital opportunities for companies to diversify their offering. It could promote innovation, increasing the use of smart contracts. Its creation will present unique challenges in data protection and privacy, which I’m sure law firms will be anxious to tackle. That's especially true for Slaughter & May: government contracts are lucrative.
But equally, the digital pound presents risks. The effects on the wider economy will doubtless be fleshed out more by the time the consultation paper concludes. However, for the time being, the changes involved seem very under-analysed considering their potentially radical impacts. Regardless, it’s unlikely we’ll see the digital pound this decade. Perhaps this is a story best left to rest until more pressing matters (consumer price inflation is still more than four times the 2% target) are resolved.