Why do we need a digital pound?

A recent article in the FT, “UK opens the stablecoin door”, essentially posed a set of recurring questions, including: “Why do we need digital currencies?” and, “Is the banking system not just fine?” But, before these questions are addressed, it is worth bearing in mind that, presently, payments have broadly been electrified, not digitized. Arguably, digital payments are effectively a bearer instrument in the same way that cash is; as opposed to cheques, debt cards, wire transfers, postal orders etc which are different forms of payments. These methods of payments rely on cash being deposited into a bank which means bank the depositor i.e., you become a creditor of the bank and thus reliant on the bank not to go bust. A digital currency can be used directly on a peer-to-peer basis to make a payment, so removing the counterparty risk of needing to use a bank and other third parties, and so reduce costs. UK payments are indeed competitive but, in order to remain so, banks and payment providers must be vigilant. It would be prudent to be aware of new technology in order to ensure consumer duty credentials are as strong as they can be. Digital currencies in the form of CDBCs and stablecoins (“pegged” is surely a far more accurate description) are simply also forms payments - which, for many, may well not be utilized but (for others) will enable payments to be made more efficiently and have the potential to offer greater transparency. Perspicuity is key in helping to preserve confidence in financial markets; indeed, confidence is one of the  principal objectives for regulators in many jurisdictions, and not simply in the UK. The more openness there is in the financial services sector, the more trust there ought to be - which has to be beneficial for consumers, regulators and product providers alike.

According to McKinsey, payments cost over $2trillion a year globally and it is expected that this cost will rise to over $3trillion by 2027. Thus, it ought to be of no surprise that many organisations are looking at payments and targeting the offering of payments as a source of new revenue, hence the explosion of FinTech firms, neo banks and, in the UK, the rise of e-money companies and challenger banks. Thanks to the foresight and open-mindedness of UK regulators (who pioneered the concept of a ‘sandbox’), the UK is one of the centres worldwide for FinTech firms. As stated by Deloitte: “London has been a key driver in the UK’s FinTech success story. As the second highest ranking FinTech ecosystem globally.” And, whilst the City is not universally loved, it is worth remembering that Deloitte furthermore considers that: “FinTech is an engine for growth - annualised growth rate of 16% vs 1.3% annualised SME growth over the past 10 years.

Likewise, it is useful to remember that the FX market is worth about $7 trillion per day, of which the UK has a 38% market share, with NYC as its next nearest rival in having a share of 19%. Historically, given that the UK had been a centre for trade and sits between the Asian and US time zones, the UK has somewhat had a unique advantage. However, as we begin to witness digital currencies having capacity to trade 24/7, the UK’s geographic advantage will be of less importance, i.e. other jurisdictions will be able to challenge the UK’s current dominate position and so result in a loss of revenue and jobs for the UK. Moreover, the UK is well-regarded as a financial services centre and often referred to as the ‘gold standard’ of financial regulation, so it is therefore imperative for it to be at the centre of innovation regarding payments. And, as the world becomes progressively more digitized, the need for digital payments will become more apparent.

But, you may well say, why? Well, one of the challenges that digital payments face is that tokenization is often synonymous with cryptos. The technology that powers cryptos is blockchain, but it can also be used to create digital representations of other more tangible assets such as equities, debt instruments, funds, real estate, commodities and, arguably, the biggest asset class - derivatives. As the chart below indicates, crypto is, in reality, a rounding error worth approximately $1.8trillion compared to other asset classes which collectively are worth $2.2quadrillion. There are many examples of highly regulated banks and asset managers increasingly realising the benefits of tokenization and, interestingly, when commenting about the recent launch of Bitcoin ETFs, Larry Fink, CEO at BlackRock (the largest asset manager in the world) stated: “ETFs are step one in the technological revolution in the financial markets,” adding, “Step two is going to be the tokenization of every financial asset.”

But why do we need digital payments? Well, as reported by the Bank of International Settlement, cash mutual funds/money market funds are worth over $9trillion globally. We are already seeing a number of highly respected global asset managers offering digitized versions, such as Abrdn asset management in the UK, Franklin Templeton in the US and Amundi in Italy, with many more in the process of following suit. But, instead of allowing investors to buy and sell once a day at a set time and have their price determined by the same asset management firm which manages the assets, digitized money market funds can offer 24/7 dealing and be priced by independent market makers. This not only allows investors more choice and, arguably, treats customer more fairly, but improves the customer duty credentials of the asset managers. Furthermore, in time there will be growing pressure to ensure that distributions will no longer be made every six months but monthly (or maybe even more frequently) for tokenized funds. The challenge is that whilst BACS payments are relatively cheap, 5p to 50p plus bank charges, if we then start to see more frequent but small income payments, the current banking rails are questionably not the most efficient way to make such payments.

In addition, once digitized, money market funds (in theory) offer individuals and SMEs a securer home for savings compared to having 100% in a bank deposit. So, potentially we could see tokenized money market funds become more widely used due to the fact that investors will be able to access their capital on the same day, as opposed to it currently taking two or three days for an asset manager to return funds to an investor. And surely, once the regulators see digitized money market funds as advantageous for consumers, they will question management firms as to why they are not digitizing their equity, fixed interest, property funds, etc, whereby unlocking the $145trillion of assets in funds to be tokenized. Hence, one could see, in months and not years, why there will be a need for more efficient forms of digital payments. And, other considerations exist, such as:

·      the ability to have programmable money using smart contracts

·      making payments globally at a fraction of the current cost

·      digital payments create a digital fingerprint so are less likely to be used by nefarious actors

·      how can you make payments in the metaverse without a digital option?

·      allowing peer-2-peer payments in almost real-time so reducing the need for counterparties and the entailing risk this can present

·      unlike cash in your wallet, a digital currency ought to be able to generate interest so treating customers fairly and enhancing the consumer duty credentials of the issuer.

It seems that what is really required is to allow banks to create “digital bank accounts” to sit alongside traditional current accounts and deposit accounts; this would then enable customers to select the cheapest option by which to receive and send money. Therefore, by removing the need for digital wallets and the expense of digital custody solutions (as ultimately the cash is held by the bank), then the way in which it is moved, i.e. physically, by cheque, CHAP, BACs or digitally, ought to be left for the consumer to  decide. Ultimately, it is imperative to allow consumers to have a choice of how they make payments, but it is vital that any digital currency issued by a UK-regulated firm needs to be 100% transparent and be backed 100% by cash deposits. This transparency will hopefully engender greater trust (and thus adoption) and help keep the UK at the forefront of innovation and be the epicentre of payments worldwide.