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CBDCs: What are They and Why is the UK Embracing Them?

January 4, 2023

Since the announcement of the UK’s 57th Prime Minister, whispers of the resurrection of a British central bank digital currency (“ CBDC ”) have once again surfaced. But what are CBDCs? Why is the UK (and in particular, Prime Minister Rishi Sunak) interested in them? We discuss their benefits and pitfalls and why businesses (and lawyers) should care.

What is a CBDC?

“CBDC” stands for “central bank digital currency” and is a term that has been widely popularised by the web 3.0 industry. Inspired by Bitcoin and other cryptocurrencies, CBDCs are a form of digital token which is pegged to (or backed 1:1 by) a countries’ own fiat currency, for example, the British Pound, the US dollar or the Euro, in digital format.

Fiat currency (otherwise known as ‘paper money’) is produced in the form of bank notes and coins that you can hold in your hand. Fiat used to be backed by other valuable commodities (like gold or silver), but since the departure from the ‘gold standard’ (in 1931), the British pound (and other currencies) are now backed by the Governments that issue them. CBDCs, on the other hand, are digital-only and are backed by fiat currency.

The Bank of England has promised that CBDCs will not replace fiat currency but will work alongside it; the BoE will act according to what the public wants.

“The way people are choosing to pay for things is changing.”

Are CBDCs just cryptocurrencies?

CBDCs differ from other cryptocurrencies (like Bitcoin, Ethereum etc.) because, instead of being offered and traded by a commercial business, they are issued by a government or central bank, or a nation’s monetary authority. They’re also much less volatile than cryptocurrencies, making them less of a financial or investment risk to users and banks.

CBDCs are considered a form of valid legal tender that can be exchanged for products and services. While the balances and transactions involving CBDCs could be recorded and function on a blockchain, this is not (yet) common practice - it's usually connected to a central database that is controlled by the issuing bank. Given this centralised method, transactions which involve CBDCs may not be anonymised, or as immutable and reliable as other cryptocurrencies are, which may delay adoption.

Why are CBDCs so popular right now?

The use of electronic money was a trend accelerated by the Covid-19 pandemic, as it surpassed the use of physical banknotes to inspire and encourage a cashless society, and therefore, the creation and adoption of CBDCs. This enabled a wider community of people to carry out digital payments without needing to open a bank account. Accessibility, financial inclusion, convenience and financial stability are at the top of the priority list for the implementation of CBDCs (particularly in developing countries).

Taking a trip around the world in 80 seconds…

At the time of writing, China, Sweden, India, The Bahamas, the EU and The Marshall Islands are all either testing out or have already introduced CBDCs into public circulation. The U.S. currently has no set plans to issue a CBDC, but there have been hints that the Federal Reserve (USFR) is considering the possibility,

“As a liability of the Federal Reserve… a CBDC would be the safest digital asset available to the general public, with no associated credit or liquidity risk.”

The USFR has in fact invited the public to an open discussion about the potential value and applicability of CBDCs in the U.S., and “is committed to hearing a wide range of voices on these topics.”

But it’s not all in aid of charity and public engagement – CBDCs benefit banks too. CBDCs provide the means to implement monetary policy, ensure stability and influence things like inflation in order to control growth in a more regulated environment. But more on that later…

Back to Britain: What’s the UK Government got to do with CBDCs?

Hailed as a crypto-friendly leader open to digital assets, Rishi Sunak’s role as Prime Minister could have pivotal meaning for the development of the UK’s part to play in the crypto industry – and leaders in the web 3.0 and fintech space are hopeful.

Adam Jackson, director of policy at Innovate Finance, a U.K. tech industry body that also advocates for crypto, called the former finance minister a "champion of fintech."’

‘"It's a positive for crypto and the general economy," Ian Taylor, director of the industry lobby group CryptoUK, told CoinDesk.

Back in April, the UK announced its intention to make this country a “global cryptoasset technology hub.” Whilst this is a bit of a tall order for our leaders, especially given the economic crisis we are currently facing, it is clear that MPs support the movement. Matt Hancock (yes, of recent ‘I’m a Celebrity’ fame), has spoken at several web 3.0 conferences and spoken loudly and proudly about his interest in and commitment to crypto. At popular web 3.0 event Zebu Live , Hancock gave a talk on the UK government’s approach to crypto,

“The market is maturing… digital assets are here to stay. They are a resilient, growing and important part of the infrastructure… we need to make sure that the regime is far more liberal.”

Remaining at the cutting edge of technology is one of the key focuses of Britain’s plan to attract investment and create jobs.

And that’s where CBDCs come in.

The Bank of England has already made leaps and bounds in research and consultation on the subject – the timeline so far has demonstrated a strong commitment to the idea of CBDCs, which are currently being debated back and forth in open discussions:

But are the BoE being backed by the Government? Back in 2021, Rishi released this video as Chancellor of the Exchequer, explaining what CBDCs are, and the UK’s plans for them – the “Britcoin”, they would call it – aimed to be released by 2025. Now, as PM, questions have been raised as to whether this is still on Sunak’s priority list. Amidst the daunting to-dos Sunak has started to face in Number 10, (aside from what colour he wants the curtains to be) the focus is currently on creating financial stability and reassuring the public that he won’t be gone in 49 days.

What are the risks of CBDCs?

There’s been a lot of hype and praise for the introduction of digital money, but there are also some key risks to take account of, whether you’re a business, a national bank or a professional, and may shed some light on why Sunak is hesitant to dive into this particular pool…

Impact on regulatory methods

From an economic perspective, the main risk of CBDCs is how much it could impact interest rates and inflation. Their introduction may cause an uncomfortable decline in interest rates for those who seek to profit from this.

It is still largely uncharted territory, but one of the ways in which CBDCs may be introduced is through “quantitative easing”. This is basically a process of lowering interest rates on savings and loans – by central banks purchasing securities, such as bonds – to stimulate spending in the economy, lower unemployment rates and boost growth.

The House of Lords’ Economic Affairs Committee produced a report this year on, “Central bank digital currencies: a solution in search of a problem?” which stated that,

“While it is yet to be established whether any future UK CBDC would bear interest, over the last decade many central banks have become accustomed to unconventional monetary policies. A CBDC would provide them with new options for responding to crises.”

Data privacy

If central banks have direct access and links to individual bank accounts, there is a risk to data subject’s privacy and over-exertion of control over their financial data. It will be important for the authorities to consider methods to safeguard personal data in their adoption of CBDCs.

Cybersecurity

The integrity of a CBDC transaction is relatively easy to corrupt – according to the Cyber Defence Service, counterfeit and double-spending are just two of the techniques fraudsters can use to “inject false value through transacting duplicates of the held amount.” Central banks will need to ensure they have adequate measures in place that can spot and prevent these duplicate CBDC payments (and any breaches of confidential information and/or personal data) from happening. In fact, the CDS recommends protecting consumers by employing a consensus mechanism on distributed ledger technology (i.e. a blockchain), which enhances reliability. 

Centralisation

As cryptocurrencies, digital assets and other web 3.0 products enter into the mainstream, will CBDCs follow, or will they get lost in the fray as individuals take a stance against anything that does not fit the new decentralised mould? So far, we have seen the blockchain industry take the public by storm, shaping the future of the financial industry in a way that seeks to exclude intermediaries from the landscape.

We predict that the risks and disadvantages might just outweigh the benefits where CBDCs are concerned. Individuals are used to accessing and using currency in private and having general financial freedom. CBDCs may result in money being moved between higher levels (central institutions) in a “controlled” or “permissioned privacy” environment in which the Government decides who can see what. There is a risk that central banks could become viewed as agents of the Government, especially where conditions and restrictions on use and spending are brought into play.

We’ll be monitoring the situation from SLHQ, preparing our very own lectern for more announcements on the wonders of web 3.0.

How can we help with CBDCs? 

There are lots of ups and downs, pros and cons, risks and advantages to CBDC implementation, but you don’t have to walk this path alone. We’ve curated a team of distributed ledger technology specialists that can help you navigate the web 3.0 space, from CBDCs, to NFTs to the metaverse.

Get in touch to see how we can support you with CBDCs.

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