Five ways a digital pound could change our world

By the end of this decade, UK consumers and businesses could be using a central bank digital currency (CBDC) to pay for goods and services or send money to others.  

The Bank of England launched a consultation on the idea of a ‘digital pound’ in February 2022 and it remains to be seen if the responses will convince it to push ahead, but its governor Andrew Bailey has described the idea of the new currency as “a profound decision for the country on the way we use money”. 

The push for a digital currency is in part a reflection of the declining use of cash, as more business is done online and things like Apple Pay and Google Wallet take the place of notes and coins. As recently as 2012, cash accounted for more than 50 per cent of payment transactions, but by 2021 it was just 15 per cent, according to a Bank of England and HM Treasury consultation paper on the digital pound. 

This is not just a UK trend with authorities around the world looking at the idea of CBDCs. In 2021, a Bank for International Settlements (BIS) survey found 90 per cent of central banks were actively looking into the idea. So far, only a few schemes have launched though, such as China’s e-CNY. 

However, while the idea of a CBDC makes sense in an increasingly digital world, it is not guaranteed to be a success. If it goes ahead, any digital pound would be pegged to sterling and would be interchangeable with cash, but beyond that much remains to be decided.  

The new currency’s relevance to consumers is likely to be heavily influenced by issues such as the payment of interest rates and whether there would be limits on how much anybody is allowed to hold.  

If it proves successful, though, it could have major implications for the way the UK economy operates and the position of banks in the financial system.  

Here are five ways a CBDC could change our world, with four potential positives and one note of warning.  

1 Improving financial inclusion 

At the moment, an estimated 1.2 million people in the UK do not have access to a bank account and thus find themselves excluded from the benefits that can bring, such as their ability to easily make payments, borrow or save. A CBDC could improve financial inclusion, although much depends on how it is designed.  

In a recent paper I co-authored with David Murakami, of the University of Milan, and Ivan Shchapov, of the Institut Polytechnique de Paris, we found a CBDC was a more effective savings vehicle for unbanked households, as it can be used to smooth out consumption and as a buffer against the impact of wider changes, such as growth or contraction in the national economy. But these effects are most apparent if the central bank pays interest on the currency – something the Bank of England said it does not plan to do.  

The authorities could also use a CBDC digital wallet for making social welfare payments and other supports or subsidies to households and businesses. That could prove to be a more efficient way of distributing these payments.  

It would be most effective if everyone was automatically given a CBDC account – something which could perhaps be done by providing one to anybody with a National Health Service (NHS) number, which would cover almost everybody in the UK. 

2 Making monetary policy more effective 

A CBDC could improve the ability of the Bank of England to influence the economy through monetary policy, including its efforts to control inflation – although this too is largely dependent on whether interest is paid on the currency.  

By adjusting the interest rate paid on digital wallet balances, the bank would be able to directly pass any changes in rates into the wider economy, rather than having to rely on retail banks to do that for it, as is the case at the moment.  

During periods of low demand in the economy, the Bank of England could also use negative interest rates to encourage greater spending.  

The ability of a CBDC to provide a central bank with this additional monetary policy lever would also be amplified if previously unbanked households held digital currency deposits and thus would be sensitive to the central bank rate. 

3 Cheaper cross-border payments 

Remittances and other cross-border payments could be made far cheaper and more efficient if they were done by using CBDCs.  

This would replace the current system of correspondent banking, which is often expensive and slow. However, for this to work effectively it requires digital currencies to be easily exchangeable.  

For someone to send money out of the UK using a CBDC, there would need to be an equivalent structure in the receiving country, so the digital pound could easily become a digital euro or digital dollar. For this to happen, central banks around the world need to agree on common technology.  

The IMF noted in a November 2022 paper that a common ledger, smart contracts and the use of encryption could offer “significant gains” in terms of market efficiency, access, transparency, costs and safety for cross-border payments. 

4 Increased competition for deposits

A well-designed, consumer-friendly CBDC could provide an alternative to conventional banks for many people – thereby forcing those banks to work much harder to attract retail deposits.  

This is particularly true if interest was being paid on a CBDC. But even without interest payments, if a CBDC system could enable more efficient payments – whether inside a country or in terms of cross-border transfers – it could provide a compelling reason for consumers to keep at least some of their assets in their CBDC wallet, rather than their regular bank account. 

5 Higher risks of financial instability

If central banks decided to offer interest rates on their CBDCs there is a risk it could lead to financial instability as depositors withdrew large sums from their existing banks and transferred them to their digital wallets.  

With this in mind, the Bank of England has said it is likely to limit how much any individual can keep in digital pounds. However, if that limit is set too low it could also reduce the role a CBDC would have in transmitting monetary policy.  

Again, the issue of interest rates comes into play. If a CBDC pays a relatively high rate of return, then consumers are likely to move more of their assets to take advantage of that, but if it is set too low there will be less reason for consumers to pay attention.  

As with other aspects of a CBDC, there is a delicate balancing act to be struck if the idea is to work effectively. 

Ganesh Viswanath Natraj is Assistant Professor of Finance at Warwick Business School. He is currently teaching on the MSc Finance, MSc Finance and Economics, and BSc Accounting and Finance programmes.