Views from Hogan Lovells’ Global Digital Assets and Blockchain Practice
Commenting on the consultation, John Salmon, Co-Head of the Digital Assets and Blockchain Practice, said:
“This is a timely consultation and comes at a vital juncture of the UK’s digital assets policy agenda. There has been a lot of discussion on the necessity for a CBDC and the use case for this varies amongst jurisdictions. It is clear when looking at it from a UK perspective we need to be assessing how a retail CBDC will complement our current infrastructure but vitally also have the capability to scale and enable a future payments network that we will be using in 2030 onwards. This is a significant infrastructure project that will take time and will need to be designed carefully.
The Bank of England has acknowledged that this is not an initiative which looks to eliminate cash, albeit the paper does note the waning use of physical bank notes over the years. Instead the Digital Pound will be used alongside existing payments rails and will be offered through a number of methods including smart devices, smart cards, e-commerce and point-of-sale devices.
The decision to explore the platform model is one that was strongly advocated for in the responses to the Bank of England Discussion Paper in 2020. It is the option that generates trust in the currency, whilst not overburdening the Bank of England and ensuring that there is fertile ground for payments firms to innovate and develop new products and services within the network.”
Lavan Thasarathakumar, Consultant in the Digital Assets and Blockchain Practice, added:
“The consultation is positive and thorough and examines six key technology design considerations: privacy, security, resilience, performance, extensibility and energy use, which have been widely discussed in the initial stages of exploration. As we move from the research and exploration stage to the design stage, it will be imperative to ensure that there is strong coordination with all stakeholders to ensure that a Digital Pound is widely adopted and reaches its full potential.
The Bank of England has put a huge emphasis on the need for privacy and attempts to diffuse any concerns around the Bank of England having access to transaction information. By design, this information will only be available to wallet providers and, in so far as it is required, law enforcement agencies.
The use of the Digital Pound in cross-border payments is also discussed and it is encouraging to see this use case being explored. There are a number of initiatives which are being led by central banks across the world and it will be imperative to ensure global coordination to facilitate interoperability.
What is clear is that in the context of last week’s consultation on a future financial services framework for cryptoassets, this further cements the UK’s ambition to become a global cryptoasset hub.”
Time to move from ‘research and exploration’ to ‘design’ of a digital pound
While the Bank and HMT judge that the digital pound is likely to be needed, they cannot know this for certain as the case for its introduction depends ‘to a significant degree’ on how the payments landscape evolves in the coming years – in particular the extent to which cash use further declines, whether new forms of privately-issued digital money emerge and how they interact with existing forms of money and payments. The Bank and HMT are therefore of the view that it is too early to take a decision on whether to build the infrastructure for the digital pound.
However, the Bank and HMT consider that now is the time to move from ‘research and exploration’ to the next stage of development of the digital pound, the ‘design phase’ of their roadmap. This will involve the development of a comprehensive architecture for the digital pound, and associated experimentation and proofs of concept in partnership with the private sector. The expectation is that, at the end of the design phase (around the middle of the decade), the Government and the Bank will decide whether to proceed to build the digital pound. The legal basis for the digital pound will be determined alongside consideration of its design.
Responses to the consultation will inform the next stage of work and constitute an important step towards making a final decision on whether to build a digital pound.
The proposed model for the digital pound is organised around three themes: a platform model, considerations around data protection and privacy, and the user experience.
- The digital pound should be designed as a platform model, as set out in the Bank’s 2020 discussion paper.
- Delivery of the digital pound would be a public-private partnership reflecting the comparative advantages of each sector.
- The Bank would issue the digital pounds which would be recorded in a ‘core ledger’ which it would build and operate to provide the minimum necessary functionality for the digital pound.
- Regulated private firms – Payment Interface Providers (PIPs) and External Service Interface Providers (ESIPs) – could then access the core infrastructure via an API. ESIPs are firms whose business is not payments, but who might provide services such as business analytics, budgeting tools and fraud monitoring. They might be granted ‘read’ access to specific data on the digital pound ledger, subject to appropriate controls and user consents. A PIP authorised to operate in the digital pound system would automatically be able to undertake the activities of an ESIP.
- The PIPs and ESIPs would deal with all user-facing interactions, including handling customers’ information, and be able to develop and offer innovative services using the digital pound. They would provide digital pass-through wallets to pass instructions from the customer to the core ledger, meaning that they would never be in possession of customers’ digital pound funds. These wallets would allow customers to hold and use the digital pound, which would always be a direct liability of the Bank.
- PIPs and ESIPs would, however, have responsibility for recording the identity of digital pound users and carrying out any necessary KYC and AML checks. The Bank would receive payment messages instructing transfers on the core ledger in anonymised form and would not know the identity of the payer and payee.
- The platform model is agnostic to many technology decisions, eg the core ledger might be centralised or use DLT. More detailed information about design, including some principal technology considerations such as this, can be found in the accompanying Technology Working Paper.
- The consultation paper acknowledges that, given the single point of failure risk with the platform model, it would be necessary to ensure that the infrastructure is protected to the very highest standards, including working with the National Cyber Security Centre.
- The platform model could support innovation and competition in three ways:
- By mobilising PIP participation, as PIPs are unlikely to need extensive prudential regulation so the digital pound could offer payments innovators an opportunity to mobilise their businesses in a simple, safe and proportionate framework.
- By providing an accessible and open infrastructure for new entrants to the payments market, subject to certain requirements for participation namely regulatory requirements, complying with the Bank’s rules as operator of the system and being operationally robust.
- By ensuring an extensible architecture, ie one in which it is easy to expand a system’s features over time without affecting its internal structure.
- Revenue models will also be important for incentivising innovation, and the paper sets out some possible revenue streams for PIPs and ESIPs that might support the provision of digital pound services (see Table D.2).
- As well as being subject to the Bank’s principles for operation (eg interoperability), including technical standards, PIPs and ESIPs would operate within a robust legal and regulatory framework to protect users and ensure the resilience and integrity of the system. The specific regulatory treatment of PIPs and ESIPs would be subject to further work by the relevant authorities, but would be activity based, proportionate and technology neutral.
- All entities in the digital pound ecosystem would have a responsibility to protect consumers from fraud and uphold robust financial crime controls.
Considerations around data protection and privacy
- The digital pound would have at least the same level of privacy as a bank account and would also allow users to make choices about the way their data is used. Responses to the Bank’s 2020 discussion paper emphasised the importance that users place on having privacy in their transactions. The digital pound would be set up in a way that enables firms to offer services where holders can opt for enhanced privacy functionality and exert greater user control of personal data.
- As the entity holding the direct commercial relationship with users, PIPs would gather and have access to personal data in order to prevent financial crime through compliance with KYC and AML requirements. The UK Digital Identity and Attributes Trust Framework could be used by PIPs and users to support access to a digital pound. PIPs would also be responsible for ensuring compliance with data protection laws and the preservation of users’ privacy rights.
- The Bank and HMT are supportive of firms exploring ways to allow small numbers of small value transactions in digital pounds to have higher levels of privacy, namely through tiered identity verification and enhanced privacy controls. Tiered accounts would also help to ensure that users can choose from a range of wallet services, depending on the amount of identification they are willing or able to provide (along the lines of the tiered accounts already available in today’s payments market). Likewise – and in line with the UK’s National Data Strategy and similar initiatives such as Open Banking – where users choose not to shield certain data, it could then be used by PIPs for commercial purposes, eg to provide additional value-added services (explored in more detail in the Technology Working Paper).
- PIPs would anonymise personal data before any sharing with the Bank. The Bank will conduct tests, and evaluate the legal, technical and operational standards needed to operationalise such a system in the next phase of its work.
- The Bank should, however, have access to anonymised transaction data and aggregated system-wide data to provide it with an overview of the total transactions taking place over a given period. Those data could also provide insights that might support innovation and improve the provision of services to both digital pound users and PIPs. The Bank and HMT will consult on what data might be collected and for what purposes in due course.
- As is currently the case with private forms of digital money such as bank accounts, law enforcement agencies and competent authorities could only access digital pound data where there is a fair and lawful basis, in compliance with data protection laws.
The user experience
- People and businesses would be the main users of the digital pound, for both in-person and online everyday payments.
- All UK residents would be able to hold and use digital pounds.
- Non-UK resident individuals would be able to hold and use digital pounds when visiting the UK and when outside the UK for payments with either a UK or non-UK resident. This would be subject to: (1) a recognition regime to determine which non-UK PIPs and ESIPs could offer digital pound wallets and other services; and (2) the UK authorities reserving the right not to grant access to digital pounds for non-residents from certain high-risk jurisdictions.
- Users should be able to make and receive digital pound payments in a range of ways, including smart devices, smart cards, e-commerce websites and applications, and PoS devices (including those that exist in stores today).
- Given the evolving payments landscape, over time the Bank and HMT would expect the digital pound to enable a broader range of payments than those that are commonplace today, eg split, batch or micropayments. They also plan to do further exploration of offline and cross-border payments.
- There is no proposal to develop a digital pound that enables government or central bank-initiated programmable money. While payments programmability could provide enhanced functionality for users to set rules on their payments, this is not relevant to HMT and the Bank’s policy objectives for the digital pound and it could also damage the uniformity of the CBDC and cause user distrust. However, in the interests of innovation and user experience, PIPs and ESIPs would be permitted to implement such functionalities themselves subject to user consent.
- The digital pound, like banknotes, would not pay (nor charge) an interest rate. Any decision to revisit this approach after the digital pound is introduced would be preceded by a review with full consultation.
- At least during its introductory period (which could last several years), the Bank would place some limits on holdings of digital pounds. An individual limit of between £10,000 and £20,000 is proposed. This would be aimed at managing any risks to financial and monetary stability. Any future changes to limits would follow consultation.
- As the Bank and HMT continue their in-depth technology research, they will review the extent to which existing and prospective infrastructures, including the renewed RTGS service and the New Payments Architecture (NPA), can support interoperability for the digital pound. The accompanying Technology Working Paper discusses the options for enabling interoperability between the digital pound and cash, and the digital pound and bank deposits respectively.
- If new, non-bank forms of payment such as stablecoins emerge, they would be required to be exchangeable with the digital pound.
- Box J in the paper considers how the digital pound could be used to tackle financial exclusion, although there is recognition that digital inclusion needs to be promoted alongside financial inclusion if adoption among the financially excluded is to succeed.
- Corporate use of the digital pound is still being explored and the paper states that it would particularly benefit from further input from stakeholders on the issues set out in Box I (namely, how many digital pounds corporates should be able to hold, and which types of corporate should have access to the digital pound).
Risks as well as opportunities
Among the challenges of introducing a digital pound, the Bank and HMT acknowledge that care must be taken in its design to manage any risks it could introduce to the Bank’s statutory objectives of maintaining monetary and financial stability.
For example, depending on the speed and scale of bank disintermediation on introduction of the digital pound (ie households and businesses switching some of their bank deposits to digital pounds), there could be implications for financial stability. As highlighted in the Bank’s 2021 discussion paper, banks losing deposits may replace them by borrowing in wholesale funding markets to maintain the same level of lending. To the extent that wholesale funding is more costly than deposits, banks might pass this on in their lending, by increasing the price of credit to households and businesses or reducing the quantity of credit they are willing to supply, or both.
What about a wholesale CBDC?
The concept of a wholesale CBDC is discussed in Box H of the paper, together with coverage of the Bank’s collaboration with industry to enhance wholesale payments through RTGS renewal and the RTGS future roadmap.
The consultation closes on 7 June 2023, and responses will inform the Bank and HMT’s future work and exploration of the digital pound. A decision on whether or not to proceed to a build phase would be made at the end of the design phase, around 2025/2026. This work will shorten the lead time for the introduction of a digital pound, which would be in the second half of the decade.
If you would like to discuss the implications of the consultation, please contact our specialist Global Digital Assets and Blockchain Practice who would be happy to provide further advice and guidance.
Authored by John Salmon, Lavan Thasarathakumar and Virginia Montgomery.