On 30 July 2024, the Bank of England published a discussion paper on its approach to innovation in money and payments (the Discussion Paper). A recurring theme is the Bank of England’s focus on the potential use of distributed ledger technology as a means of facilitating transactions in financial markets, whether that be through programmable ledgers, including tokenised deposits and stablecoins, or other methods.
The Discussion Paper serves to reiterate the Bank of England’s expectation that distributed ledger and blockchain technology will play a potentially significant role in the UK payments space.
The Bank of England has a number of critical roles and responsibilities in the payments sector, both as a regulator and supervisor of the banking and financial market infrastructure systems, and in operating core infrastructure such as the CHAPS high-value payment system and the Real-Time Gross Settlement (RTGS) service in the UK.
The Bank of England identified two key principles in the Discussion Paper that would guide its approach going forwards:
- The singleness of money. The principle that all forms of money must be exchangeable with one another at par value (whether held in deposit accounts, or physically in notes or coins).
- The finality of settlement. Recognising that money is a medium of exchange that assures parties that payment has been made at par value.
Programmable Ledgers
The Bank of England acknowledges that central banks must be fast to engage with innovation in money and payments, noting the risks and opportunities they present. The Discussion Paper focusses primarily on programmable ledgers in financial markets. In short, these are shared ledgers (often based on distributed ledger technology) that record transactions without the need for a separate participant to manually maintain such ledger.
Programmable ledgers present a range of benefits and use cases, including:
- Automation and reductions in settlement time (particularly in wholesale financial markets), in turn limiting credit exposures between counterparties.
- Lower costs driven by a reduction in back-office and manual processes.
- The ability to hold fractions of high-value assets (and so widening the scope of potential investors and increasing liquidity).
The questions remain, however, whether the technology is sufficiently more attractive than traditional financial infrastructure, what the cost and risk of any transition would be and whether it will ultimately be adopted at scale.
Examples of tokenised financial instruments based on distributed ledger technology include:
- Tokenised deposits. These are deposits recorded on a programable platform, which are tokenised and may be transferrable to customers of the same bank or customers of other financial institutions.
- Stablecoins. An instrument backed by assets that purports to maintain a stable value by reference to a fiat currency.
The Bank of England’s Response to Date
In recent years, the Bank of England has implemented a number of initiatives in response to the changing payments and settlement landscape.
RTGS renewal programme. In 2017, the Bank of England opened up settlement accounts to nonbank payment service providers, increasing access to RTGS. In 2021, a new access policy for omnibus accounts was introduced, allowing RTGS to interoperate with new technologies and business models (including distributed ledger technology). Further work has also been undertaken to improve RTGS, including the upcoming introduction of a new core settlement engine as well as the rollout of the ISO 20022 global messaging standard for CHAPS payments, with the aim of improving international operability and cross-border payments.
Digital securities sandbox for tokenised assets. The Digital Securities Sandbox (DSS) has been established together with the UK Financial Conduct Authority. (See our January 2024 article “The UK Digital Securities Sandbox: Relaxing the Regulatory Environment for UK Fintechs.”) The DSS is open to a range of firms and will modify regulations to facilitate participants’ use of technologies (including distributed ledger technology) in the trading and settlement of digital assets (including certain debt and equity securities).
Regulating tokenised deposits. The Bank of England is clear in the Discussion Paper that, provided tokenisation does not change the underlying economics and fundamental nature of a depositor’s claim, it will treat a tokenised deposit similarly to a traditional deposit. It will also expect retail deposits to be taken in a way that meets the applicable eligibility requirements for depositor protection under the Financial Services Compensation Scheme. Banks are expected to consider other novel challenges that may arise in connection with such use of digital money and update supervisors of relevant innovation plans.
Regulating stablecoins. The Bank of England is considering feedback to its November 2023 discussion paper in relation to the introduction of a regulatory regime for stablecoins. Proposals included: (i) 1:1 backing in central bank money, (ii) limiting remuneration for the holding of central bank deposits by systemic stablecoin issuers, (iii) limits on holdings of stablecoins, (iv) a safeguarding regime for stablecoins (in the absence of deposit protection), and (v) capital requirements in respect of risks resulting from shortfalls of backing assets. We expect to see further commentary from the Bank of England on this developing area in the coming months.
Retail central bank digital currency (CBDC). The Bank of England continues to explore the possible introduction of a UK CBDC (often referred to as a “digital pound”). (See our 1 February 2024 client alert “Centralising Cryptocurrencies: What’s Next for the UK’s Digital Pound?”) Any decision will likely be driven by broader trends in the evolution of money and payments.
What Are the Bank of England’s Plans Going Forwards?
Whilst some steps have already been taken to modernise the UK’s payments and settlement systems, the Bank of England acknowledges that more will be required and has set out its future plans and considerations as follows.
Settlement and Financial Stability
The Discussion Paper notes that the Bank of England has a low risk appetite for a significant shift away from transactions being settled in central bank money (i.e., via RTGS) and towards commercial bank money (i.e., on the balance sheet of commercial banks). There are concerns that a commercial bank’s credibility may be called into question during systemic stress, resulting in a loss of confidence that may take time to regain and could have broader consequences for monetary and financial stability (with a risk of contagion to the wider economy).
As a result, the Bank of England is exploring ways to increase access to central bank money as a settlement asset, including by reviewing RTGS access arrangements. By way of example, the Bank of England believes that increasing the number of direct CHAPS participants could mitigate any counterparty, credit and liquidity risks that currently exist between the 38 direct participants and the several thousand indirectly participating financial institutions. Any indirect participant settling payments of 2% or more of total CHAPS flows is currently expected to become a direct participant, and so a lowering of this threshold could increase existing levels of direct participants.
In addition, the Discussion Paper identifies significant financial stability risks from the use of stablecoins for wholesale transactions. The primary concern is that such use may become an alternative for market participants in circumstances where the financial system is under stress, leading to a sudden bank disintermediation.
Provision of Central Bank Money
The Bank of England is of the view that it is essential that central banks keep pace with technological advances (such as tokenisation) to avoid a scenario where the central bank platforms are unable to interact with other prevailing platforms (such as those based on distributed ledger technology), which could result in a shift from central bank to private money.
The Bank of England is working with the industry to design the necessary functionality to “synchronise” the interaction of central bank money and distributed ledger technology platforms. In addition, wholesale central bank digital currency solutions are also being considered, which would allow for the exchange of tokenised assets and tokenised central bank money across platforms using distributed ledger technology.
The idea is that enabling compatibility between central bank settlement and bilateral exchanges across stablecoins and tokenised deposits will support the key Bank of England principle of maintaining “singleness” across innovations. With these solutions in mind, the following policy outcomes are sought by the Bank of England:
- Central bank money must keep pace with technological advances in financial markets.
- Innovations in financial markets must be harnessed in a way that supports financial stability and monetary policy objectives.
- The UK’s financial market infrastructure must remain at the forefront of developments in finance, which will help support innovation and growth.
A programme of experiments is proposed to test both RTGS functionality as well as tokenised wholesale central bank digital currency, assessing the differences and interoperability of the various technologies.
Retail Payments
In the case of retail payments, the Bank of England is focussed on pursuing the following policy outcomes:
- Singleness of money. New retail payment systems must be interoperable with RTGS to facilitate settlement in central bank money and maintain confidence that all forms of money are exchangeable with one another at par value.
- Innovation. The retail payments ecosystem must support safe and sustainable innovation, make available alternative forms of payment (including on programmable platforms) and be interoperable with overseas equivalents.
- Resilience. There must be end-to-end resilience across the payments chain, with policymakers holding the tools to address single points of failure.
- Effective governance and funding. Payment systems must have governance frameworks enabling effective supervision, with sufficient funding to ensure their resilience and modernisation.
Innovation and the Global Financial System
The Discussion Paper notes that central banks must avoid developing approaches in domestic silos and consider how best jurisdictions’ systems can interoperate to reduce frictions to cross-border payments, whilst remaining cognisant of the risks of interoperability.
What’s Next for the UK’s Central Bank?
The Discussion Paper invites feedback on the topics covered by 31 October 2024, and a feedback paper outlining those responses can be expected during the first half of 2025. Meanwhile, the Bank of England continues to progress a number of initiatives, including the RTGS renewal programme, the DSS and their work on a UK CBDC. We will continue to monitor developments in this space.
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