Old wine in a new bottle?

I recently wrote about the Bank of England’s consideration of the case for a Central Bank Digital Currency (CBDC). This is a digital form of public money: its only other forms are the physical ones, namely banknotes and coins. Every other form of money is private.

The distinction is not usually something anyone needs to pay much attention to. In fact, public and private money are freely interchangeable under the current financial system. Bank deposits, which are private money, can freely be exchanged for notes and coins, which are public money, and vice versa. That is possible because there is sufficient confidence in private money that the promise to pay, as written on every bank note, will be honoured.

In reality, most of us now use private money far more widely than public money. When you pay for a coffee using a smartphone wallet payment, or use a card to pay for your groceries, you are using private money.

On 10^th June 2021, Christina Segal-Knowles, executive director for financial markets infrastructure at the Bank of England, gave a speech about stablecoins. This was new to me, so I thought I better find out what on earth she was referring to.

A quick look at my trusty Chambers dictionary revealed no such word. Wikipedia contains the following definition:

Stablecoins are cryptocurrencies where the price is designed to be pegged to a cryptocurrency, fiat money, or to exchange-traded commodities (such as precious metals or industrial metals)

First things first then: stablecoins are private money. Confidence in the credibility and stability of private money are fundamental concepts of financial stability. There have been financial crises where the loss of such confidence has led to instability – most recently, the failure of Northern Rock, when customers queued outside branches to exchange their deposits before (they believed) it was too late.

Critically, the distinction between stablecoins and other cryptocurrencies is that they are asset-backed. Therefore, their volatility and risk are the same as that associated with the underlying asset. In contrast, Bitcoin has no intrinsic value and could prove worthless.

The Bank of England has published a discussion paper that examines the implications of stablecoins for its financial and monetary stability mandate. The paper envisages a scenario where a large number of households and businesses move their deposits from banks into a stablecoin or CBDC.

According to the Bank of England, the most significant risk arises from the potential for stablecoins to undermine confidence in money and payments, and hence in the wider financial system.

However, the Bank of England considers it follows that, if stablecoins seek to be widely acceptable and widespread substitutes for commercial bank deposits, it must be the case that stablecoins will have to meet the core elements of the existing regulatory framework for private money, which underpins confidence that it is interchangeable with cash. These are:

1. A legal claim for prompt redemption at all times, for amount initially deposited, at no cost to the depositor.
2. Capital requirements to lower the risk of insolvency (of the stablecoin issuer), calculated according to the nature of the risks that the issuer undertakes (credit, operational and market risks), in order to provide a cushion to absorb losses.
3. Liquidity requirements to ensure redemptions can be met in most circumstances, supported by eligibility for central bank support where relevant to meet extraordinary demands.
4. Protection for depositors, most likely under the Financial Services Compensation Scheme.

In other words, so far as the Bank of England is concerned, stablecoin might be a newly minted word, but the fundamental questions that stablecoins pose are nothing new. The aspiration is that, if new forms of digital money can be made safe, they could potentially make payments even faster and therefore cheaper and more efficient than conventional bank deposits.