Today the Bank of England unveiled a paper on new forms of digital money, seeking feedback by September 7. The questionnaire covers both central bank digital currency (CBDC) and stablecoins, but a significant part of the accompanying paper focuses on the transition to digital currencies and how stablecoins might be regulated. It explores four ways to manage the assets that back a stablecoin. One of them is a synthetic CBDC. If the Bank of England chooses that route, then it may not issue a CBDC itself.
The paper’s focus is on retail stablecoins and a CBDC digital pound. Recently the Bank unveiled a new type of central bank account that caters to wholesale interbank settlement tokens, which have similarities to stablecoins.
Like other papers on these topics, the Bank of England recognizes that digital money, whether a CBDC or a stablecoin could enable faster, cheaper and more efficient payments, with more functionality than what’s available today.
At the same time, the transition to new forms of money carries risks, particularly for the banking system. If banks lose depositors, which is a cheap source of funds for bank lending, they will have to raise funds from wholesale lending markets that are more expensive. In turn, this will make consumer borrowing more expensive, pushing borrowers to explore non-bank lending.
There appear to be risks now, but until the transition to digital currencies starts to happen, the full implications will not be entirely clear.
The central bank is keen to avoid users experiencing radically different risks depending on whether they choose a stablecoin or commercial bank money. Hence it’s exploring different regulatory models for stablecoins.
Four regulatory approaches to stablecoins
A stablecoin must be backed by assets that are at least 100% in value in all cases. The models outline by the Bank of England are:
- for a stablecoin issuer to become a bank, or
- to hold High Quality Liquid Assets (HQLA), or
- to hold central bank deposits, or
- to deposit the stablecoin assets at a commercial bank.
The banking model is not seen as a good match because a key focus of regulating banks is balancing short-term deposits and long term loans. If a stablecoin issuer is not a lender, some of the rules don’t apply.
Turning to the HQLA model, the stablecoin’s assets would be invested in either central bank reserves or highly liquid bonds. But during times of market stress, those bonds might not be so liquid. If allowed, in these circumstances the issuer might be able to draw on central bank lending facilities.
A third approach is a synthetic CBDC, a term used to describe where the stablecoin issuer deposits the stablecoin’s backing at the central bank. The primary difference between a CBDC and a synthetic CBDC is whose liability the money is. With a synthetic CBDC, the currency is the liability of the stablecoin issuer, not the central bank. In Scotland, Northern Island and Hong Kong, physical banknotes are issued on this basis.
As an aside, the former Governor of China’s central bank has stated that the digital yuan is a synthetic CBDC. The state banks in China deposit money with the central bank and issue the same amount in digital yuan, which is the liability of the state bank.
Coming back to England, the final model is the bank deposit model, which is similar to the current e-money regime, which is likely to be re-vamped. This approach may be higher risk because, in addition to operational risks, which all of the models have, there is also the risk associated with the custodian bank. Rumors about a custodial bank could cause a run on a stablecoin, and vice versa.
Our read of the paper is that the HQLA or synthetic CBDC approaches are preferred. And if a synthetic CBDC becomes the route, there may be no need for a full-blown CBDC. Unless there’s a concern about being hostage to a couple of big stablecoin issuers.