Deputy Governor of the Bank of England Ben Broadbent has spoken out on the implications of a central bank digital currency (CBDC) for the financial system as we know it.

In Broadbent’s lecture at the London School of Economics on March 2, he focused on what a central bank digital currency could look like, and potential economic implications of introducing one.

Central Bank Digital Currency

A CBDC could be issued by a central bank to widen access to the central bank’s balance sheet. Liabilities on the central bank’s balance sheet include banknotes and commercial bank reserves, and are the means of settlement for all of the economy’s transactions. Currently, only banks can hold deposits at the Bank of England. A CBDC could open up access to these liabilities to specific groups of financial services firms, or even to individuals.

A CBDC could also allow a central bank to set a negative interest rate on cash, rather than only deposits. The Bank of England’s Chief Economist signalled in 2015 that the U.K. government was considering this possibility.

Broadbent recognizes that there could be significant economic implications if a CBDC competed with commercial banks by permitting individuals to make deposits. In a fractional-reserve banking system, commercial banks accept deposits and loan money using these deposits as collateral. This can be to other banks, businesses, individuals and organizations. This leads to a cycle of lending and increases the money supply in the entire economy.

While the central bank’s balance sheet consists of liquid assets, commercial banks’ balance sheets are mostly illiquid assets in the form of loans. Broadbent described commercial bank balance sheets as “inherently fragile” due to their being backed by very different assets of mostly illiquid loans. As the government guarantees deposits at the Bank of England, a flight to safety may take place and drain commercial banks of resources.

Given the Bank of England’s responsibility to promote financial stability, opening up access to central bank deposits may seem counterintuitive. However, Broadbent says this could encourage commercial banks to “narrow” and shift to structures with assets as liquid as their liabilities. In this scenario, “deposits would become inherently more secure.”

However, a shift to this structure could reduce lending by banks to the real economy. Many small and medium enterprises (SMEs) are unable to issue their own securities, so lines of credit from banks are vital support. In the U.K., the British Bankers’ Association recorded £107.5 billion ($152 billion) in SME borrowing facilities at the end of 2015, including £26.6 billion ($37.7 billion) in new loans provided by banks to SMEs in 2015.

Blockchain as a Clearinghouse

“The main point here is that the important innovation in Bitcoin isn’t the alternative unit of account … but its settlement technology, the so-called “distributed ledger.” This allows transfers to be verifiably recorded without the need for a trusted third party. It is potentially valuable when there is no such institution and when verifying such information on a multilateral basis is costly,” said Ben Broadbent, Deputy Governor of the Bank of England

Broadbent identified the distributed ledger as the most important innovation in digital currencies, describing it as a “decentralized virtual clearinghouse and asset register” that “offers an entirely new way of exchanging and holding assets, including money.”

He recognises the potential for distributed ledgers to replace the existing complex system of custodians of securities, brokers, exchanges and clearinghouses, each of which is obliged to keep its own records. There is much potential for systemic efficiency savings; clearance and settlement of securities has been estimated by Autonomous Research to cost G7 economies $54 billion annually.

What’s Next?

The Bank will continue examining potential use of digital currencies as a part of its “One Bank Research Agenda.” This also encourages the wider community to consider policy questions, monetary and financial stability perspectives on CBDCs, implications for government-backed deposit insurance and regulation of institutions offering access to CBDCs.

Potential use of blockchain technology will also be investigated in the Bank’s review of its Real Time Gross Settlement system, which transfers balances between participants’ accounts at the Bank.

At this stage, the Bank is raising more questions than it answers. It is not the only one carrying out such research; the People’s Bank of China has announced that it is also discussing the possibility. There is clearly significant potential for CBDCs from a policy perspective, but structural implications must be considered.