I keep running into this conversation so I figured I’d sum it up here.

In the UK there is a very popular myth that Scottish pound notes are legal tender in England.

They are not.

If you don’t believe me just check out the BoE website where the fact is set out clearly.

There is also a popular myth that the UK has some say in what currency the Scottish get to keep.

They don’t.

The truth is that Scottish pounds are already technically quite different to English pounds, and that in the UK we actually have a system of parallel currencies in place.

If English vendors accept Scottish pounds it is because they choose to according to their own free will. No law states they have to accept them. They are inclined to do so, however, because literally 100s of years worth of monetary history suggests it’s very unlikely that the value of a Scottish pound will disconnect from an English pound.

In Scotland there are four private banks that have the authority to issue banknotes.

(Btw this is why I always tell the Bitcoin brainwashed that they are ironically calling for something we already have. A system of independent issuer currencies already exists it’s just that most of the time private issuers see value in pegging their units to the official legal tender (that printed and issuer by the main central bank authority) for stability reasons.)

I have heard it erroneously stated many times that the BoE determines the money supply in Scotland. It does not. It determines the money supply of English/welsh money only.

It just so happens that through historical precedent the four issuer banks in Scotland (mainly because the English would always demand tax in English sterling) back every Scottish note they issue with an English note or coin in the reserve at the Bank of England.

That means Scottish notes are fully collateralized on a 1:1 basis with English notes, giving them no reason to trade at a different value.

This, btw, is exactly what PayPal does when it issues units and how it ensures its units are pegged to the underlying currency at all times.

Over years the collateral regime has been formalized, but I believe it originated on an entirely informal basis serving the interests of the Scottish issuer banks. Nevertheless nowadays the BoE supervises the collateral relationship for public interest reasons.

Here’s the BoE on the matter:

To back their note issue, authorised banks may use a combination of Bank of England notes, UK coin and funds in an interest bearing bank account at the Bank of England. Bank of England notes held as backing assets may be held at an authorised location or at the Bank of England. Notes held at the Bank may include £1 million notes (Giants) and £100 million notes (Titans), which in physical terms are permanently held at the Bank. or at the Bank of England. Notes held at the Bank may include £1 million notes (Giants) and £100 million notes (Titans), which in physical terms are permanently held at the Bank.

What this de facto means is that the BoE only has to worry about English pound supply because it’s own supply represents both Scottish currency in circulation and the remaining unhoarded English currency in circulation.

If Scotland was to leave the UK there is no reason why it couldn’t continue to collateralise its Scottish pound issuance in exactly the same way. The only difference is it would have to keep the English money in its own vaults as banknotes, instead of at the BoE. Though perhaps even this is negotiable.

The only difference is that Scottish domiciled banks would no longer be entitled to the BoE reserve system, or the BoE central bank lender of last resort guarantee.

This is likely a big problem for a country whose primary bank had to be bailed out by the uk authorities and to this day is dependent on BoE liquidity support.

(And thus more than likely doesn’t independently own the English sterling it needs to cover all the currency liabilities it has in issuance.)

While a Scottish bank could still maintain a UK arm that remains a member of the BoE system, and the UK could still own a stake in that bank, there would be no obligation for the BoE to defend or support its Scottish interests and by extension the value of the Scottish pound, which is predominantly made up of privately issued bank money.

In short, while the Scottish could keep the pound if they really wanted to, the chances that they could afford to do so is low. More than likely the amount of English collateral backing the Scottish currency liabilities of Scottish banks is insufficient to defend the Scottish pound at its current value. Without BoE support not only would the value of the Scottish pound deteriorate relative to English sterling it would likely fragment in value between the four issuer banks.

The obvious thing to do would be for the Scottish to establish their own central bank to harmonise the value of existing units, via a lender of last resort function.

Doing so would also allow them to top up the missing English collateral with alternative state assets such as oil reserves/Scottish state assets/debt or a state Treasury relationship that implies the currency is backed by taxable revenues of the country. But even this would never guarantee a 1:1 value with the English pound.

The Scottish currency would instead become much more volatile and heavily influenced by commodity prices.

Scottish state debt demand meanwhile would determine rates for that currency rather than gilt rates.

In the event that Scottish debt/currency was very popular and traded at very low yields it’s unlikely the Scottish cbank would need to accumulate too many state assets to defend the value of the currency. If it was very unpopular however, cbank asset purchases would be necessary at the cost of more liquidity in the Scottish system and greater disconnection from the English pound.

Consequently, the real economic risk is if a sharply devaluing Scottish pound leads to the mass hoarding of English pounds in the economy, a la the preference we saw for euro notes with a DE serial number during the euro crisis.

The only difference is that for a depressed economy a devalued Scottish pound in a zone where the English pound is still the preferred store of value would not necessarily be a bad thing, especially if the Scottish pound remained the unit of account. Instead it would bring great trade benefits to the country (especially one which is resource independent) and lead to potentially greater velocity of Scottish money supply relative to English supply.

Eventually, over time, the country could with the use of greater trade revenues, try to reestablish the peg on more equal grounds if it wanted to.

Though this would be entirely be dependent on the new Scottish pound becoming the main unit of account rather than the primary store of value. If for some reason Scottish shopkeepers/manufacturers preferred to operate or quote prices in English pounds regardless the benefits of having a devalued state currency would be entirely lost.