The official currency of the United Kingdom, the British pound sterling (GBP) is regarded as the world’s oldest currency in use. The evolution of the GBP follows a fascinating and rich history, that spans more than 1,200 years.

The History of the GBP & the Bank of England

The first usage of British currency dates back to medieval England in 775 AD, where pennies made from sterling silver were widely adopted and used.

The establishment of UK’s central bank in 27 July 1694 marked an important milestone in the modern financial system, representing the model upon which many of today’s central banks are based. Known as the Bank of England, it is responsible for managing the currency and monetary policy of the UK. From issuing banknotes, setting key interest rates, and managing gold reserves, the Bank of England engages in key functions that ensures that the overall financial system functions fully.

The Bank of England was initially created in 1694 by King William III to fund a war against France. At its inception it was a private bank with the main objective of financing government expenses, until it was nationalised in 1946. Sterling banknotes were originally handwritten, then became partially printed in 1725, with standardized values starting from £20. From 1855, the banknotes were entirely machine-printed.

In 1797, Britain faced a major threat to its banking system when gold reserves dropped from £16 million to £2 million after a rush of gold redemptions from local and foreign note holders (the 18th century version of a bank run). This became known as the ‘Restriction Period’, where a fearful frenzy was ignited from the public fear of invasion by France. To prevent a systemic financial fallout, the British government enacted a temporary restriction to stop the Bank of England converting its banknotes into gold. This enabled the government to print more money to finance the war with France, which led to the pound devaluating, since there was an excess of currency relative to the actual gold backing it.

Making matters worse, the Restriction Period from 1797 to 1821 enabled forgers to thrive and prosper. To compensate for the shortage of gold coins, the Bank of England had to issue low-denomination notes which were easily forged. Since forgery of British banknotes constituted a capital offence, over 300 forgers were hanged during that period.

In a pivotal moment for the UK, during the Great Depression in 1931, the British government decided to abandon the gold standard because of its unsustainability, which had been adhered to for more than two centuries. A failing economy and political turmoil in the UK diminished the global confidence in the British pound, leading to a sharp decline in its reserves.

Overview of the Pound Sterling (GBP)

The Great Britain Pound (GBP) represents the official currency of the UK. It is the fourth most-traded currency in the foreign exchange (forex) market, which is the largest and most liquid market in the world with more than $5 trillion of daily trading!¹ The UK pound has a strong global presence, and is among the top three most held reserve currencies.

Only the Bank of England has the right to print money, or to use a more technical term, banknotes. (It must be mentioned that besides the Bank of England, three banks in Scotland and four in Northern Ireland on which are conferred the authority to print UK banknotes.) Banknotes were originally paper IOUs that were backed by gold, granting holders the right to claim gold deposits held at the Bank of England. After moving away from the gold standard in 1931, the British pound became fiat money. Fiat refers to currency sanctioned by a government to be legal tender, backed by public confidence of the government rather than actual, physical commodities. This allows money to be printed by the UK government as and when they deem fit, according to the country’s monetary policies.

Since the GBP is fully controlled by the government (via the Bank of England), it is a wholly centralized operation, meaning that all control, power, and influence is assumed by the British government, allowing for flexibility, efficiency and speed. However, the downside of a centralized system is the lack of accountability and transparency to the public. A centralized architecture is also highly vulnerable to security risks and threats that can undermine the system.

The terminology ‘Fiat’ is derived from the Latin term ‘Let it be done’.

Mechanics of the Fiat System: Fractional Reserve Banking

After moving away from the gold standard, all fiat currencies – including GBP – adopted the method of fractional reserve banking, where banks are legally required to keep only a small fraction of their Sterling for withdrawal purposes. In other words, only a fraction of total bank deposits are backed by actual, readily available cash. Fractional banking expands the economy by freeing up capital that can be loaned to other parties, thereby increasing the money supply.

UK Money Supply: Outstanding Total Sterling Notes and Coin in Circulation (M0 Data)

(Source: Bank of England Database)

Since 2009 the total amount of sterling notes and coins in circulation has steadily increased. Over 10 years, the UK money supply increased by over 60%, from approximately 53 billion in 2009, to a high of 85 billion in December 2018. A country’s money supply must always be measured against its economic growth: its Growth Domestic Product (GDP). An increase in the money supply higher than the growth in economic output (measured by the metric ‘Gross Domestic Product’) will cause inflation.

Since only the Bank of England has the authority to issue money that is legal tender, the supply of GBP is theoretically infinite, as it can be printed at will by the UK government, in accordance to the state of the economy and their monetary policy. Since the GBP and all fiat currency have no limits, they are referred to as inflationary currencies. Conversely, cryptocurrencies (such as Bitcoin) are deflationary currencies, due to their fixed and limited supply.

Inflation: Public Enemy #1

A critical role of the Bank of England – or any other central banks – is to regulate the country’s money supply and prevent inflation (the general increase in prices of goods and services over time, caused by an oversupply of money chasing the same number of goods). Inflation is harmful to the economy since it systematically reduces the value of money, meaning that over time, fewer goods and services can be bought with a given sum, rendering people financially ‘poorer’.

UK Inflation Rate

The UK inflation rate has been decreasing since 2011, indicating the effectiveness of the Bank of England in managing the country’s money supply.

(Source: TradingEconomics | UK Inflation Rate)

Generally, central banks around the world aim for an acceptable level of inflation that stands at 2% or lower². A too low inflation rate is often associated with weak economic conditions, while a rate too high would reduce the public’s purchasing power. In 2018, UK’s inflation rate stabilized at a comfortable rate of 2%.

The Value of the GBP

The value of GBP is influenced by inflation, where a relatively lower rate of inflation will result in a stronger GBP) confidence in the UK’s economy and its growth prospects; will result in its appreciation; economic growth, since the strength of GDP-measured economic activity reflects the economic health of the country, thereby directly affecting the strength of the GBP; and balance of payments (BOP), a surplus of which equates to a higher degree of capital being pumped into the UK economy, thereby strengthening GBP value.

The interconnectedness of the global markets allows for free trade between the UK and the world. Greater levels of demand for UK’s currency will strengthen the GBP directly, resulting in its appreciation relative to other fiat currencies. As with other form of currency, such as cryptocurrencies, adoption and traction represent the pillars for currency value.

Payment Options

There are many ways for UK citizens to use their hard-earned money. Cash, in the form of physical banknotes and coins, represents the oldest mode of payment for goods and services, yet the advancement of technology has fostered a wave of digitization that is changing users’ preferences. Contactless payment in the form of debit, credit or smart-cards has overtaken cash as the most popular form of payment in the UK³.

With more than 100 banks in the UK and over 97% of UK citizens having a bank account¹¹, a strong financial infrastructure is required to support the country’s banking needs. In 1996, UK launched the unifying Real-Time Gross Settlement system, which allows financial institutions to easily transact and settle payments between member banks. The RTGS system is capable of settling more than £500 billion worth of transactions on a daily basis — almost a third of the UK’s annual GDP.

There are three main bank transfer schemes in the UK:

1. Bankers’ Automated Clearing Services (BACS)

BACS has been in operation for over 50 years¹² and is the oldest interbank mechanism. BACS payments are used for interbank transfers and direct credit transactions within the UK, representing the most common mode of salary payment for workers. Of all options, BACS is the slowest payment processor since it takes three working days for a transfer to be processed. However, an advantage is that BACS is the most cost-effective transfer mechanism, with transactions being virtually free or at the very least incurring a minimal cost.

2. Clearing House Automated Payment System (CHAPS)

CHAPS was introduced in 1984¹³ to facilitate instant payments, and is mostly used for retail/wholesale transactions and high-value payments within the UK. Users use CHAPS to execute large, time-critical payments (transfers over £ 10,000) that need to be settled instantaneously, such as the down payment for a house. The average fee for a CHAPS transaction is approximately £25, making it unpopular with low-value transfers. The processing time for a CHAPS transaction can range from instantaneous to a wait of one day.

3. Faster Payments

Faster Payments was introduced in 2008²¹ to circumvent BACS transfer delays, and prohibitively expensive CHAPS transactions. Faster Payments is widely used by regular customers making smaller, quicker transactions in the UK, with a transfer limit of £250,000. An average transfer could be processed in a matter of seconds, making it a popular option for lower-value transfers. Faster Payments transactions usually incur a small fee, a figure slightly more expensive than BACS transfers.

Black Wednesday: The Day UK Bowed Out of the European Exchange Rate Mechanism

Given the many factors that affect currency valuation, managing the country’s monetary supply is an arduous and complex task. One prominent monetary disaster faced by the UK happened on September 16, 1992, when the British pound exited the European Exchange Rate Mechanism (ERM)²². The ERM was conceived in the late 1970s as part of the European Monetary System blueprint, in a bid to reduce exchange rate variability and enforce stability within the EU prior to its integration into a single currency (later known as the Euro). However, the UK entered the agreement under unfavourable conditions and weak financial fundamentals. Faced with a depreciating currency value due to huge selling pressure from currency speculators (most notably, George Soros), UK was forced out of the ERM since the British pound fell below the lower limit specified by the ERM.

Financial Derivatives: Boon or Bane?

The 2007-2008 crisis, also known as the Subprime Mortgage Crisis, was considered one of the most devastating financial crises since the Great Depression of the 1930s. It left the global financial stage in a terrible state after decimating trillions of dollars in economic output and wealth. The US economy suffered losses of more than $20 trillion²³, while the cost to the British economy totaled £7.4 trillion in lost output³¹. The British economy officially fell into a recession, with its GDP falling by 1.5% in the last quarter of 2008, after suffering a 0.6% drop in the previous quarter³². The UK unemployment rate fell to around 8% from a stable 5% during the second half of 2008, and to add insult to injury, the British pound suffered a 24-year low against the US dollar, further reinforcing its devaluation.

Cost of the Financial Crisis (% of GDP, 2008-2011)

(Source: XBRL)

Although there were many factors that led to the crisis³³, a major reason for the scale of the destruction was the proliferation of financial derivatives. The deregulation of the US financial industry allowed banks to innovate and create sophisticated financial derivative time bombs through a complex process called securitization. The wave of globalization fostered a deeply interconnected international financial network that crumbled one after the other once the underlying loans defaulted in an environment of increasing interest rates.

Derivatives are financial contracts that are valued according to their underlying assets, most commonly made up of such financial assets as stocks, bonds, currencies, and commodities. Derivatives were initially used to hedge financial risks but have morphed into primarily speculative assets. There was considerable financial engineering of financial derivatives prior to 2008, particularly towards subprime mortgage loans. Mortgage-backed derivatives are made up of individual mortgage loans that are stacked up and used as collateral. Through a series of other financial innovations, such as credit default swaps and collateralized debt obligations, it was obvious that banks were creating tremendous risk in the system without any recourse, due to the lax legal system.

Value of Derivative Market vs World GDP (2000 – 2012)

(Source: “Short Communication Open Access Investment Banks and Credit Institutions: The Ignored and Unregulated Diversity”)

The value of the derivative markets far outstrips the combined global value of the world’s GDP, which represents a real concern. Derivatives could significantly increase systemic risks due to their high-risk traits and the speculative nature of their valuations. However, derivatives are also known as hedging tools that can reduce risk exposure and contribute to the efficiency of the markets¹²³.

Besides the 2008 financial crisis, a similar crisis faced by the UK was back in 1980. The UK entered a recession due to the then government’s hiked interest rates, an appreciation in the GBP, and an excessively-tight fiscal policy. Despite this crisis being better than that of 2008, the statistics were still devastating, with the unemployment rate doubling from 6% to 12% while the economy contracted into the negative growth territory.

¹ Average daily turnover in the global foreign exchange market from 1998 to 2016

² Why does the Federal Reserve aim for 2 percent inflation over time?

³ UK debit cards transactions overtake cash for the first time

¹¹ UK Unbanked Population

¹² BACS History

¹³ CHAPS History

²¹ Faster Payments History

²² Exchange Rate Mechanism (ERM) Definition

²³ Financial Crisis Losses and Potential Impacts of the Dodd-Frank Act

³¹ Credit crisis cost the nation 7 Trillion, says Bank of England

³² Office for National Statistics, Quarterly National Accounts

³³ Causes of the 2008 Global Financial Crisis

¹²³ What are Derivatives?

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