What is a £20 banknote actually worth? In law, nothing more than two £10 notes: the holder has (only) the right to cash it in for two lower denomination notes. That can be disconcerting considering that cash, and in particular the ability to convert on demand money held with commercial banks into physical cash, is a cornerstone of the stability of our financial system.

The ability to liquidate bank account balances into cash remains key to maintaining trust in the financial system, and robust regulatory mechanisms preserve that ability - paradoxically, precisely so that it may never need be exercised. In other words, financial regulation, amongst other mechanisms, ensures the value of account balances (commercial bank money) remains pegged to the value of cash (central bank money). Getting that wrong can have dire effects.

Trust in digital money

So how does this translate into new forms of digital money (such as stablecoins)? Given the speed of developments, this is arguably one of the most pressing questions currently facing financial regulators globally. To what extent should the regulatory and other mechanisms that ensure trust in commercial bank money be applied to new forms of digital money?

The answer given by Andrew Bailey, Governor of the Bank of England (BoE) in a major new speech seems to be: more than the market seems to think.

The focus is on five key characteristics:

  1. The first is convertibility at par and on demand into state-backed (fiat) money: there must be a robust mechanism - and enforceable legal rights - for the holder of digital money to exchange it for a form of money backed by the state. The BoE specifically points out that it “is not acceptable to […] argue that by holding backing assets such as sovereign bonds […] that is good enough to ensure convertibility into fiat money at par”. That begs a number of questions, including comparisons with commercial bank money, and existing e-money rules (which do permit investment in some safe assets). It will also challenge the viability of certain potential stablecoin models, increasing the likelihood of a greater reliance on fees or other sources of monetisation.

    The upshot as things currently stand is that many stablecoins designed for use in payments in the UK will likely be - or will be required to be - e-money, and subject to regulation accordingly. Is that regime fit for this purpose in its current form? The answer from the BoE would seem to suggest not, as measured against the four other characteristics preserving the value of commercial bank money (discussed below).

  2. The second is the availability of a statutory protection scheme, such as the FSCS in the UK. E-money holders do not benefit from FSCS protection currently. Arguably, insofar as e-money institutions are concerned, that is because they are required to safeguard funds or safe assets on a 1-1 basis with e-money issued, meaning a protection scheme could be viewed as superfluous. However, e-money holders are nevertheless exposed to certain risks, including operational risks and in some cases fluctuations in value of the safeguarded funds or assets as compared with the issuer's liabilities to holders. Establishing or extending a protection scheme to stablecoins will take some time. Funding such a scheme in the context of global stablecoins will give rise to novel issues.

  3. Thirdly, there must be clear and effective rules when things go wrong, i.e. on an insolvency. Yes, e-money institutions must safeguard funds/assets; however, at present there is no special resolution regime. That leaves the default corporate insolvency regime, which may be lengthy and complex. There is also no guarantee that the other creditors of the institution will not assert a claim to assets seemingly subject to safeguarding. All of this poses challenges if a stablecoin is used for day-to-day retail payments (think rent or salaries). Recent experience suggests a cautious approach.

  4. The fourth relevant characteristic of commercial bank money is access to the BoE as lender of last resort. Although e-money institutions can open settlement accounts with the BoE, they cannot in general open reserves accounts or access its balance sheet. The corollary of a claim on the issuer is issuer risk (even if that risk is partially mitigated). The question then - particularly if a stablecoin were to become systemically important - is who, if anyone, should step in when all else fails.

    Putting Pandora back in the box

  5. Finally, there must be a robust regulatory framework. Unless and until an effective global regulatory regime emerges, technology's ability to transcend borders will for the time being have to bend to jurisdictional limitations on effective regulatory oversight. In other words, if you want to set up a sufficiently important stablecoin operating in the UK, you will almost certainly have to create a local entity, overseen by local regulators. Directly or indirectly, many national regulators have the levers at their disposal to force certain payments operations onshore. The BoE points to existing banking standards (i.e. when regulators force a bank to create a local subsidiary) in this context when discussing when it might look to exercise those powers.

"No global stablecoin project should begin operation..."

So what is the upshot for stablecoins? Of the five areas of focus, only one is at present within the control of the designer of a stablecoin project: ensuring there is a claim to convert the coin on demand at par into fiat. The others require regulatory, and in some cases legislative, action. The ball therefore appears to be firmly in the court of financial regulators. The stakes are high, balancing financial stability on the one hand and a position at the forefront in development of technology and finance on the other.

One important area not considered in great detail in the speech is how to determine what counts as a "stablecoin" for these purposes. The BoE states, as compared with existing systems, a stablecoin “changes not only how you pay but what you pay with”, i.e. “stablecoin systems transfer the asset itself - the stablecoin - from one person to another”. Although intuitive, a criterion of that nature will raise very nuanced questions when applied in practice.

Could many of these issues not simply be side-stepped through the BoE issuing digital bank notes - i.e. a central bank digital currency (CBDC)? The BoE has been at the forefront of developments in this area, previously suggesting one model could be for a central bank to operate a core ledger accessible via API to service providers, ultimately servicing end customers. In other words, a digital wallet could store digital pounds recorded on a ledger maintained by the BoE. However, for the BoE, "the answer is not in yet". That must surely be right given the potentially profound effects of a CBDC.