When I pop to my local newsagents for my Friday night treat, it is still jarring to find I must spend at least £3 when using my debit card. This means instead of one, I have to buy two bars of chocolate. It’s not good for my waistline (even with ‘shrinkflation’),
and it is not ideal for the shop owner either.
They are trying to cover the fees imposed by the likes of Visa and Mastercard for using debit or credit cards, with average
processing fees for debit cards said to be 0.28% of transaction value on every transaction.
I could solve this by using cash, but often I have none on me, so I end up buying more chocolate than I should on an evening.
I’m not the only one who isn’t carrying cash; cards have come to account for the overwhelming proportion – more than 85% – of money spent. We have become increasingly reliant on US card giants with Visa and Mastercard, which account for 95% of all transactions
using UK-issued cards.
Consumers’ choice to pay with plastic and the dominance of US card giants leaves UK businesses with little choice but to pay the fees set by these networks. A recent investigation by the UK’s
Payment System Regulator concluded that Mastercard and Visa do not face effective competitive constraints in the UK, as there are no alternative providers.
Could a digital pound, or sterling stablecoins, have the potential to provide a needed alternative?
How will the introduction of stablecoin impact the payments system?
A decision on whether to introduce a digital pound is still some way off. However, the Bank of England's proposals for the UK's new regulatory framework for private stablecoin-based retail payments could potentially pave the way for stablecoins to offer
a viable alternative. The Gillmore Centre Financial Technology provides a detailed assessment in our
response to the Bank of England’s recent
consultation on this.
Under the Bank’s proposals, the UK is currently the only jurisdiction in the world offering stablecoin issuers regulated access to central bank reserves, something that might prove a game changer in terms of the suitability and adoption of stablecoin for
widespread use in everyday payments.
A dual tiered regime is proposed: stablecoin would be regulated by the FCA, but any stablecoin that is systemic, would also be regulated by the Bank of England and subject to additional privileges and burdens.
If you look at the FCA regime, it is not too far from the existing business models of asset-backed stablecoins, where they issue their own coins and invest the proceeds in safe assets to earn a return (albeit FCA regulation and supervision would ensure the
quality and transparency of these backing assets).
Once a stablecoin is adjudged to be big enough to be part of the UK financial system, it would move into the systemic regime of the Bank of England, requiring full backing of its coins with unremunerated central bank reserves on a one-for-one basis. These
reserves wouldn’t earn any interest.
This would make the coins incredibly safe but takes away the stablecoin issuers’ business model. Thus, moving into transaction fees as an alternative revenue source is something any systemic stablecoin would have to consider.
Since consumers do not face a transaction fee when paying with cards, stablecoins might need to compete with card networks on merchant fees and hope merchants would encourage consumer adoption.
As full reserve backing would enable 24/7 real-time settlement; stablecoins could also compete with card networks on the speed of settling payments which is also important for merchants.
Currently, any new entrant in the retail payments market would have to rely on bank deposits as a settlement asset and thus also rely on banks’ legacy systems.
Under proposed stablecoin regulations and with access to central bank reserves, this would no longer be the case: private stablecoins could issue their own settlement asset and operate their own payment rails. While interoperability with existing forms of
money and payment systems would be essential, this would nevertheless allow new players to bypass gatekeepers and legacy systems. Meanwhile the full reserve requirement would make stablecoins a safer and more liquid settlement asset than bank deposits.
Indeed, card companies themselves are
recognising the potential for this sort of shift, and
moving to position themselves as payment rails for stablecoin and other new settlement assets.
The unknown is whether and how quickly a payment stablecoin might emerge and develop once we have a regime for them in place.
New stablecoin regulation and the UK payments market
The UK Government’s recent
review of the payments market highlighted two significant weaknesses that require improvement. Firstly, the cumbersome and time-consuming process of person-to-person payments through banks compared to the simplicity of tapping a card. Secondly, the high
transaction fees that merchants, like my local newsagent, are burdened with. These areas present opportunities for new sterling stablecoins to address and potentially improve.
US dollar-pegged stablecoins have rapidly emerged as a $150 billion industry that the US Treasury Department is now
looking to bring within the regulatory perimeter. However, it is important to note that these stablecoins remain primarily settlement assets for trading cryptocurrencies and are not yet suitable for everyday retail payments.
Currently, there are no significant sterling-based stablecoins, although Tether is considering
issuing a sterling coin in response to the UK’s regulatory agenda.
However, the proposed new regulatory regime and the attraction of being backed by central bank reserves - something Circle has
long been lobbying for in the US, albeit with interest - could potentially give the UK an edge in this emerging technology, supporting its diffusion for everyday payments.
The European Union’s regime on stablecoins, which will come into effect this year, also has a tiered system: when stablecoins reach a certain scale under the EU’s regime, they are subject to additional regulations and scrutiny. However, by contrast with
UK proposals, they do not gain access to ECB reserves.
Instead, they will be required to hold more commercial bank deposits as a share of their overall reserve assets. This introduces additional credit risk if they are for example swapping essentially credit risk free government debt for riskier commercial bank
deposits. We saw this in action with Circle’s $3.3 billion of USDC Coin reserves deposited with Silicon Valley Bank when it failed last year.
Holding more bank deposits also limits potential for expansionary money creation by stablecoins. The deposits held at commercial banks continue to fund the bank, but additional purchasing power is not really created because the stablecoin can’t spend these
deposits.
In contrast, when a stablecoin invests coinholders’ deposits in securities, the securities seller can spend these deposits, and the stablecoin holder can spend their stablecoin, allowing both to circulate. The securities seller could also choose to pay down
bank debt, reducing commercial bank lending and funding.
Requiring stablecoin issuers to hold significant bank deposits mitigates both of these scenarios. It ensures these deposits continue to fund commercial banks' assets, preventing the potential substitution of bank loan financing with bond finance, which could
contract bank credit and deposits.
The UK proposal for full backing with central bank reserves clearly also avoids this sort of expansionary money creation but without introducing credit or liquidity risk.
However, central bank reserve access means systemic stablecoin growth in the UK would, unlike in the EU, take deposits and reserves from commercial banks, thus competing more directly with them. But after successive rounds of quantitative easing, banks
are holding excess reserves with the Bank of England and pocketing the difference between the rate they receive on their reserve accounts and the rate they pay their own depositors. It could make a lot of sense to move this part off commercial bank balance
sheets into digital pounds or into full reserve stablecoins.
Some view the proposed requirement for full backing with unremunerated reserves as overly stringent, potentially signalling an implicit rejection of systemic stablecoins, however, this regulatory framework could potentially position the UK to become the
first jurisdiction where innovation in this rapidly-emerging sector translates into everyday retail payments.
The proposed tiered regime may offer important room for innovation, allowing stablecoins to start under a less onerous regulatory regime that provides space to launch, experiment, and grow before becoming burdened with systemic regulations.
We do see a risk that a non-systemic stablecoin sector claiming to be money but not held to the same rigorous standards could undermine trust in stablecoins in general. The proposed provision for “systemic at launch” could give new issuers access to central
bank reserves from the outset, avoiding any concern or doubt over the safety or value of their coins and allowing them to focus on innovation and efficiency in payments.
This is the latest in the Gillmore Centre Series, in which authors from the Gillmore
Centre of Financial Technology at Warwick Business School examine new innovations in fintech from an academic perspective. Keep an eye out for more articles from the Gilmore Centre to learn more about new developments in the field.