The Bank of England, fintech and the start of a quiet revolution

Mark Carney, governor of the Bank of England, chose to use the annual Lord Mayor's Banquet for Bankers and Merchants of the City of London Mansion House speech to highlight his view that fintech is central to the future success of global financial markets. Had he given the speech on the day and in person, his 'embracing of fintech and blockchain' might have started a revolution as some have suggested.

Unfortunately, however, the speech was never given as it coincided with the tragic death of MP Jo Cox and instead was only quietly published online. While in this form it hasn't led to revolutionary action, its publication nevertheless may be evidence of the beginnings of quiet but fundamental change. 

Dragging the Bank of England into a new century

Email, Facebook, Instagram and WhatsApp have all changed the ways in which we communicate. But our ability to communicate directly, instantaneously and openly stands in direct contrast with how we access finance. Finance continues to be inefficient, arranged around "a series of hub like brokers, clearing houses and exchanges" as the governor notes in his speech.

But technology is unbundling banking into its "core functions of settling payments, performing maturity transformation, sharing risk and allocating capital", and to keep up, commercial banks must recognise that the "dawn of narrow banking" is here, that portfolio optimisation has reached a new level of sophistication and that the very nature of money is changing.

To deliver "nothing less than a democratic revolution for all who use financial services" it is not only the commercial banks that must change. The very foundations of central banking also need to be shaken, in his view.  

Validating blockchain

One shake that needs to take place is in respect of the ledger – an early, simple and "profoundly transformational development" in financial services.  "There is no finance without the ability to record transactions, balances, and obligations", according to his speech.

In making those comments Carney is highlighting and validating the widespread and sometimes feverish interest in blockchain technology and distributed ledgers. He asks: "If distributed ledger technology could provide a more efficient way for private sector firms to deliver payments and settle securities, why not apply it to the core of the payments system itself?"  

He even proposes that a distributed ledger could be used to replace the technology underpinning the Bank of England's current real-time gross settlement (RTGS) system, emphasising its benefits in terms of resiliency. If the Bank of England's own proof of concept project for a distributed ledger demonstrates that the technology can deliver a more resilient financial infrastructure than that which is currently in place, Carney's speech can be taken as an indication that the Bank will take steps towards its implementation.

But this is not to say that anything will change in the short term. As Carney acknowledges, though distributed ledgers promise greater resilience, many questions around resilience, reliability, security and scale remain to be answered.   

Opening up Bank of England systems

Access to central bank money is another area that is in need of shaking, according to the governor, as only 48 institutions currently have access to RTGS in the UK while all others need to settle transactions via agent banks. Payment service providers and e-money institutions are therefore at a disadvantage. No matter how innovative their services may be or how much their customers prefer to deal only with them and not other financial institutions, they remain subject to the costs of indirect access to central payments infrastructure.

The idea of allowing payment service providers and e-money institutions direct access to the central real-time settlement system would have significant implications for banks, and banks no doubt will want to engage with the central bank on just how level the playing field would be if this development were to take place. As banks have argued in relation to similar ideas around access to payment systems being made more generally, safeguards around resilience, the standards to which new players are held and how access is enabled all need to be addressed in a consistent manner.

Banks cannot be charged with all of the burdens of compliance while other institutions get all of the benefit. They do not want to be left providing the utility, which their competitors use to win customers with a lower level of cost to themselves.

A central bank digital currency to guard against “shocks” such as Brexit?

A third major shake would be the development of a central bank-issued digital currency. Mark Carney's speech promises that the Bank of England will continue to research the viability of a digital currency which he describes as "the ultimate risk-free asset" and "in its extreme form" the means to "fundamentally and perhaps abruptly re-shape banking".

While realistically the development of a central bank-issued digital currency is still "some way off", the Bank of England has moved ahead with its research agenda and published the view that its development could have "clear macroeconomic advantages" and result in "efficiency gains and stabilisation effects".

In a weighty staff working paper, which the Bank of England released last month, the view was taken that a central bank-issued digital currency could be envisaged which would enable "universal, electronic, 24x7, national-currency-denominated and interest-bearing access to a central bank’s balance sheet". Such a currency could play multiple roles in responding to shocks to the financial system, including credit boom-bust cycles.

A central bank-issued digital currency could also lead to reductions of real interest rates and some monetary transaction costs. The paper even goes so far to suggest that in one scenario, it could result in "an increase in the steady-state level of GDP of almost 3%".

While the development of a central bank-issued digital currency may be some way off, it is no longer a notion that can be easily dismissed as an unrealistic ideal.

Launching an accelerator

Mark Carney also takes the view that the culture of the central bank needs to change in terms of how it approaches innovation. Like the Financial Conduct Authority, he sees the importance of engaging with the fintech community directly and the potential for innovators to solve "real issues facing policymakers" through a central bank-run fintech accelerator.

Beyond distributed ledgers, the governor sees opportunity for innovators to find new ways to analyse data, for machine learning, anomaly detection and pattern recognition techniques to develop and for new data anonymisation and cyber security products to benefit the bank. The success of the Bank of England's engagement with the wider fintech community may just determine how quickly and how loudly the revolution of financial services comes to pass.

Luke Scanlon is the Head of Fintech Propositions, and Yvonne Dunn is a partner, for Pinsent Masons, the law firm behind out-law.com