Bank of England Retains £120 Billion in Government Bonds to Back Banknotes

The Bank of England has announced that it will retain £120 billion of long-dated government bonds to support present and future banknote issuance.

This move is a legacy of quantitative easing, which began as an emergency measure during the financial crisis and produced an £895 billion portfolio of gilts and eligible corporate bonds.

The Bank must now unwind this portfolio without unsettling the bond market, on which the Government depends for its borrowing. To do so, it will retain a portion of the government debt to support banknotes, primarily UK government bonds known as gilts.

This arrangement has raised questions about the backing behind British currency. Historically, gold was used to back paper money, but in 1844, Sir Robert Peel's government passed the Bank Charter Act, which separated the Bank's note-issuing operation from its other activities and imposed rules on what could support the currency.

The act required a fixed amount of notes to be backed by government securities, with anything beyond that needing to be backed by physical gold. Although Britain eventually abandoned gold convertibility, the principle remained: the promise printed on a note should lead somewhere beyond the institution making it.

Today, this leads into the state's own balance sheet, supported by the credibility and taxing authority of the country issuing it. While critics may argue that fiat currency relies too heavily on institutional confidence, the Bank of England maintains that Britain has deep capital markets, functioning institutions, and a long record of honouring its debts.

The arrangement is circular, with the Government issuing bonds, the central bank holding those bonds as assets, and the central bank then issuing money against them. The entire structure relies on confidence in the institutions involved, which can be formidable but is not finite.