The digital euro: the future of central banking in Europe?

Central Bank Digital Currencies (CBDCs) continue to receive increasing attention not only from the ECB but all over the world. So far, 10 countries [1] have already deployed CBDC programmes with another 15 countries [2] currently conducting pilot programmes. In total, 105 countries are considering using CBDC programmes, representing over 95% of global GDP and including 19 of the G20 nations [2].

Since late 2021, the Digital Euro is currently in the investigation phase [3]. Looking forwards, the European Commission is expected to introduce a Digital Euro bill in 2023 and we could see a full launch as early as 2025.

What are CBDCs?

CBDCs combine the blockchain technology used in crypto-assets with more traditional forms of money, creating an electronic record or digital token of a country’s official currency. This differs from other cryptocurrencies as CBDC is the digital form of fiat currency [4] that is backed by the central bank itself (as opposed to Bitcoin or Ethereum). In the Eurozone, this would mean a digital currency that is backed by the ECB and pegged to the Euro itself.

Why is the ECB interested in CBDCs?

The ECB’s main objective is the maintain the financial stability of the Eurozone using monetary policy. Central banks achieve their macroeconomic objectives primarily through the manipulation of money supply. This system relies on the use of intermediaries to pass on the central bank’s monetary policy decisions to consumers.

The growing use of cryptocurrencies removes large amounts of value from the traditional economy, and thus out of the Central Banks’ monetary policy reach. Further, cryptocurrencies are highly volatile and could lead to significant losses in value for both retail and institutional investors. Should this volatility continue as the cryptocurrency market grows, it could cause significant problems to the stability of the financial system. Another major concern for Central Banks is the use of cryptocurrencies outside of the traditional money system for illicit activities. Cryptocurrencies can be used to make anonymous, untraceable transactions and have received a lot of negative attention as a result.

The creation of a CBDC would retain the ECB’s ability to control the money supply, as the digital currency is simply an extension of the existing fiat currency (the Euro) but presents an alternative payment mechanism to other cryptocurrencies that keeps value in the traditional money system. As the economy and payment systems modernise it is felt that large amount of money could be moved out of the traditional money system and therefore out of the ECBs control. Fabio Panetta – a member of the Executive Board of the European Central Bank and the Chair of the High-Level Task Force on Central Bank Digital Currency, told MEPs “If we don’t satisfy this demand, then others will do it”.

By creating a currency on an open ledger and regulated by a central bank, the need for third parties and intermediaries in the transaction of currency would also be removed, allowing households and businesses to make transactions directly between one another, backed by the issuing central bank. In theory, this increases the transparency in the monetary system, removes third party risk and the associated cost of intermediaries in transactions, and increases the ability of regulators to monitor illegal transactions and activity. The creation of a CBDC is therefore an important step in maintaining the role of a central bank as payment behaviours change in a modern and increasingly digitalised economy.

The other side of the coin

Many who support the emergence of crypto assets argue that the involvement of Central Banks in the monetary system is the reason that alternative money forms are required. Despite their nominal independence from government decision-making, Central Banks are ultimately held to account by the government and should act in the public interest. For many, this blurs the lines of independence and results in the centralisation of a large amount of decision-making power that can have huge consequences on households. The limited supply, or known growth rate of money supply in cryptocurrencies, removes the need for a centralised institution to control large amounts of any given currency. This problem is particularly resonant for the ECB given their role as a central bank for all of the nineteen countries that have adopted the Euro. 

The creation of a CBDC does not address this centralisation problem and leaves Central Banks ultimately responsible for transactions and the monetary policy relating to that currency. The idea of using blockchain ledgers also raises issues surrounding privacy and removes the anonymity of traditional cash transactions.

Another concern is that a strong CBDC issued by a currency backed by a larger economy, such as the ECB or the Federal Reserve, could overtake local currency in developing economies, especially in cases where the local currency is not stable in value. The end result would be similar to those countries that have suffered hyperinflation in the past and adopted foreign currency to stabilise their economies. For example, during the height of hyperinflation in Zimbabwe around 2008/09, estimates put month-to-month inflation at nearly 80 billion per cent. This resulted in Zimbabwe stopping the printing of domestic currency and starting to use foreign currency, eventually transitioning entirely to the American Dollar by the end of 2015. This kind of situation could lead back to the centralisation issue on a much larger scale and raise problems with monetary policy and potential contagion effects from systemic issues in one economy to the global financial system.

The small matter of regulation

As with most financial innovations, there is the question of regulation. The creation of a CBDC would lead to complex regulation and undoubtedly require significant changes for banks who will look to hold it on their books. There could be implications on Capital, Liquidity, Operational capabilities and SMF considerations. Although, as CBDCs could essentially be viewed as cash, the extent and impact of regulatory change are debatable. The Digital Euro bill expected in 2023 will provide more clarity on the legal framework and regulation that could allow the launch of the Digital Euro.

Closer to home

To date, the ECB have made significant investment and genuine progress in their CBDC project. As mentioned, the digital euro bill is expected in 2023 which will provide a legal pathway to the creation of the Digital Euro. At the time of writing there is an ongoing consultation targeting stakeholders with the objective of understanding the need and expectation as well as gathering crucial research and evidence on topics like privacy and AML/CFT rules. Following experiments, the ECB expects to be able to launch a prototype in late 2023, with realistic expectations for a full launch no earlier than 2025. With other countries around the world much further into CBDC projects, including the Digital Yuan project being expanded and being used as part of Chinas Covid-19 response, ECB policymakers and economists seem to have already made their decision on the Digital Euro project and the significant investment reflects their intention. Some key European countries including Germany and France have even called for the ECB to speed up its CBDC project over fears of being left behind by other nations. All things considered it seems a near certainty that the Digital Euro will become a reality in the not-so-distant future, though there is lots of work to be done before this point.

This article was written by Ollie Gassor, Financial Services Consultant, Mazars, UK.

References:

[1] The Bahamas, Antigua and Barbuda, Saint Lucia, Saint Kitts and Nevis, Grenada, Saint Vincent and the Grenadines, Nigeria, Dominica, Montserrat and most recently Jamaica. [2] Atlantic Council; [3] A digital euro; [4] A fiat currency is a currency that’s value is not backed by any commodity, like gold, and instead has value due to the trust its users have in its use as a median of exchange.