The opportunities and challenges of a digital euro

On 12 January 2021, the ECB concluded its public consultation on the possible introduction of a digital euro and will be publishing its findings this spring. The ECB will decide by mid-2021 whether to push ahead with its plans for a digital euro and, if so, what form this will take.

The concept of digital currency is nothing new. US economist James Tobin, for example, proposed as early as 1987 that the Federal Reserve (Fed) should make a form of its own deposits available to the public. These ‘deposited currency accounts’ would be completely risk-free as a direct claim on the Fed.

Meanwhile, central banks around the world are also showing an increasing practical interest in developing digital versions of their currencies. A recent BIS paper found that, by 2019, around 80% of central banks worldwide were researching digital currencies (Figure 1). Invariably, the purpose of a digital currency is to supplement rather than replace physical cash.

A Central Bank Digital Currency (CBDC) is defined as a fully fledged digital currency and the digital equivalent of cash, i.e. a direct claim on the central bank,which would mean that digital currencies are completely risk-free. CBDCs could also receive interest payments, possibly even negative or with a multi-tiered system depending on the amount held. Private ‘currencies’ such as Bitcoin are not fully fledged currencies. Bitcoin is not a debt claim against anyone and is not backed by a central bank or any other body that monitors the value of the money. A CBDC on the other hand, like its physical counterpart cash, indirectly has an intrinsic value due to its status as legal tender. At the very least, the user is certain they can use it to pay their tax debt to the government.

According to a recent survey by the Bank for International Settlements (BIS), central banks are investigating the concept of digital currencies for several reasons.
One is to ensure the security and robustness of the payment system. A digital currency can help ensure secure access to central bank money in the event of unforeseen events such as natural disasters.

Secondly, a digital currency can promote the efficiency of the domestic and international payment system by making full use of new technologies and by responding to the gradually declining use of physical cash for payments. Digital currencies can also promote the financial inclusion of people who currently do not have access to the traditional payment system. This is particularly relevant in emerging economies.

A third important reason revealed by the BIS survey is financial stability in all its aspects. The main idea is to protect the autonomy and sovereignty of monetary policy within the domestic economy, against the background of alternatives that may become readily available digitally. These digital alternatives can be of a private nature, such as Bitcoin, but they may also be issued by foreign central banks. In other words, this defensive reasoning extends beyond the payment system itself. It also takes into account the possible consequences should it become possible to hold deposits, and potentially also loans, in an alternative digital currency. All central banks involved currently exclude CBDC deposits. However, this may change in the future and lead to a less effective monetary policy transmission system.

The loss of control over the domestic money supply could potentially also undermine financial stability. For example, it is not clear who will assume the role of Lender of Last Resort if other types of digital deposits end up creating liquidity problems.

The initial results of the ECB’s consultation show that potential users of a digital euro are mainly concerned about protection of privacy (cited in 41% of responses). This is followed by the security of its use (17%) and its pan-European nature (10%).

Its practical design aside, a digital euro might have some major economic implications. For instance, will a CBDC remain a supplement to cash or eventually replace it, at least unofficially? Through the economies of scale in payments (the ‘network effects’), this kind of evolution can happen quickly. Moreover, the government has an incentive to support such a trend as part of its efforts to combat fraud and money laundering. If physical cash really were to become obsolete, one positive knock-on effect for monetary policy would be that the effective lower limit of the policy interest rate would be relaxed. The interest rate for the digital euro – if applicable, in a multi-tiered system which depends on the amount held – plays a crucial role here.

The introduction of a fully risk-free digital euro could also facilitate bank disintermediation. Collection of deposits, and consequently lending, by commercial banks may be affected. In their plans for a CBDC, all central banks do indicate that their digital currencies would only be intended as a means of payment and not as a form of saving or investment. This can be achieved, for example, by setting an upper limit for holding digital euros. However, well-functioning currencies are not just means of exchange but also serve as
stores of value. If a potential digital euro becomes a success, the central bank may well yield to users’ demand to use the digital euro as a means of saving as well.

Finally, the possible arrival of CBDCs would also have potential implications for the international monetary system. It cannot be ruled out that digital currencies will compete for the dominant role in global financial markets in the future. In particular central banks that are already openly promoting a greater international role for their currencies may go down that path. The representatives of a digital monetary world order would therefore need to explain the interrelationships between the various currencies (cooperative or competitive). Either way, whoever comes out on top will have the prestige of issuing the world’s leading international transaction and reserve currency. For the US dollar – the current incumbent – the stakes are the highest.

The information contained in this publication is for information purposes only and may not be considered as investment advice.