• Federico Mammana

A digital euro? The ECB’s take on a fully digital currency

On 2 October 2020, the European Central Bank published a report presenting its considerations on the possibility of a digital euro, explaining its objectives, the requirements it would need to meet, its potential benefits and risks.

Cryptocurrencies, stablecoins and CBDCs.

The idea of a digital currency has become increasingly popular in the last decade. First, cryptocurrencies, like Bitcoin or Ethereum, and the blockchain technology made their appearance, with the most enthusiastic of their supporters predicting the end of centralized monetary systems. Nevertheless, both experts and central bankers refused to consider them a threat to the status quo or to central banks’ authority as monetary policymakers, and rightly so. The high volatility of such instruments reduces their feasibility as a store of value and unit of account, making them nothing more than a speculative asset.

BTC/EUR fluctuations since the birth of Bitcoin

Then, in June 2019, Facebook announced its intention to establish its own digital currency, called Facebook Libra. In order to avoid the volatility problem, Facebook intended Libra as a stablecoin, which is a digital currency whose value is linked to another currency or, as in Libra’s case, to a basket of currencies. However, critics point out that Facebook, as any other private company, can fail, while central banks (usually) do not; they argue that this undermines the long-term credibility of the currency. Then, some cast doubts on the reliability of (foreign-based) private companies with respect to security and accountability. Finally, regulatory authorities are not so keen on the idea of a parallel private currency, especially because of the threat it poses for the effectiveness of monetary policy and the stability of financial markets; hence, it is unlikely that Libra would be granted the status of legal tender anytime soon.

However, Facebook’s announcement, along with the increasing popularity of e-commerce and electronic payments, clearly indicates the direction in which society is moving with respect to money and payment methods. For these reasons, many central banks are now carrying out extensive research on Central Bank Digital Currencies (CBDCs), pondering different technical and organizational designs. CBDCs could represent a digital alternative to cash and bank deposits controlled by a public authority; this would ensure stability in the value of the digital currency and in the overall financial and monetary system. In theory, it would also guarantee a higher degree of payments efficiency and cyber resilience. Currently, the People’s Bank of China leads the race, being the first to start testing its digital yuan by distributing an equally small sum to 50,000 randomly selected citizens. Establishing a technologically advanced digital yuan might serve China’s long-lasting goal of internationalizing its currency. Others, like the U.S. Federal Reserve, the Bank of England and the Bank of Canada are looking for ways to stay on top of research and innovation. In this geopolitical, economic and technological competition, the ECB places itself as one of the frontrunners.

Digital euro report: objectives and requirements

In the aforementioned report, the ECB presents the digital euro as a liability in the Eurosystem’s balance sheet, complement to cash and central bank deposits, to be used and widely accepted by European citizens and companies as a form of retail payment. The digital euro would be convertible at par with the traditional euro, and as such it would be a risk-free asset. The report finds a quite solid legal base for a digital euro in the TFEU; however, it recognizes that further legislation would be needed to strengthen the status of legal tender of the digital currency, especially in the case of direct distribution to the public.

The purpose of the report is not to signal an intention of the ECB to issue a digital currency in the near future. Rather, it is a way to inform the public on the institution’s findings and considerations on the matter, in the spirit of transparency that has always characterized it. Most importantly, the report presents the ECB’s priorities and objectives, as well as the actions it will need to take to face future developments in the Eurozone. For starters, should alternative (digital) forms of payments become widely used in the Eurozone, the Eurosystem must be ready to provide a safe, stable, cyber-resilient, competitive, and user-friendly alternative. The ECB fears that the recent movement from cash to private digital forms of payment risks increasing the financial isolation of those "unbanked" people with less access to digital means; this is why a digital euro should maintain cash-like features and be widely accessible. Such commitment also requires the ECB not to shy away from using the best technology available: a digital euro should be competitive both within and outside the Eurozone, while, of course, not discouraging more efficient private alternatives.

The digital euro would need to be consistent with an effective monetary policy and should not represent a threat to financial stability. Indeed, the ECB envisages restrictions on the circulation of digital euro, either to avoid its use as a form of investment, or to ensure that its use by non-European citizens does not cause excessively volatile capital flows or exchange rates. Moreover, the ECB report considers paying an interest rate on digital euro holdings. Different (and varying) interest rates could be applied to different holding amounts, in order to disincentive holdings above certain thresholds.

Functional aspects of a European CBDC

In principle, all CBDCs face a trade-off between being flexible and being cash-like. Indeed, the report lays out two possibilities: the digital euro could have an online dimension, which could allow greater control over its circulation and remuneration at the expense of users’ privacy, or it could be made available offline, implying fixed remuneration rate and greater privacy, but also the need to establish an ad hoc infrastructure for electronic payments services. Even a combination of the two scenarios may be a viable solution.

Indeed, one of the main dilemmas concerns the design of the digital euro’s infrastructure. The latter can be set out either as top-down systems, with the ECB being the sole issuer and with some degree of involvement of financial intermediaries (back-end infrastructure), or as networks of users, supervised by the ECB, based on blockchain technology (end-user access solution). As of now, the former case seems more plausible. A “back-end” digital euro infrastructure might be more or less centralized, with varying involvement of commercial banks and other intermediaries.

In the scenario of highest centralization, holders of digital euros would be given a digital euro account directly at the ECB. This direct relationship would be beneficial in achieving a greater financial inclusion in the Eurozone and a greater protection of depositors from the systemic risks affecting commercial banks. On the other hand, the ECB would be effectively competing with commercial banks in the market for bank deposits, particularly if the digital euro paid a nonnegative interest rate. Many, especially the ECB itself, fear that this might make it more difficult for financial intermediaries to raise funds, which would in turn cause an increase in interest rates on loans, with all the negative effects this would have on the economy through reduced investment and consumption. Moreover, the existence of a digital euro increases the risk of bank runs during financial crises, as depositors looking for a safe haven would want to move their savings to the virtually default-free central bank and wait out the storm, aggravating the balance sheet crisis of commercial banks as a result. A centralized digital euro would also inflate the ECB’s responsibilities in terms of security and operational protocols, as well as its riskiness as a financial institution.

Opportunities and risk for monetary policy

The elephant in the room is clearly the relationship between the CBDC and monetary policy. On the bright side, the ability to maneuver the interest rate paid on the digital euro would endow the ECB with a more direct channel to the real economy, getting around the problem of reserves sitting idle in banks’ vaults that undermined the transmission of monetary policy after the 2008 crisis. Hypothetically, the ECB might even be able to overcome the zero-lower-bound limitation. The digital euro would also serve a defensive purpose, protecting the financial independence of the Eurozone in a time when other countries are developing their own CBDCs.

However, some are concerned by the identity crisis the ECB might go through if it decided to admit deposit from private holders of digital euros. It is not so difficult to imagine that a digital euros account could be used to carry out “helicopter money” policies to impact the real economy in a more direct way. Detractors argue that this might represent an intrusion in fiscal policy, from an institution that, after all, does not have an explicit political mandate and is not subject to democratic accountability.

In any case, the report shows the will of the institution led by Mrs. Lagarde to be careful, and to approach the issue in the most impartial and scientific way possible. As of now, the digital euro seems quite a distant reality. Nonetheless, a distant reality the ECB believes is important to start discussing seriously, with all the parties involved. In fact, the European Central Bank wants to hear your opinion too.

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