Horizon 2026: rendez-vous with the Digital Euro

The Digital Euro will be the digital currency issued by the ECB.

“Our work aims to ensure that in the digital age citizens and firms continue to have access to the safest form of money, central bank money”
ECB President Christine Lagarde

On the 14th July 2021 the Governing Council of the European Central Bank (ECB) officially announced the start of a period of study and analysis of a future digital currency — Digital Euro — which would complement fiat cash in the eurozone. Fabio Panetta, Member of the Executive Board of the ECB, announced “We will commit the resources necessary to design a marketable product. But a decision about whether or not to issue a digital euro will only come at a later stage”.

The investigations will begin in October 2021 and will last for about 2 years, during which it will be necessary to confirm the feasibility of the project and its implementation in a context of opposition from various stakeholders, including European citizens and financial institutions.

The ECB will have to interpret how the new digital currency will be distributed to holders and citizens without neglecting the impact on the market and the implications at the legislative level (a new unitary legislation at EU level would be necessary). Only at the end of these two years of research will the final decision be taken and possibly start a testing phase, involving banks, companies and other major stakeholders.

The ECB has published a number of reports from which it is possible to infer what the main features of the new European digital currency will be. In the document issued in October 2020 (“Report on a digital euro”) the ECB’s focus seems to be on the analysis of the benefits and challenges that the digital euro will bring to the market and to payments.

Although to date there are no prototypes on which to base studies, by a reverse analysis, it is possible to guess what the main expected benefits could be from the goals set by the ECB.
Here is what we think will be in the spotlight :

• Security : A suitable technology will safeguard the privacy of users, who will be able
  to freely use the CBDC with the same privacy and freedom as with banknote
  transactions.
• Monetary Policy : A digital euro directly administered by central banks would improve monetary policy management by directly distributing cash where needed (money lending) and also managing interest rates to influence consumption and investment choices of the non-financial sector.
• Cost reduction : With the development of a new technology and the reduction of the use of more traditional means of payment, it would be possible not only to reduce the costs (processes and systems) but also aspiring to an improvement in the
  ecological footprint of euro area payment systems.
• Easy accessibility : Since the digital euro will be complementary to banknotes, appropriate ease of use and accessibility for all operators will be guaranteed. By means of a standardized front-end solution, access to private payments will be granted to anyone, including those which are not currently part of the financial system, ie. private individuals who do not have a bank account and who currently only use cash.
• Risk free : As the digital euro is a sort of crypto currency, an individual would hold a virtual wallet directly with the ECB instead of with a commercial bank, reducing infinitesimally the possibility of the custodian bank going into default or of cash being lost or stolen.

Many of these features — security, cost reduction, accessibility… — are typical of the most well-known cryptocurrencies Should we therefore take this as a sign of openness and acceptance of the ECB towards the world of cryptocurrency? In reality, this is not a concrete hypothesis, in fact more than once, the members of the ECB have shown their aversion to this environment: in a recent interview with Bloomberg Christine Lagarde, ECB President, warned her audience stating “Cryptos are not currencies, full stop”.

However, which technology will be used to support the euro of the future remains a open question.

To date, it is still unclear and certainly one of the biggest challenges to be faced. Among the options mentioned in the ECB reports is the trichotomy: TARGET Instant Payment Settlement (TIPS); distributed ledger technology (DLT); or a hybrid system in which the two previous options would coexist.

The so-called TIPS, is a payment system that already exists and operates in Europe, while the DLT, although already used by some commercial banks, would be a technology to be further explored and developed, since there’s no experience that could serve the needs of 400 million customers. The decisive criteria taken into consideration during the testing carried out by ECB are several, including: number and speed of transactions per second (it should meet the needs of 400 million users); environmental impact and carbon footprint; privacy and compatibility with current AML standards.

What is certain is that the ECB is not pursuing the creation of a crypto currency, which, given their price volatility and lack of a public institution backing them, are impossible to consider currency :

“They are not currencies; they are not money.”
Fabio Panetta to the Financial Times 14/06/2021

This new environment would encourage citizens to disinvest their money from commercial banks in favor of cheaper and safer deposits directly with the central bank. This would create a relocation of money that would pose new challenges for the banking system.

In this new context, commercial banks would be competing with central banks to attract the money of European citizens. Obviously, European citizens would be more inclined to deposit their CBDCs to central banks as they are deemed to be safer and guaranteed. The blockchain firm Guardtime, in this regard, conducted a survey on adults from ten different countries, asking how likely they would be to use a CBDC, and the result was that nearly two out of three respondents would use the CBDC if launched.

This reduction in the availability of credit for banks could lead to a raise in the cost of lending in parallel with a decrease in supply or an increase in requirements.

Moreover, the reduction of liquidity in financial institutions would also lead to an alteration of the ratios taken in account by rating agencies, incurring in a potential downgrade, ie. the liquidity coverage ratio (LCR) and the net stable funding ration (NSFR).

In order to mitigate these risks, a 3 thousand euros threshold proposition has been introduced on CBDC deposit: any amount above such limit would be subject to negative interest, stimulating individuals to relocate money to traditional banks. This is only a
proposal at the moment, in fact doing so would risk overcoming a problem by creating new ones : let’s suppose we receive an amount higher than 3 thousand euros in CBDC to our deposit account held at the ECB; to avoid the payment of interest we should deposit the excess in an ordinary bank account; but this would require the use of the latter which would not be desirable (do not forget that a desiderata of CBDC is the complementarity to banknotes, which do not need to be necessarily stored in a bank).

Another major aspect is the decrease in the number of payments and transfers processed via traditional systems (electronic bank transfer). Indeed, in the light of the investments in digitalization made upfront by banks, they would suffer from a reduction in fees on transactions that take place in a decentralized manner in the CBDC.

Anyway, the digital euro will arrive, bringing with it not only challenges but also many opportunities for banks, such as the possibility of reshaping themselves on the new CBDC system and blockchain by offering new services and products.

The game that can be lost is the one with time. Panetta speaks of 2026 as the date for the introduction of the Digital Euro. Five years to the launch of the new European currency, five years in which other companies, even private ones like Facebook, will launch their own. Isn’t there a risk of being late for the age of digitalization ?

Par Alberto Salice, Consultante Senior chez Square.