Payments expert Piet Mallekoote continues The Paypers CBDC series with a focus on the digital euro: what are its objectives, potential risks, work done so far, and future outcomes.
Central banks have been providing society with cash (public money) for hundreds of years. Since the introduction of the use of (debit) cards at the point-of-sale in the 1990s, the digitisation of payments has continued to advance. Especially in the past decade, digital payments have taken off. New technology, users' preferences, and regulations were behind this. As a result, the use of cash has declined sharply. Despite this, the vast majority of payments at the point-of-sale in the euro area are still made with public money (cash) (59 percent; Figure 1). Meanwhile, commercial bank money (private money) accounts for 90 percent of the total money supply (Figure 2). The difference between the two is that public money is a claim on the central bank and private money is a claim on commercial banks. The distinguishing feature is that a central bank cannot go bankrupt.
Central banks belatedly realised that, in the digital age, they had been on hold for too long with a digital redevelopment of the paper banknote. The idea of digitising the banknote dates to 2015-2017, when, following the financial crises, a number of central bankers, in search of a more effective monetary policy, started paying attention to it. Several central banks then started exploring it, including the central banks of Denmark and Sweden. Facebook's announcement to set up a global payment system in 2019 and the rise of crypto assets accelerated the exploration of central bank digital currencies (CBDC). China had already started this in 2014.
Digital central bank money can be distinguished into wholesale central bank money and retail central bank money. The former deals with (digital) reserves that banks (traditionally) hold with the central bank for, among other things, payment settlement and monetary policy purposes, while the latter deals with the digitisation of cash.
A survey by the Bank for International Settlements (BIS) suggests that by 2022, 93 percent of major central banks (86) engage in CBDC in their work. 70% of central banks are (also) researching wholesale digital central bank money. The core of this includes making cross-border payments between different currency blocks more efficient using new technology (DLT). In the context of this article, this will not be discussed further. By 2022, many central banks have intensified their CBDC efforts. In the said BIS survey, 15 central banks expressed their expectation to have a CBDC system live by 2030.
Central banks pursue different goals with (retail) digital central bank money, with the ranking of those goals differing by geographical area. For emerging markets and developing countries, financial inclusion and improving the efficiency of payment systems is a key reason. In almost all countries, financial stability and payments safety and robustness are high on the argument ladder. Being able to continue to conduct its own, autonomous, monetary policy is also often cited as a reason. Highly digitised countries see digital central bank money as a relevant fall-back function in case of disruptions to the current payment infrastructure.
Keeping up with new technology is also a key driver. For instance, Cecilia Skingsley, Head of the BIS Innovation Hub, recently stressed in a speech to the Atlantic Council that central banks need to be forward-looking in responding to new technology so as not to cut themselves off at the pass when it comes to improving public money and its innovations. In her view, this is the answer to the common comment about CBDC: a solution looking for a problem.
Progress central banks CDBC differ
The progress of CBDC projects at different central banks varies by country. Interestingly, emerging markets and developing countries are leading the way. This has to do with achieving greater financial inclusion in those countries. The Bahamas, Nigeria, Jamaica, and the Eastern Caribbean are live with a CBDC system (Figure 3).
China is still formally in the pilot phase and is increasingly expanding it to formidable numbers (though usage per citizen remains very low). Other currency blocs are lagging. Among Western central banks, the ECB is the furthest along. There is a difference in approach between the ECB (see below) and that of other Western central banks. Whereas the latter primarily opt for technical pilots on a limited and isolated payment segment, the ECB has developed a concrete and broad proposal of what a digital euro could look like and how it should work for the public (based on technical neutrality). In all these projects, the basic assumption is that a CBDC will not replace cash but is in addition to cash. This gives the public a (greater) choice, not only within the public money segment but also in the total pallet of payment options.
The ECB sees three objectives for a digital euro. First, preserving public money as a monetary anchor for the financial system. By this, the ECB aims to ensure that the exchangeability of commercial bank money for public money should never be threatened by a reduction in cash. This is essential for confidence in money, in the payment system, and for financial stability. However, this argument is not uncontroversial. For instance, Bofinger and Haas point out that a digital euro will have an insufficient role to act as a monetary anchor if it is limited solely to a means of payment for consumers. In their analysis, the role of anchor is fulfilled by a credible monetary policy that ensures price stability. Angeloni and Niepelt take a similar view in their comments to the European Parliament. Grünewald, on the contrary, considers the role of monetary anchor to be central from a confidence point of view. Brunnermeier and Landau also point to this trust aspect, to which they attach the condition that a digital euro must then be widely available. They see public money as essential for maintaining financial stability.
Second, protecting the strategic autonomy of European payments. Much of point-of-sale and online payments are currently based on products from non-European providers. While these have led to many innovative applications, efficiency, and convenience, in a further digitising Europe, the ECB wants to avoid complete dependence on these (often data-driven) parties. Payments have become an increasingly strategic element in geopolitical relations, and this is where an autonomous European solution fits in, reducing this dependency.
And thirdly, there is the promotion of efficient and innovative applications. Despite more than 20 years of the euro's existence, there is still no complete single market for payments. In a recent panel discussion on the digital euro at MoneyLive, the fragmentation of Europe's payment system was cited as a major concern. The digital euro will put an end to this fragmentation of payment methods. Incidentally, the EC and the ECB are pursuing the same goal with the Instant Payment regulation recently adopted by the European Parliament and the European Council, while the European Payments Initiative (EPI) also aims to reduce fragmentation. A digital euro does not stand in the way of these developments; in fact, private initiatives are necessary for sufficient innovations in the payments market.
The introduction of a digital euro is not without risks. Digital euro deposits lead (in most cases) to lower deposits at banks. This lower deposit base could lead to frictions in lending, possibly resulting in higher interest rates. Furthermore, a digital euro may increase the likelihood of a bank run in crisis situations. To mitigate these risks, the ECB intends to introduce control measures. At the core of this is that a digital euro cannot be used as a hoarding tool. This function remains part of the commercial business of banks. A cap on the balance to be held should prevent this. This ceiling will be set by the ECB before the launch. ECB's (former) Executive Board member Panetta has indicated he is thinking of a maximum of around EUR 3000 per capita. This amounts to about one trillion euros for the entire euro area (as a reminder, the number of outstanding banknotes is almost 1.4 trillion euros). However, control measures are not uncontroversial. Monnet and Niepelt believe that introducing a limit does not make a digital euro more attractive. While they acknowledge the risks of disintermediation and of a bank run, they expect - after an adjustment period - disciplining behaviour in the banking sector to mitigate these risks. In the hearing before the European Parliament on 28 November, former Governor of the Central Bank of Spain, Ordonez, also expressed strong opposition to a system of limits. In his view, without such a system, monetary transmission becomes more effective. Grünewald argues that a system of limits leads to cash remaining the only monetary anchor for the public and thus the ECB misses its intended target. She, with Hofmann, favours, after an introductory period, raising or removing the limit, using the UK as an example (GBP 10,000-20,000). Angeloni, on the other hand, thinks a EUR 3,000 limit is on the high side, given its potential risk. Banks also opt for a low limit: the umbrella of cooperative banks, the EACB, for example, mentions a limit of up to EUR 500. The aforementioned hearing before the European Parliament called for more research on the impact of limits. For the time being, it can be noted that the possibility cannot be ruled out that a cap set at the introductory period may act as a door opener with amounts being increased later on.
In October 2023, the ECB concluded the two-year research phase towards a digital euro. The findings are summarised in ECB. Following stakeholder consultations, the ECB adopted a set of draft principles.
The starting point of the design is that all citizens can pay with a digital euro anywhere and in the same way in the euro area, in physical shops, for online purchases, and in P2P. An offline payment option offers a higher degree of privacy (the intermediary has no insight into these payments). This form is closest to cash (cash-like).
Distribution model: the ECB uses the so-called two-tier model, where supervised (PSD2) parties, take care of the distribution of the digital euro and perform all front-office activities (as banks already do for their customers). The ECB will make a digital euro app available for this purpose.
Privacy is seen by the public as the most important aspect of a digital euro. However, the ECB is clear: complete anonymity, as is the case with banknotes, is not a viable option. Online payments will be subject to the same rules as current private payment methods with prevailing money laundering and terrorist financing (AML/CFT) requirements. The ECB has indicated that information on payments will not be shared with the Eurosystem. The European Data Protection Supervisor (EDPS) and the European Protection Board (EDPB) have jointly urged the European Commission to apply anonymity for low-value online payments as well.
Control measures: a digital euro app will provide users with a mechanism that converts balances from the commercial bank account into digital euros and vice versa, if the limit is reached or is insufficient for a payment (waterfall and reverse waterfall). Merchants cannot hold digital euro balances. These are converted into commercial money upon receipt- within a day.
Compensation model: the ECB has set some principles for the compensation model. For consumers, a digital euro will be free of charge. It is still unclear how intermediaries, to whom the ECB outsources distribution, can be adequately compensated for the necessary investments and operational costs. The ECB is considering an interchange fee, but this seems to prove insufficient to cover the costs of issuing banks. Several authors (see references above) have pointed to sufficient incentives for payment service providers to distribute a digital euro (Angeloni, Grünewald, Monnet, Niepelt). Banks have also pointed this out.
Legal tender. On 28 June, the European Commission published a legal proposal for the digital euro, giving the digital euro the status of a legal tender. Under this, merchants have an acceptance obligation. This proposal mandates the ECB to issue a digital euro after the proposal is accepted by the European Parliament and the European Council. Recently, negotiations have started on this bill. Given the upcoming elections, it is unclear when a decision on this legislative path can be taken.
In October, the ECB Governing Council decided on a follow-up phase in the form of a two-year preparation phase. During this phase, the Rulebook of the digital euro scheme will be finalised, the ECB will select a technical provider, and experiments on technical aspects will be conducted. By the end of 2025, the ECB may then decide whether or not to introduce a digital euro (if the law is passed), after which the realisation phase will start. The potential go-live phase is envisaged for 2028-2029.
A big step forward, but concerns remain
A digital euro aims to provide a widely accessible public alternative to the declining use of cash, allowing payments to be made in the same way everywhere in the euro area. The ECB's elaboration provides a clear picture of the broad scope and forms of payment with a digital euro. In doing so, the ECB has taken a major step forward. Together with the legal proposal, it defines the contours of a future evolution of the payment system. However, cooperation with payment service providers is needed to further shape this evolution by capitalising on new technological applications with innovative services. Instant payments and EPI's plans offer ample opportunities for this.
Having said this, a number of concerns remain. First is the adoption of a digital euro. Research by the ECB shows that European citizens are not eager for a new payment product unless it offers clear added value. An offline payment option seems innovative, but past experiences with offline payment functionalities proved to lead to insufficient mass and ended as a result (for example Chipknip, Proton, Avant). With new technology, this may be different, but not for sure. Reducing fragmentation is a great thing and the question is whether Instant Payments will not already provide that.
The compensation model is another concern. Without a healthy revenue model, there will be insufficient incentives for banks to distribute a digital euro and for entrepreneurs to accept it. One example is China where the use of the digital yuan is agonisingly slow because merchants have to offer it for free and has no revenue model. Further research seems appropriate for this.
Thirdly, further research seems necessary on the level of limits, privacy safeguards, and pilots to test consumer behaviour appropriately. In all these research fields, cooperation with private parties is important. Much work remains to be done before a decision to introduce a digital euro can be made. In this regard, it is hoped that users will be given the opportunity to test the experiments the ECB is envisioning so that their experiences can feed into the final decision-making process.
About Piet Mallekoote
Piet Mallekoote studied macroeconomics at the University of Amsterdam. After a career of 25 years at the Dutch Central Bank he was -until his retirement in 2021- CEO of the Dutch Payments Association for many years and CEO of Currence (brand owner of Dutch payment schemes, among the online payment product iDEAL). He was a member of the Digital Euro Market Advisory Group of the ECB (till November 2023). Currently, he is a member of the Dutch Institute of Financial Disputes and advises several payments companies.
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