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Better late than never

It seems merely a matter of time until a digital euro and other innovative central bank currencies are introduced as a response to currencies developed in the private sector. They will offer a number of benefits, but they also entail certain risks, for example for credit institutions and the central banks themselves.

Slowly but surely, the digital euro is taking shape. The European Central Bank (ECB) recently announced a pilot project concerning the introduction of its central bank digital currency. The project will run for two years, after which the ECB intends to make a final decision. The ECB has emphasised that the digital euro is not designed to replace cash if it progresses beyond the pilot phase. But it could combine the security of cash with the convenience and innovative potential of digital payment methods.

Central banks around the world are forging ahead with CBDCs

Stage of planning for a total of 75 central banks that were surveyed

Central banks around the world are forging ahead with CBDCs
Detailed explanation: Research: creation of working groups to research possible applications, consequences and feasibility; Pilot: initiation of testing on a small scale in a real-world environment; Development: initiation of the technical setup and early-stage testing in a controlled environment; Inactive: no activities; Cancelled: CBDC initiative cancelled; Launched: issuance of a CBDC Information correct as at 21 July 2021; sources: Atlantic Council, BIS, Union Investment.

Many central banks around the world are developing digital versions of their national currencies, which are referred to as central bank digital currencies (CBDC). One reason for this is that the use of cash for payments has been declining for years while electronic payment methods have been gaining in popularity. In times of crisis, however, people like to revert to cash. But the decline in the use of cash is creating challenges regarding the availability of coins and bank notes. A situation where the growing dominance of electronic payments drives up the cost of supplying notes and coins to such an extent that direct access to cash becomes impossible could undermine public confidence in the currency.

Cash payments are in decline

Change in cash transactions as a proportion of the total transaction volume between 2010 and 2020 (percentage points)

Cash payments are in decline
Sources: BIS, MGI, national central banks and statistical offices, Union Investment

Pressure from China and private initiatives

We do not know much in the way of details yet, but it was high time the ECB addressed this subject. After all, others are already much further down the line. The People´s Bank of China, for example, initiated preparations for its CBDC as early as 2014 and plans a full-scale rollout of the digital renminbi in time for the 2022 Winter Olympics.

And China’s plans are not the only thing putting pressure on the ECB. Facebook’s announcement in 2019 of its intentions to introduce a private digital currency called ‘Libra’ (now changed to ‘Diem’) was a real wake-up call. For the central banks, it was a warning shot. Private currencies could very realistically lead to the circulation of money outside the control of the central banks. If these unregulated systems grow too large, price stability and the stability of the financial system could come under threat. The central banks would have little influence over the money in circulation and, by extension, the financial services based on these currencies (e.g. lending) and the associated creation of money. However, in a crisis, they would still have to step in as ‘fire fighters’, which means that taxpayers would ultimately still be footing the bill.

The digital euro would be fail-safe

So, what does the digital euro have to offer and how does it compare with Bitcoin and with the booming methods of electronic payment? The popular cryptocurrency and PayPal are certainly digital solutions, but they are no real competition for central bank money. However, so far, the latter has been available only in the form of cash and central bank deposits of credit institutions. Central bank money in the sense of a claim against the central bank is risk-free, unlike current account balances, for example, which merely represent a claim against the relevant commercial bank. This is the trump card of the digital euro – it is digital central bank money and, as such, not subject to default risk.

The ECB is addressing several issues at once with the digital euro. Firstly, the currency guarantees access to highly secure central bank money, even in an environment in which the use of cash continues to decline. At the same time, it makes the overall payments system more resilient because a greater variety of payment channels are available. And the ECB also seeks to promote healthy competition and innovation. The central bank is not profit-oriented, i.e. it is effectively impartial and can therefore guarantee free access to the digital euro as a ‘platform’. Private market participants can use this platform to develop innovative applications. If the digital euro is joined by compatible counterparts from central banks in other countries, the processing of international payments might also become cheaper and easier.

Risks for commercial banks

But the central bank needs to be careful. If implemented poorly, the digital euro could also pose risks. If the amount of CBDC that can be held as a deposit is not limited, bank balances could be withdrawn from conventional accounts and converted into secure central bank currency very rapidly, which would increase the risk of a ‘digital bank run’. This would be catastrophic for the banking system, because banks could end up in distress even more quickly if their solvency is in doubt.

Interest on digital euro deposits would also put pressure on commercial banks. It would put the ECB in direct competition with private sector banks with regard to customer deposits. This could hold back lending and, consequently, growth. The ECB will monitor these aspects carefully over the next two years.

In the event that the ECB decides to go ahead with the digital euro in 2023, it has set itself a time frame of around three years for the actual development and implementation. That is an ambitious schedule. The launch of a digital central bank currency is a highly complex undertaking with much at stake. A failed launch, e.g. due to technical issues or cyber attacks, could have devastating consequences for the central bank’s reputation and credibility – arguably its greatest assets. The ECB cannot afford to make any serious mistakes in the introduction of this new currency format and a potential launch will therefore be meticulously prepared.

The battle against private currencies could be difficult

Even if the potential launch of the central bank digital currency goes smoothly, there is no guarantee that it will be a success. The decline in the use of cash for payments coincides with an upward trend in cash deposit volumes. This means that central bank money is particularly attractive to people as a repository of value. However, if the ECB designs the digital euro primarily as a means of payment and restricts its use as a means of storing value, e.g. through quantitative limits, it will struggle to compete with private currencies. In addition, a key feature that attracts users to cash is anonymity. A central bank digital currency cannot offer the same degree of anonymity, even though the ECB is likely to dedicate significant thought and effort to the subject of privacy. Another crucial factor for success and public acceptance will be how easy and convenient it is to use the currency. In this respect, the digital euro will need to stand up to comparison with other digital payment methods.

Like other central banks, the ECB continues to emphasise that there is no foregone conclusion to its research in this area – but in all likelihood, it will be merely a matter of time until the digital euro is launched. This is partly due to the fact that China’s advances in this area will probably trigger a chain reaction among other central banks as no one wants to fall behind in the technology race. And partly because the ECB and other central banks will find themselves forced to take action if they want to retain a level of influence on the continuous and unstoppable transformation of the world of payments.

As at: 21 July 2021