A digital euro: opportunities but also pitfalls

Economic opinion

More than 80% of central banks are researching a digital currency. The ECB also completed its public consultation in January 2021 and is likely to decide by mid-2021 whether and how it will develop a digital euro. The exact design will depend on the objectives of the central bank itself (such as robustness and efficiency of the payment system, financial stability and the autonomy of monetary policy) and the needs of potential users (such as privacy, security and a pan-European scope). Besides opportunities, there are also pitfalls, such as the potential impact on the financial intermediation of the banking system and on the relationship of different digital currencies in competition for the status of global transaction and reserve currency.

On 12 January 2021 the ECB’s public consultation on the possible introduction of a digital euro ended. The ECB will publish the conclusions in the course of spring this year, and decide by mid-2021 whether to proceed with its plans for a digital euro and, if so, in what precise form.   

The idea of a digital currency is not new. As early as 1987, for example, Tobin proposed that the Federal Reserve (Fed) offer a form of its own deposits to the wider public. These deposits would be completely risk-free as a direct claim on the Fed. Meanwhile, the practical interest of central banks worldwide in digital versions of their currencies is also increasing. According to a recent BIS paper, by 2019, around 80% of central banks worldwide were researching such a currency (Figure 1). Invariably, the intention is that a digital currency is a supplement, not a replacement, for physical cash. 

What is a ‘real’ digital currency ?

A fully fledged digital currency (Central Bank Digital Currency or CBDC) is the digital equivalent of cash, i.e. a direct claim on  the central bank. In this sense, this digital currency is completely risk-free. A CBDC may also receive an interest payment, possibly even negative or with a multi-tiered system based 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 watches over the value of the money. A CBDC, like its physical counterpart cash, does indirectly have an intrinsic value through its status as legal tender. At the very least, the user is certain of being able to use it to pay his or her tax debt to the government.

Why a digital currency ?

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

Secondly, a digital currency can promote the efficiency of the domestic and international payment system by making full use of the new technology and by responding to the gradually declining use of physical cash for payments. A digital currency can also promote the financial inclusion of those parts of the population that currently do not have access to the traditional payment system. This is particularly, but not exclusively, the case in emerging economies. 

A third important motivation that emerges from the BIS survey is financial stability in its broad sense. First and foremost, it is about protecting 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 also, for example, issued by foreign central banks. This defensive motivation thus goes beyond the payment system itself. It also takes into account the possible consequences when deposits, and possibly also loans, can be held in an alternative digital currency. For the time being, all central banks involved exclude CBDC deposits. Nevertheless, in the future this may change and lead to a less effective monetary policy transmission mechanism. 

Moreover, the loss of control over the domestic money supply may lead to dangers for financial stability. For example, it is not clear who will assume the role of Lender of Last Resort if liquidity problems arise in connection with deposits in alternative digital forms.

According to the first results of the ECB consultation, the main concern of potential users of a digital euro is the protection of privacy (41% of responses). This is followed by the security of its use (17%) and its pan-European nature (10%).

Potentially far-reaching implications

Independently of its practical design, a digital euro might have some important economic implications. For instance, the question arises whether a CBDC will remain complementary to cash, or eventually replace cash, at least de facto. Through the economies of scale in the payment system (the ‘network effects’), such an evolution could occur quickly. Moreover, the government has an incentive to support such a trend in the context of combating fraud and money laundering. A positive side effect for monetary policy of a disappearance of physical cash would be that the effective lower limit of the policy interest rate would become less strict. The interest rate for the digital euro, whether or not in a multi-tiered system depending on the amount, plays a crucial role in this respect.

The introduction of a fully risk-free digital euro could also facilitate bank disintermediation. Collection of deposits, and relatedly lending, by commercial banks may be affected. In their plans for a CBDC, all central banks do indicate that the digital currency would only be intended as a means of payment and not as a form of savings or investment. This can be achieved, for example, by imposing an upper limit on the holding of digital euros. However, the role as a store of value is, alongside that of a means of exchange, a defining feature of a properly functioning currency. If a potential digital euro becomes a success story, it is not inconceivable that the central bank will respond favourably to users’ demand to be able 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. A digital monetary world order would therefore have to clarify the framework of interaction of the various currencies (cooperative or competitive). This potential rewards of such a competition are the benefits of issuing the leading international transaction and reserve currency. For the US dollar- the current incumbent- the stakes are the highest.


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