By Nicky Maan, Chief Executive Officer, Spectrum Markets
About 20 years after introducing the euro, the European Central Bank (ECB) is approaching the next phase of its project to develop a digital euro. While this phase has been officially called a “formal investigation phase” by the ECB’s Fabio Panetta, member of the ECB board of directors and first vice president of Banca d’Italia, there is little doubt that the digital euro will become a reality soon.
Prior to the issuance of euro coins and banknotes on January 1, 2002—the largest cash exchange in history for the 12 member states of the European Union (EU)—there had been a three-year “shadow” existence of the currency, used for settlement and electronic payments since January 1, 1999. Before that, there was a 10-year preparation phase during which economic and political convergence issues had to be solved. While many of the obstacles of yore no longer exist, there are new challenges today; although the ECB exercises care in addressing them, it envisages the preparation phase for its digital euro to be half as long as that of its analogue mother.
In October 2020, the ECB published its first report1; since then, it has been testing options for technology and infrastructure that may facilitate the issuance of the digital euro in line with the Eurosystem’s objectives of currency stability, integrity, security and—as a new requirement specific to the currency being digital—confidentiality. As Panetta told the Financial Times recently, the ECB “tested the possibility of running a digital euro with a centralised system, a decentralised one, a mixture of the two and with offline payments” organised in four workstreams. After the upcoming investigation phase of two years—during which it will also consult with the European Parliament, the European Commission, the European Council and the group of European finance ministers—the ECB plans on an implementation phase of around three years in cooperation with banks and technology providers.
It is important to note that the digital euro will not be a crypto-asset. Crypto-assets can be asset-referenced tokens (crypto-values intended to serve as mediums of exchange and which—through reference to fiat currencies, commodities or other crypto-values—should have a stable value, also known as stablecoins). They can be e-money tokens (crypto-assets intended to serve as mediums of exchange and denominated in fiat currency). Or they can be utility tokens (crypto-assets that offer digital access to applications, services or sources and are accepted only by issuers).
This outlines the core difference: crypto-assets are digital representations of values or rights that can be electronically transmitted and stored based on the usage of the distributed ledger technology (blockchain). The digital euro is not a token, nor does it constitute e-money issued by supervised private entities.
The ECB describes the digital euro as a risk-free form of central bank money, a digital representation of cash issued exclusively by itself and always remaining its liability. As with the existing euro, the ECB holds itself accountable for warranting the stability of the digital euro’s purchasing power through the enforcement of its monetary policy. The common umbrella term for such currency is CBDC (central bank digital currency).
But again, the digital euro itself will not be a crypto-asset. While the usage of a blockchain would help solve the confidentiality issue mentioned earlier, it would, at the same time, entail challenges to the integrity of payments conducted by means of the digital euro since the principles of know your customer (KYC), anti-money-laundering (AML) prevention and countering the financing of terrorism (CFT) would be difficult to exercise. The backend infrastructure solution to be finally chosen by the ECB will depend on other factors, too. It could, for example, employ the existing central bank digital money-transaction system it has used for wholesale transactions since 20082: TARGET2 (T2) for wholesale payments, TARGET2-Securities (T2S) for the settlement of securities trading in central bank money and TARGET Instant Payment Settlement (TIPS) service for instant payments. This would, however, prevent it from applying an account-based model in which end-users have their accounts in a centralised Eurosystem infrastructure, since it couldn’t process the extreme volume of (single) payments.
However, a centralised approach based on accounts directly provided to retail customers by the Eurosystem wouldn’t be a smart approach in the first place as it would significantly disrupt commercial banks’ businesses. Here, it is not exactly the fate of a single institution that concerns the ECB but rather the threat to overall financial stability—apart from the fact that the ECB doesn’t have the capacity to perform all the client-facing operations: entering into retail banking would force banks to enter into riskier assets, curb lending and deposit more funds with the ECB. Indirectly, it would harm the efficient transformation of maturities in which money is borrowed and lent within the private sector, which is vital for the functioning of the economy. What’s more, it would blow up the ECB’s balance sheet, with the respective liquidity, credit and foreign-exchange risks attending it.
There are many more implications inherent in introducing a digital euro, which, if misconceived, can have serious consequences. Thus, the ECB will likely act very cautiously with a view to the share of payment transactions the digital euro can assume from the non-digital euro and the maximum funds an individual may hold in an account. In consideration of these particulars, the ECB has issued a set of core principles and general and scenario-specific requirements. Aside from assigning it the status of central bank money convertible at par, the ECB has committed itself to the market neutrality of the digital euro; it has also made its equal accessibility throughout the eurozone a core principle. General and scenario-specific requirements, to an extent not yet discussed, include cash-like features (for example, allowing for offline payment and inclusion), competitive features (making the digital currency sufficiently attractive) as well as requirements for its resilience, safety, cost and ecological efficiency, which prevent it from becoming an investment vehicle rather than a means of payment.
A concrete legal framework also does not yet exist—although most aspects of the target functional design are theoretically covered by the TFEU (Treaty on the Functioning of the European Union) or the ESCB (European System of Central Banks) Statute; formally, the basis is not in place for the treatment of the digital euro as legal tender.
The development of the final architecture will be a very interesting process to follow. The ECB has indicated it may use TIPS to process retail payments based on the digital euro and that national central banks are already employing distributed ledger technologies (DLT)3. The latter suggests that decentralised infrastructures—so-called DLT market infrastructures under the DLT pilot regime4—could play a substantial role in the settlement of transactions as well as in collateral management, securities lending or repo transactions in the processing of delivery versus payment quite soon.
References
1 The High-Level Task Force on Central Bank Digital Currency (HLTF-CBDC) of the European Central Bank: “Report on a digital euro”, October 2020.
2 Spectrum Markets: “A Brave New World: The Settle Men’s Club (Part 1/3)”, Thibault Gobert.
3 Spectrum Markets: “A Brave New World: The Rise of DLT Market Infrastructures (Part 2/3)”, Thibault Gobert.
4 Spectrum Markets: “A Brave New World: The Rise of DLT Market Infrastructures (Part 2/3)”, Thibault Gobert.