Digital euro

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A retail digital euro released into a complex financial system could become a ‘liquidity vampire’ if severe stress erupted in the banking system. But if soundly designed it could also bring many benefits. Justin Pugsley reports.

Many retail banks are opposed to a central bank digital currency (CBDC) euro, fearing it could trigger unintended consequences. But in other quarters there is lots of enthusiasm. “One of the primary motivations is the digitalisation of the European economy. But also modernisation and future-proofing are an important aspect,” says Conrad Kraft, executive director at the Digital Euro Association (DEA).

He explains that it would open up new possibilities around digital ledger technologies and even new economic frontiers such as the metaverse. Also, embedding programmability could give a digital euro its unique selling proposition. 

Eurosystem central bankers are more nuanced. They think a euro CBDC might be needed to fend off stablecoins arrangements displacing central banks and being able to circumvent prudential rules fostering new systemic risks. Another more distant possibility is that a foreign CBDC could become embedded in the eurozone economy if merchants flocked to it, say to gain efficiencies. 

“I believe these fears are justified,” says Viktor Prokopenya, a technology entrepreneur and venture capitalist, adding that the European Central Bank (ECB) is prudent to investigate CBDCs rather than risk being displaced.

The core issue

The core issue is that a retail version of a digital euro would be available to the public and would be a liability on the ECB. Currently, most digital money used by the public is a call on commercial banks. 

Therefore, if there was a loss of confidence in the banking system – as happened in some countries during the 2007–9 global financial crisis (GFC) – depositors could stampede into digital euros at the tap of a phone app. Digital euros could become a conduit for the fastest bank runs in history, making them an existential threat to deposit takers. Digital euros, an incarnation of physical cash, would be the safest place to park money during a financial crisis.

“I think that is the biggest danger that a wrongly designed CBDC could bring,” says Wim Boonstra, a senior vice president at RaboResearch Global Economics & Markets. He warns that had a digital euro been around during the GFC, it could have made bank runs worse. It could even have hit solid credits, such as RaboBank, as confidence in the banking system was evaporating, he says. And bank runs can still happen despite deposit guarantees.  

Caution rules

Interestingly, eurosystem central bankers appear to be relatively enthusiastic over creating a digital euro. But they stress if it is ever released into the wild, it will be under strictly controlled conditions. Also, they want commercial banks, including deposit takers, to be an integral part of a digital euro ecosystem. 

Commercial banks have all the Know Your Customer and anti-money laundering capabilities in place to vet CBDC holders. Numerous central bankers have made it clear to Global Risk Regulator that activities like customer onboarding is not something they want to get involved in. 

Central bankers also challenge the notion that a digital euro will necessarily become a ‘timebomb’ lurking in the undergrowth of the financial system. 

“We have already seen digital runs. This is what happened to the Greek banks [during the euro financial crisis] when people transferred their money to other banks,” says Ulrich Bindseil, the ECB’s director general of market infrastructure and payments. He notes that wealthy individuals and institutional investors can also easily buy, for example, bonds electronically through their brokers. And he adds that central bankers would have the tools to control CBDC volumes. 

A hard cap 

Two particular safeguards are being studied. “At the moment, there is the idea to restrict the volume and/or restrict the price via a tiered interest rate,” says Heike Winter, who is responsible for policy issues relating to retail payments at the Bundesbank. 

Mr Bindseil adds that if a fixed upper limit is chosen, it would need to be set from the start. Otherwise if it is a ‘floating’ cap, people could rush into digital euros at the merest sign of troubles in the banking system to front run changes in the limit. A €3000 cap has been suggested.  

there is a question of whether the digital euro, as envisioned right now, will attract many people to use it

Dirk Niepelt

Mr Boonstra worries about the caps not being hard enough and frets over potential scenarios where there could be political pressure to raise the limit in the event of a banking crisis. Others think €3000 is too low. “In my view, at this point, there is a question of whether the digital euro, as envisioned right now, will attract many people to use it as a means of payment,” says Dirk Niepelt, professor of economics at the University of Bern, noting that current payment systems are easy to use.

He believes the discussion is too retail-centric, adding that the suggested cap is far too low to make the digital euro of much use to businesses. However, central bankers told GRR that they could consider drafting separate requirements for businesses. 

The worry with introducing exceptions is that they could become work-arounds for determined savers to accumulate more digital euros than desired during a banking crisis. 

Tiered remuneration 

The second safeguard under consideration is more market-based and is to use a tiered remuneration mechanism on digital euro holdings. The more digital euros held the lower the interest rate, which could even become negative on large holdings. 

During normal times this might be a good mechanism for balancing flows between commercial bank money and digital euros. But there’s a problem. “It will not help prevent a bank run,” says Mr Boonstra. Indeed, during periods of panic, depositors understandably become obsessed with capital preservation rather than return on capital.

Mr Bindseil points out that these designs are still very much in the investigation phase. Claudine Hurman, director of financial infrastructures, innovation and payments at the Banque de France, explains that it would require stress testing and scenario analysis to fine tune these tools.

Payments choices 

Apart from defending the ECB’s sovereignty, it spies a possible opportunity to boost the eurozone payment industry. Payments are heavily dominated by US companies, which makes EU authorities feel somewhat twitchy about events beyond their control. 

Mr Bindseil believes a digital euro could give the European payments industry an opening to catch up and reverse the trend of a gradual loss of relevance. Nonetheless, eurosystem central bankers are keen to point out that any digital euro payment system must be interoperable with existing private payment solutions and would not be designed to replace them. 

Mr Prokopenya speculates that a digital euro could run on top of the TARGET Instant Payment Settlement (TIPS) infrastructure service. “The digital euro would be a potential ‘zero cost’ competitor, as it will not carry regulatory costs,” he says. The Bundesbank’s Ms Winter says it could use existing eurozone clearing infrastructure.

Whatever the risks and benefits of a digital euro, a period of deep analysis and thorough testing will be needed before allowing it in the financial system. It will also require working closely with the banks to ensure they are well prepared to operate alongside it. 

This article first appeared in Global Risk Regulator, and is extracted from a longer piece called Banks fear digital euro becoming a ‘liquidity vampire. It covers the topic in greater depth with more input from eurosystem central bankers and also investigates issues around privacy and whether pursuing a wholesale CBDC might be a better option. There is also commentary from Annelieke Mooij from Tilburg Law School over some tricky questions relating to the digital euro’s legal tender status.


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