ECB Watch: Digital euro on the way - little disruptive MVP for the time being

The much-anticipated digital euro is coming, and the dice could be thrown today. But the digital euro will probably be introduced in a less disruptive format with so-called "holder limits" and plenty of room for the banking and financial sector. Thus, this process will probably be less groundbreaking than the introduction of the euro itself — at least for the time being.

Digital euro - probably by the mid-2020s

Actually, the announcement of the ECB's "new" monetary policy strategy (which has already taken place) was the expected monetary policy highlight for 2021. In recent months, weeks and days, however, it has also become apparent that the ECB will make further landmark decisions in the summer towards a roadmap for a (possible) introduction of a digital euro or, more precisely, a digital currency for retail and end customers. A decision is expected today according to various media hints.

A "Go" decision has become the most likely outcome, especially since the ECB President has taken a very clear position in favour of the digital euro. The expected positive decision was preceded by intensive consultations in expert circles and surveys among the population. Since the topic of the digital euro is polarising (especially in German-speaking countries), we see it as positive that very extensive consultations are taking place in expert circles and that end-customer feedback is being actively collected. The ECB has clearly taken the consultations and end-customer feedback into account. In this respect, the decision expected today is for the time being less groundbreaking or disruptive than has been speculated for a long time. In the following, we will take an initial look at the most important background and decisions.

It is important to note that the digital euro is not a quick fix. In all likelihood, a two-year granular exploratory phase will start before a further test phase lasting several years (probably three years) begins. A digital euro could thus come in the mid-2020s (the eight-year term of the current ECB president ends in 2027). Such a cautious timetable is justified, since we are dealing here with moey — the "object of turst" — and this then in conjunction with an "IT project".

Pressure to act at international level, securing data sovereignity as policy imperative

Ultimately, concepts such as the digital euro are about securing the state's monopoly on money and data, also in the context of declining cash payments. Given the high preference of customers for user-friendly digital payments, private payment services have increasingly established themselves in recent years, reaching into core areas of central bank activity, i.e. their responsibility for secure payment and financial systems. In this respect, it is not surprising that currently projects such as the digital euro (or other state digital currencies) are primarily aimed at a state digital offering in the currency area for private and end customers, even if the introduction of a state currency in the institutional central banking business would certainly be technically easier and have fewer macroeconomic implications. In a way, the comprehensive establishment of numerous private currencies — with currency competition at the expense of the customer — could even be seen as a historical step backwards. Moreover, the comprehensive establishment of private means of payment would imply that even more sensitive data would become privately usable. The plan for a digital Yuan in China is also clearly driven by the ambition not to leave the field to private large national payment service providers. For Europe, there would also be the risk that such innovations could be very strongly driven by companies outside the euro area, which makes data governance issues even more acute. Moreover, large-scale cyber risks may still be better hedged in the state space than in purely private solutions. Thus, the issuance of a digital euro fully under the sovereignty of the ECB in the sense of a monetary monopoly with no vested interest in data generation is certainly a coherent project. Especially since the topics of data security and privacy were central aspects in the ECB's surveys in terms of customer expectations.

But it is not only private-sector alternatives that have put the ECB under pressure; more and more other (leading) central banks are also working on such projects, and at some point interoperability and competition will also be at stake. In this respect, the introduction of a digital euro should also open up numerous options and offer advantages to the European financial ecosystem as well as to the EU and the euro area. More details on such basic ideas can be found here in a comprehensive ECB study based on the consultations on the digital euro.

Digital euro probably first wallet solution and real-time means of payment - not an asset!

Following the public consultations, also with stakeholders, the ECB has conducted further detailed surveys on the digital euro (here is the link to the corresponding report). We see broad support here, but also some critical points. In principle, many respondents are in favour of a digital euro, but apparently data security and privacy take precedence over innovation. Surveys show a high preference for web- and wallet-based solutions with offline functionalities and (cross-border) interoperability. In the area of user-friendliness, easier cross-border payments are also in the foreground. In addition to user-friendliness, surveys focus on privacy and security. Customer expectations and ECB indications also show that there should still be a place for private payment providers and banks. Private end customers do not expect to interact directly with the ECB, which in our opinion would also not be operationalisable or, practically speaking, would require massive onboarding, KYC and AML capacities on the part of the ECB. At the moment, it looks like banks and financial intermediaries will be an important part of the digital euro ecosystem, and the ECB does not want to become a full-blown financial services provider. Commercial bank accounts will be necessary to use the digital euro and there are thus opportunities to build business ideas around the digital euro.

For a digital euro in the retail sector, it is a matter of deciding at the technical level whether a centralised (with little involvement of intermediaries) or decentralised solution with extensive involvement of intermediaries is preferable. With the claim to act as a substitute for cash, the digital euro would ideally be a direct deposit at the central bank without the involvement of a third party. However, we think that in such a setup too many operational and legal risks would be taken directly by the central bank. In this respect, we think that intermediaries will also play an important role in the digital euro, so to speak as a door opener or gatekeeper to an ECB real-time payment system; even if a large part of the ultimate responsibility for the back-end infrastructure will lie with the ECB. In this respect, the ECB as the operator of a complex retail and real-time payment system would certainly expose itself to increased operational risks as well as legal and reputational risks.

It seems that the digital euro will not be established as a DLT (Distributed Ledger Technology) system (i.e. blockchain-based), as currently planned. The ECB apparently sees too great an operational risk here, or even a threat to its political goal of quickly introducing a digital euro. Rather, the ECB is currently considering the use and upgrading of already established real-time payment systems. Hence, for the time being the digital euro will not become a competitor for DLT-based applications. Concerns about any kind of programmability of the digital euro are thus (at the moment) invalid.

All in all, it is clear that a digital central bank currency will also have to offer special product features or an USP (unique selling point) compared to private-sector solutions. The latter can lie precisely in the areas of privacy and data governance, without neglecting efficiency and customer experience considerations. In addition, the consultations have shown that many citizens still associate the digital euro with crypto-assets (such as Bitcoin), while professional players have a clearer view of possible innovations for payment transactions. In this respect, it should be noted that the currently envisaged first draft of the digital euro is certainly only a "minimum viable product (MVP)". Moreover, the ECB clearly wants to establish the digital euro as a means of payment and transaction, not as a comprehensive value storage and investment vehicle; indirectly, however, state-owned digital currencies can take some of the hype out of the crypto "currency market" or counteract speculation that a private cryptocurrency will actually establish itself as a (legal) tender.

Preferences attached to the digital euro (% of respondents)
ECB, RBI/Raiffeisen Research

Holder or payment limits as with cash - for the time being, not very disruptive for the money creation process

In all likelihood, the digital euro will initially be provided with rather restrictive "user" or "holder" limits, which makes sense for many reasons and makes it less disruptive.

First, a digital euro or its absolute security as a central bank claim without "holder limits" could trigger shifts in the sense of bank runs or capital flight movements (inside the euro area) even faster in times of crisis than before. This is true in the technical sense and also in the sense of the underlying herd behaviour; and we have certainly seen bank runs and capital flight movements in Europe in the recent past. In addition, arbitrage processes would also have to be taken into account here - without limits - for bank deposits that exceed statutory deposit insurance limits of EUR 100,000, for example.

Secondly, a digital euro without "holder limits" could fundamentally change the re-financing structures in the banking sector. In principle, the digital euro would be assumed to be interest-free. Nevertheless, it could cause demand deposits to flow out of private banks and/or only be held at higher conditions. The roll-out of a digital euro in the retail sector could also have a strong influence on payment habits and liquidity holdings. On the one hand, part of the high excess liquidity could flow away from the commercial banks — which would be positive. On the other hand, it could also be necessary to offer higher deposit rates in certain market phases; the refinancing conditions could shift permanently. In addition, the dependence of the banking sector on capital market financing could then increase or instruments such as LTROs would have to be maintained on a rather permanent basis (for banks without access to capital markets).

Thirdly, there are indications that a high degree of digitalisation in the banking and financial sector can contribute to a higher willingness to take on debt among the population. Thus, amount user or holding limits also make sense from this perspective. This is especially true if the digital euro is defined as a clear substitute for cash and its modernisation, and if the aim is to counter an excessive use by private customers for the purposes of the "hidden economy", which is also the intention of the widespread cash payment limits in Europe and the EU (which range from 1.500 to approx. 14.000 to 15.000 euros).

As a pure cash substitute, a digital euro should clearly not be disruptive to the process of money and credit creation. Currently, cash represents only about 10% of the broad money supply M3. With the apparently envisaged usage limits in the range of several thousand euros, (larger) parts of this share of the money supply M3 (depending on acceptance) could be covered, but not more.

Monetary aggregate M3 (% of total)
ECB, RBI/Raiffeisen Research

Digital Euro - widespread negative interest rates ante portas

A digital euro would open up the technical possibility for the ECB — if necessary — to enforce negative interest rates across the board. This option would exist and cannot be ruled out, even if the ECB has so far emphasised that such considerations are not the focus of its deliberations. However, such concerns also show a (high) degree of mistrust towards the ECB that should not be underestimated, or that it is suspected that this promise could also be broken. To some extent, such concerns could apparently be defused with legal regulations, but a residual uncertainty still remains. Moreover, without clear holding limits for the digital euro, it could experience massive inflows in times of crisis. The establishment of negative interest rates on the digital euro, which cannot be ruled out, could also be necessary to counter international capital flow risks in the event of too widespread distribution and/or international usage. In this respect, we think that a combination of holding limits and negative interest rates as a "defence mechanism" cannot be ruled out in the long term (depending on which holding limits and international usage become established in the end). In this respect, this point also speaks in favour of an introduction in the private customer sector (for residents of the euro area) with limitations in the first place.

Conclusion and outlook

The first shot of the digital euro will in all likelihood be less disruptive in many dimensions (technically and in terms of holder limits) than often feared. At present, it is not totally clear whether the ECB will be able to establish itself with the digital euro — despite all understandable political ambitions — against private-sector service providers in the payment traffic market. In order to help the digital euro achieve a breakthrough, we believe it will be important to gradually and prudently expand the holding limits and at the same time work permanently on technological innovations. In the event of a substantial expansion of the holder limits, however, important regulatory decisions and fundamental decisions about the overall monetary framework will also have to be made. Keywords here are: One-tier (central bank) money system vs. two-tier money system with active participation of regulated private-sector actors in the "sovereign" task of money creation. Such decisions then require comprehensive democratic debates and legitimisation.

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Gunter DEUBER

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Gunter Deuber is heading the Economics and Financial Analysis division (Raiffeisen Research) at Raiffeisen Bank International (RBI) since 1 January 2021. Since 2011, Gunter Deuber has held leading positions in RBI's Economic and CEE Research and has continuously expanded the cooperation with his research colleagues in RBI’s subsidiary banks in CEE. Since the early 2000s, he has been analysing economies, banking sectors and market topics with a focus on CEE and EU/euro area topics for RBI in Vienna, but also in the international (investment) banking context in Frankfurt. He regularly presents the views of Raiffeisen Research and his research team at meetings with investors and clients. He is a well sought-after speaker at landmark events in the finance and banking industry and a guest lecturer at several universities/teaching institutions. In 2019, he was nominated for the US State Department's IVLP (International Visitor Leadership Program). Gunter has published several edited volumes on Euro/EU crisis issues and published various articles in professional journals and industry magazines. Outside the office, Gunter enjoys travelling with his family and long-distance running.