Vice President of the Bank of China Research Institute: Development Prospects and Challenges of the Digital Euro

Key points

If the digital euro is properly designed and used, it can significantly improve the European payment system, but the challenges it faces in terms of privacy security, financial risks, supervision, and infrastructure cannot be ignored. In addition, the digital euro may have an impact on the international financial system and monetary system.

Digital currency is the engine of the digital economy and the booster of the digital society. In recent years, more and more countries and regions have actively explored the digital form of legal tender, and the central bank digital currency (CBDC) has gradually moved from theory to practice. In July 2021, the European Central Bank Management Committee officially launched the digital euro project, which will conduct investigations and evaluations on key issues such as technical routes, legal frameworks, application scenarios, and potential impacts in the next two years. This marks a new stage in the development of the digital euro. The digital euro will have a huge impact on the currency payment system and financial markets in Europe and even the world, but the challenges and risks it faces cannot be ignored either. 

Digital Euro Project Launch Background

First, the demand for digital currency has become more prominent. With the rapid development of network technology and digital economy, residents’ consumption, investment, and savings behaviors are becoming increasingly digital. Since the outbreak of the new crown epidemic, digital work and lifestyles such as online shopping, online teaching, online office, and telemedicine have become more active. The public’s reliance on contactless payments has increased and the demand for online financial services has become increasingly strong. According to a research report by the European Central Bank on consumer attitudes towards payment in the Eurozone, about one-half of the respondents indicated that they prefer to use non-cash payment methods, and the proportion of cash payments in the total payment has also increased from 2016 79% dropped to 73% in 2019.

Second, there are many problems with existing payment methods. One is the poor availability. According to 2017 data from the World Bank’s Global Financial Inclusion Index database, 5% of the population in the Eurozone still has no bank accounts, while the proportion of other underdeveloped economies in the European Union is even higher. Due to the lack of trading accounts and technical support, this type of financial exclusion can only use cash to pay. The second is the high transaction cost. Bank card payment networks usually require three or four parties to participate in processing transactions and collect various fees such as exchange fees and license fees. The transparency and settlement speed are not satisfactory. The third is the imperfect pan-European payment system. There are many payment methods available to European consumers, such as local payment systems such as GIRO (General Interbank Recurring Order) in Germany and CB card (Carte Bancaire) in France, and out-of-area payment systems such as Visa, Mastercard, PayPal, and Alipay, but they still lack A payment network covering the entire Europe. Fourth, cross-border payments are inefficient and risky. At present, European cross-border clearing is highly dependent on the World Banking, Financial and Telecommunications Association (SWIFT) controlled by the United States. Cross-border transactions take 3-5 days to arrive. The clearing efficiency is low, the handling fee is high, and it faces credit and liquidity risks. .

Third, encrypted digital tokens such as Bitcoin and non-sovereign digital currency projects such as Facebook have developed rapidly. According to incomplete statistics, there are currently more than 10,000 cryptocurrencies in the world, with a total market value of more than 2 trillion U.S. dollars (data from the CoinMarketCap website, as of August 26, 2021). Due to the lack of value support, sharp price fluctuations, low transaction efficiency, and huge energy consumption of cryptocurrencies such as Bitcoin, it is difficult to perform currency functions in the market. Its “decentralization” and “complete anonymity” characteristics are also easy to be compromised. Criminals use money laundering, terrorist financing and other illegal economic activities to endanger financial security and social stability. The European Central Bank believes that under the trend of increasing digitalization, providing a risk-free, accessible, and efficient central bank digital currency can offset the risks of encrypted assets dominated by large technology companies and avoid adverse effects on financial stability and monetary policy.

Fourth, the international community attaches great importance to and actively develops the research and development of central bank digital currencies. The latest survey report of the Bank for International Settlements (BIS) shows that about 86% of central banks in 65 countries or economies around the world have carried out digital currency research, 60% are conducting experiments or proof-of-concepts, and 14% have deployed pilot projects. At present, the central bank digital currencies of most countries and economies are in the R&D and testing stage, which makes the European Central Bank’s sense of urgency to develop a digital euro increasingly.

The status quo of the digital euro project

Based on the above background, the European Central Bank changed its previous cautious attitude and actively carried out the conceptual design and practical exploration of the digital euro. The research and development of the digital euro entered the fast lane: at the end of 2019, the European Central Bank established the Central Bank Digital Currency Working Group and launched the “European Central Bank Digital Currency Working Group”. “Chain” is a new concept project to explore the anonymity of digital currencies; in September 2020, the digital euro experiment will be launched to evaluate the digital euro distributed ledger, privacy and anti-money laundering, restrictions on the digital euro in circulation, and end-user access. The feasibility of the field design technology; in October 2020, the digital euro report was released, expounding the core guiding principles, potential application scenarios, legal foundations and technical routes of the digital euro issuance; in July 2021, the digital euro project entered a two-year period The investigative stage of the US aimed at solving the key issues of currency design and how to distribute it to the public. The decision was supported by Germany, France and other countries.

The development process of the digital euro can be summarized from three aspects: legal framework, practical exploration, and technical route.

(1) Legal framework. The digital euro issuance has a certain legal basis, but it is relatively weak. In June 2018, the European Union promulgated the “Fifth Edition Anti-Money Laundering Order”, which classified cryptocurrency business and banking, payment processing, gaming and other services into the same legal category, stipulating that banks cannot refuse to be cryptocurrency or cryptocurrency without a valid reason. The virtual asset business provides services to regulate and supervise the use of private digital currencies from the legal level. In 2020, the European Union has intensively issued documents such as the “Artificial Intelligence White Paper”, “European Data Strategy”, and “Europe’s New Industry Strategy” to ensure Europe’s competitive advantage in the digital economy. After that, the European Commission launched the drafts of the Digital Market Law and the Digital Services Law to strengthen anti-monopoly supervision in the field of digital payments, regulate the use of financial data, and create a legal environment for the introduction of the digital euro.

(2) Practice exploration. EU member states have carried out practical explorations in terms of conceptual design, distribution mode, cross-border payment, and privacy protection. The Italian Banking Association has begun to experiment with a digital euro based on distributed ledger technology, focusing on how the technical feasibility and programmability of infrastructure and distribution models can be used to distinguish the central bank’s digital currency from existing electronic payment systems. Spain’s Iberpay, which is responsible for the fast payment system, cooperated with 16 Spanish banks and successfully completed a proof-of-concept test to test different design options for the future digital euro. The Central Bank of Lithuania applied its blockchain-based digital commemorative coin LBCOIN project experience to the study of the digital euro, proving the feasibility of the cross-border digital euro supported by distributed ledger technology (DLT). Bank of France and eight well-known companies, including Accenture and HSBC, have carried out CBDC trials with the aim of realizing the modernization of inter-bank settlement. The results of the experiments will lay the technical foundation for the development of the digital euro. The Bank of the Netherlands reported that the country is preparing to develop CBDC, and has offered to use it as a test site for the digital euro.

(3) Technical route. The European Central Bank will base on the actual situation and reasonably determine the technical route. As a supplement to cash and central bank deposits, the digital euro is designed to focus on the retail transaction digital euro for individuals and non-bank companies, aiming to provide the public with a simple, cost-free and credible digital payment method. In terms of operating mechanism, considering that the European Central Bank does not have sufficient professional knowledge and experience to provide services such as transaction monitoring, customer analysis, and relationship maintenance, the digital euro will adopt a two-tier operating model. Specifically, the central bank is responsible for issuing digital euros, operating back-end infrastructure and keeping transaction ledgers; regulated payment intermediaries are responsible for payment services and account maintenance services. In order to deal with the exchange rate risk, currency substitution and economic crime brought by the cross-border movement of the digital euro, the European Central Bank is trying to use the multilateral CBDC system to explore the feasibility of cross-currency and cross-border transactions. Standards (such as regulatory frameworks, market practices, information formats and data requirements, etc.), use technical interfaces or common settlement platforms to interconnect systems, or establish a single multi-currency payment system to achieve cross-border and cross-currency interoperability plan. For example, the Bank of France, the Swiss National Bank and some private institutions jointly launched a wholesale digital currency (wCBDC) cross-border settlement experiment, mainly focusing on the inter-bank wholesale loan market. The Bank of France is convinced that the project will significantly improve payment efficiency, security and transparency. In addition, the digital euro is designed to allow non-euro area residents to obtain and use it. In the future, it may be possible to avoid capital flows and excessive exchange rate fluctuations by limiting the number of holdings and formulating return policies.

Possible challenges of the digital euro

The digital euro will play a role in monetary policy, payment networks, inclusive finance and other fields; but at the same time, the digital euro also faces severe challenges in terms of privacy security, financial risks and supervision, infrastructure and system construction.

First, it is difficult to find a balance between privacy protection and the restriction of illegal financial activities. The results of the European Central Bank’s public consultation on the digital euro show that the public has the highest requirements for the privacy of digital currency payments, followed by security and the wide range of applications. From a theoretical perspective, there is a conflict between the anonymity and traceability of digital euro transactions. If the user uses the digital euro without verifying his identity, that is, the payment is anonymous, it may provide fertile ground for illegal activities, hinder anti-money laundering and combat terrorist financing activities, which is not in the public interest; if the user shows his identity and transaction information when accessing the digital euro service , Geographic location and search records, etc., may be obtained by intermediaries and breed gray transactions, increase the risk of data leakage and data abuse, infringe on the privacy of users, and even threaten the safety of personal property.

Second, there are big differences in technical knowledge, infrastructure, legal environment and preferences in the Eurozone. The basic level of European countries is quite different, and the digital euro has a long way to go to reach pan-European payments. The consumption habits and cash preferences of the Eurozone countries vary. For example, countries such as Germany, Malta, Austria, and Cyprus prefer cash payments; on the contrary, France, Belgium, Finland, and Luxembourg prefer non-cash payment methods. The construction of digital technology infrastructure in different countries is uneven, and the degree of digitization varies from one country to another. The proportion of cash paid in the Netherlands has been declining year by year, and it has an efficient and reliable digital payment infrastructure. Most payments are in digital form. It has introduced a number of measures to improve the efficiency of the payment infrastructure, such as instant payment. Greece’s digital development is relatively pessimistic, and it belongs to the ranks of “left behind countries”, with Internet access and penetration rates lower than the EU average. The legal environment of digital currency in each member state is also different. For example, Germany has strict regulations on digital currency, allowing some banks to store digital currency and carry out digital currency custody business from 2020. Individuals can only engage in related businesses with official approval; while the Austrian government’s regulation of digital currency is relatively loose. Some companies accept digital currency payment methods, attracting a large number of start-ups in the digital currency field to set up companies here.

The third is to put forward new requirements for the financial supervision system. The digital euro will fundamentally change the role of central banks, commercial banks, and non-bank financial service institutions in the financial system, and will impact the regulatory system in such links as circulation, issuance, and clearing. The existing laws and regulations are not perfect, the regulatory policies are not perfect, and the regulatory model does not match the digital currency financial market, etc., which may make it difficult for the regulatory framework to cover the digital euro. In the absence of effective supervision, the digital euro may become a virtual safe haven for criminals to conduct illegal financial transactions, inhibiting the private sector’s market participation and R&D innovation, and affecting the stable and healthy development of the financial market.

Potential impact of the digital euro project

The typical characteristics and technical route of the digital euro are different from traditional currencies. If properly designed and used, it can significantly improve the European payment system and promote the innovation and development of finance and the digital economy. In addition, the digital euro may have an impact on the international financial system and monetary system.

One is to increase the risk of “digital runs” in commercial banks, and appropriate design solutions must be adopted to effectively deal with financial disintermediation and fluctuations in financing sources. A Morgan Stanley research report stated that if all euro zone citizens over the age of 15 convert 3,000 euros in bank deposits into digital euros controlled by the European Central Bank, total euro zone deposits (including deposits from households and non-financial companies) will be With a reduction of 873 billion euros (or 8%), the average loan-to-deposit ratio (LDR) of euro area banks will increase from 97% to 105%, especially in small countries such as Greece, Latvia, Lithuania, and Estonia. The report shows that the availability of digital euros will increase the speed and potential scale of bank deposits transfer to digital euros, leading to a decrease in stable funds composed of retail deposits in banks, which in turn will affect banks’ ability to provide credit to the real economy and credit growth in the market. Allocation efficiency will cause “digital run” and “financial disintermediation”, which may affect the stability of financial markets and the effectiveness of monetary policy. The digital euro may also change the financing structure of commercial banks. The “digital run” will lead to a decline in bank deposit funds, forcing banks to rely more on market financing, thereby increasing the cost and instability of market financing, and reducing the bank’s net stable funding ratio (NSFR). In response to the above-mentioned financial disintermediation and changes in financing structure, the digital euro report proposed that measures such as establishing a tiered return system and setting user holding caps can be adopted to reduce the impact of the digital euro on financial stability.

Second, the emergence of the digital euro may lead to the substitution of currencies of other countries. The low cost and convenience of digital payment reduce the cost of currency switching and accelerate its acceptance by the public. The network spillover effect generated by the payment method and storage method of the digital euro will accelerate this trend. The availability of the digital euro may make third-country currencies with unstable currencies and weak economic fundamentals be replaced in whole or in part, causing the digital euro to gradually become a local means of payment, savings method and even a unit of account, that is, “digital euroization” . On the one hand, “digital euroization” poses a threat to the monetary sovereignty of non-eurozone countries, or even triggers dissatisfaction and political tensions among overseas governments; without proper design and safeguards, currency substitution will also increase the asymmetry of the international monetary system , Increasing the difficulty of foreign exchange control and preventing capital flow risks; in addition, the transaction data generated by the use of the digital euro is an important strategic asset. If it is controlled by a non-local government and used maliciously, it will seriously threaten the security of the country and people’s property. But on the other hand, from within Europe, the digital euro can accelerate the use of the euro by EU member states, reduce the risk of exchange rate fluctuations, and promote overall European economic growth and digital technology innovation.

The third is to change the monetary policy transmission mechanism and improve the efficiency of currency delivery. The European Central Bank broke through the current central bank’s cautious idea of ​​not accruing interest in digital currency experiments, and proposed a tiered interest accrual system in the digital euro report. The interest-bearing digital euro, as a new monetary policy tool, breaks the limit of zero cash interest rates and provides the central bank with a direct and powerful policy interest rate transmission mechanism. Specifically, the central bank can adjust the interest rate of bank deposits and loans by adjusting the interest rate of the digital euro, which can be directly transmitted to households and companies holding digital currency, and affect the financing cost of the real economy. In addition, the digital euro helps to improve the efficiency of currency delivery. After a series of transmissions of traditional monetary policy, it is very likely to be affected by the macroeconomic environment and micro-individuals and fail to achieve the expected results; while the programmability of the digital euro allows the central bank to understand the payment, specific purpose, and usage of each transaction. Such currency circulation information is conducive to precise control of the money supply in the economy, thereby affecting household savings and consumption, and improving the accuracy, effectiveness, and timeliness of monetary policy. However, considering that there is an upper limit on the amount of personal holdings of the digital euro, the total amount of central bank cash and digital currency assets is not large relative to the scale of bank deposits, and the impact of the digital euro on monetary policy will be very limited.

Fourth, it is difficult to shake the hegemony of the US dollar in the short term, and it will intensify competition in international currencies in the long term. According to SWIFT statistics, the U.S. dollar has an absolute advantage in the use of international settlements, asset reserves and foreign exchange transactions in the medium and long term, and the Euro ranks second. The U.S. uses the hegemony of the U.S. dollar to levy international seigniorage, controls the global cross-border payment system, and frequently implements financial sanctions, which has long aroused dissatisfaction with other countries in the world. Some believe that the emergence of the digital euro may challenge the dominance of the dollar, rewrite the global reserve currency pattern, and impact the currency sovereignty of various countries. But in fact, the international role of the euro depends more on the EU’s international trade scale, the robustness of economic policies, the breadth and depth of financial markets, the perfection of laws and regulations, the construction of relevant infrastructure, and the inertia of international currency usage. The issuance of the digital euro will not shake the US dollar’s ​​central position in the global financial system. This view is more based on political demands rather than economic and financial laws.

It is worth noting that the current monetary system structure will undergo gradual adjustments in the long-term, and the leading digital currency will have an advantage in international currency competition and may intensify international currency competition. In November 2019, Harvard University professor Rogoff pointed out that a new currency competition has arrived, and this time is a central bank digital currency war. In July 2021, Professor Chekhetti from Brandeis International Business School even compared the digital currency competition of central banks to an “arms race.” If one country launches attractive trading methods, other countries may fall into demand for their own currencies. The plunge or the sudden increase in capital outflows of financial institutions may lead to the prisoner’s dilemma of competing to develop digital currencies. It can be expected that as mainstream currencies such as digital renminbi (6.4438, -0.0010, -0.02%), digital euro, digital dollar, and digital yen gradually enter the testing and use stage, digital currency competition will become increasingly fierce. This “new currency war” may even subvert the world financial structure and reshape the international monetary system. There may be three situations in the future currency system: the most conservative situation is to maintain the status quo, a CBDC issued by a major country or alliance dominates, and CBDCs from other countries play a supporting role; the intermediate situation is to form a multi-country CBDC network and be provided by the public sector A basket of synthetic hegemonic currencies; the most radical situation is the formation of a regional digital currency zone, where digital currencies issued by the government or privately compete with each other. Obviously, the emergence of digital currency has increased the dimensions of international currency competition, and the evolution of the international monetary system is destined to be a long and uncertain process.

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