What will be of the Central Bank Digital Currencies (CBDCs) in the ECB?

Executive Summary

Throughout history, money and payments have taken various forms: bartering, cowry shells, minted coins, gold, metals, all the way to the Bretton Woods System which ended the Gold Standard in 1971 and re-affirmed the US dollar (Edwards, 2022). With the introduction of cryptocurrencies in the late 80s to early 90s, one foresaw a shift in the way we think of currencies and banking. However, this did not fully solidify until 2009, when Bitcoin was introduced by ‘Satoshi Nakamoto,’ in a bid to circumvent traditional banking cleavages after the 2008 financial crisis (Edwards, 2022). In 2010, the price of Bitcoin was $0.09, ending at $315.21 at the start of 2015 (ibid). By December of 2017, the currency had exploded to $19,345.49, a 6037% increase over two years (ibid). For the Europeans, as for many market economies, the monetary system operates under the complementarity of public and private money, monies guaranteed by commercial banks and central banks (CBs) (Panetta ECB Speech, 2022). Due to this unprecedented rise in Bitcoin, and other cryptocurrencies that were introduced, one has witnessed a flourishing of a new crypto-market, one that could undermine the robustness of that very monetary system that depends on banknotes and third party assurances (ibid). It is then apt that the ECB is imploring the idea of issuing Central Bank Digital Currencies (CBDCs) and adjusting their monetary policies to progressive digital solutions (ibid). Especially with the rising concern of the EU to the threat of cryptocurrencies undermining and usurping “monetary sovereignty” (ibid).

If these cryptocurrencies are left to widespread adoption, without oversight, planning or regulation we can see stablecoins — cryptocurrencies pegged to currencies or commodities but decentralised — exacerbate oligopolies in markets, impacting market functionalities and real interest rates, with undesirable monetary-policy implications (Panetta ECB Speech, 2022). As there remain these cleavages, we may be left exposed and vulnerable to cyber attacks without sufficient safeguards, making illicit crypto activities all the more difficult to track and stop, as has already been the observation (Europol, 2022). Although these potential consequences have not all surfaced, they should not be undermined, just as the 2008 financial crisis took over, we don’t want to face another unexpected disruption to our markets, and not be prepared for it. It is then most advisable to address this growing market now and look to the future, prepared.

This brief will explore the motivations of developing such a CBDC, its limitations and concerns and potential frameworks to shape regulation for such a crypto-market to thrive.

Motivations and Limitations

The topic of cryptocurrencies has been in foreign policy circles, especially within the EU, for a few years now. The interest in these Central Bank Digital Currencies is fastly growing. In a report issued by the Bank for International Settlements, nine out of 10 central banks, covering 90% of global GDP, were already exploring CBDCs and their positioning on it (Kosse and Mattei, 2022). Some are already nearing the final stages of implementation and/or operation of such currencies, like in Nigeria (ibid). And now that Bitcoin is growing and becoming accepted internationally, i.e. becoming legal tender in El Salvador and in several US states (Idel, 2021), do the Member States want to absorb and prosper within this digital market, one that is valued at more than 2.11 trillion euros (ibid).

One would’ve assumed that the impetus for launching an agenda was the growing use of crypto in the European financial space but that was not only it — the 2019 announcement by Facebook to launch its crypto ‘Libra/Diem’ and its far-reaching effects to billions of online users, was seen as a threat to regulators and spurred some internal inquisition into the topic area (Stolton, 2021). Alongside these motivations, there is concern of a steady decline in cash as a form of payment, and with large players like China exploring CBDCs, it provides an opportunity for the ECB to become a world leader and take hold of an area before it spirals out of their control (Passacantando, 2022). As demand for cash declines, stablecoins are rising and large foreign payment networks like Visa have crucial roles in banking across Europe (ibid), elements that can take hold of the monetary system and they see that issuing these CBDCs could act as the necessary maintenance of confidence in the system and protect the monetary sovereignty of the Eurosystem (Panetta ECB Speech, 2022).

Some of the most prevalent issues in introducing and adopting a digital euro have to do with its very nature: being a cryptocurrency. Unlike stablecoins, CBDCs are backed by a central bank thus making them less volatile, legal tender and rather centralised (hence regulated), which makes them more stable and secure to introduce (Smith, 2022).

CBDCs do not permit for decentralised finance (DeFi), a core principle of cryptocurrencies, but their attractiveness not only comes in their aforementioned security but also in the privacy of P2P/P2B transactions (Bindseil, 2022). However, if the CBDCs replace the cash in circulation or sees large increases of deposit funding, this may pressure-cook money market rates and inflate a CB’s balance sheets (Panetta ECB Speech, 2022). Similarly, CBDCs may exacerbate (digital) bank runs — when a large number of clients or IFIs withdraw their deposits due to concerns of solvency (Hayes, 2021) — as digital currencies wouldn’t have to be subject to scarcity-related pricing schemes or other control tools (Bindseil and Panetta, 2020). Moreover, having to issue zero-remunerated CBDCs without restraint would imply the end to the ECB’s Negative Interest Rate Policy (NIRP), therefore some constraints must remain to assure there isn’t a large monetary degradation (ibid). The proposed solutions? A two-tiered or limited remuneration system with deposit ceilings that disincentivize CBDC holdings (Jamet et.al, 2022) and prevent the currency being used as an investment tool, especially by corporate entities (Passacantando, 2022).

In addition, there have been cited concerns over privacy and anonymity, cyber-security concerns (particular to monitoring potential attacks), offline functionalities (and what those mechanisms would look like), regulations and functionalities outside of the eurozone, info-sharing between agencies (von Gerlach and Salmon, 2022), structural bank disintermediation, and most academically, the inappropriate expansive powers being granted to the Central Bank, threatening the democratic function of the institution (Bindseil, 2022). So it is not to say this project is without its fair share of concern.

Conversely, some analysts say these ballooning balance sheets could in tandem act as incentives for banks to increase lending and provide a floor on deposit rates (Panetta ECB Speech, 2022). Likewise, some scholars claim that the CBDCs would actually improve capital allocations by making access to payments easier and reducing transaction costs and simultaneously foster healthy competition in the bank’s funding market by reducing their market power (Jamet et.al, 2022).

To summarise in the words of the very individual in charge of this agenda, Fabio Panetta,

“We need to strike a balance so that the digital euro is not “too successful,” but is, “successful enough.” We need to solve the “CBDC trilemma,” according to which central banks’ objectives of payment efficiency, financial stability and price stability cannot all be achieved together” (Panetta European Central Bank Speech, 2022).

Despite all of these efforts, the crypto programme hasn’t been very popular in Europe. In a poll conducted by Redfield & Wilton Strategies in 2021, looking to identify European interest in cryptocurrencies and attitudes towards financial regulations, one observed Europeans only heard “a little bit” about these currencies and cited a lack of knowledge as their primary reason for avoidance in this market (Sarkar, 2021), likely signalling a reason for why there hasn’t been much movement: it’s not as popular (Walsh, 2021). Interestingly however, there was a significant percentage of citizens that saw it necessary for their own governments to regulate such currencies (Walsh, 2021).

Perhaps a majority of citizens voting in favour of national regulation signals a concern for an overreaching ECB, so perhaps the very idea of a CBDC like the proposed ‘digital euro,’ would be that very thing — overreaching (Idel, 2021). And should the knowledge on cryptocurrencies grow, one may expect a stronger resistance to a regulatory framework of a currency that is, in its very essence, intended to be as decentralised and self-monitored as possible (ibid). Of course now Brussels is faced with the decision of crafting their crypto programme, in a way that appeases the European people, and at the same time, attracts crypto investors and allows for the EU to catalyse crypto-market growth (ibid).

This all the more illuminates that for the EU, just like for all national governments, their CBs and international bodies, regulators are at a standstill of choosing to either closely regulate and centralise this upcoming market, like through CBDC creations, or adopt a different legal framework that allows for stablecoins to operate smoothly and decentralise the process (ibid). Given the polling, choosing a CBDC centralised mechanism would not be a welcome solution. But given the rampant attention in this field, globally, the EU needs to be concrete and steadfast in forming its stance.

The policy dimension

The proposition and abroad

The issue with a new market, as is expected with any new venture or problem, is where and how to position your (economic) policy. In the case of the ECB, the Governing Council has taken a firm stance on how it envisions its CBDC, with some irregularities.

In late 2020, the ECB released its Report on a digital Euro, signalling how it foresees its digital euro project coming to fruition and how it understands the world of cryptocurrencies in its context. Interestingly, the report highlighted a central register (or blockchain) for the digital euro, running the currency under limited bank intermediaries, faster payment processing (especially under the recently launched Target Instant Payment Settlement System (TIPS), and targeting anonymity in a manner that safeguards client details but also complies with anti-money launding and anti-terror financing regulations through some monitoring mechanisms (ECB Report on a digital Europe, 2020). Moreover, the ECB foresees the aforementioned threshold on account balances to avoid excessive capital outflows or currency substitution abroad (ibid). Most peculiar, the report posited that for it, a CBDC (or digital euro), would act merely as a digital form of cash, under the supervision and direction of the issuing authority, the Central Bank (ibid). To design a framework and a policy centred around centralisation, regulation and monitoring, built for a ‘cryptocurrency,’ that in effect is not viewed in any different light than a digital wallet, leaves much to be desired.

However, the ECB is in good company here. Other countries are following the same path. In Nigeria, the eNaira was deployed in 2021 and is the first fully functional CBDC (Smith, 2022). Meanwhile in the US, UK and Canada, research and pilot programs have moved ahead (Wass, 2022). Both Chile and South Korea, in their prospective reports on adopting CBDCs, have stressed the importance of monitoring (Pymnts, 2022) and identity verification in virtual transactions, all reaffirming this anonymity principle of CBDC transactions and the desire to incorporate such an offering into their monetary policy (ibid).

New challenges

But there is another dimension to this domain besides financial instruments, a geopolitical one. China is far into its e-CNY currency development under the Digital Currency Electronic Payment (DCEP) system, which already threatens the international position of the euro, which has been stagnating in international foreign reserves (Boonstra, 2022). This all the more exacerbates cross-border transaction monitoring, should China use its e-CNY and DCEP to settle transactions between parties outside the surveillance of SWIFT (ibid).

Despite the ECB leading the R&D into their digital euro and the numerous reports published on it, three major concerns lag: how will privacy be regulated, communicated and appropriated? To what extent will there be decentralisation as per the original mandate of cryptocurrencies, and how will having intermediaries stifle the crypto project? And finally, what may be the anticipated spillover effects on cross-border transactions, or capital flight or foreign exchange volatility because of the introduction of this CBDC?

It’s apt then that the ECB have been holding consultations, and before passing to legislative phases, will conduct more enhanced studies on the consequences and by-products of such currencies being introduced. Germany and France have been pushing these efforts since last year, for fear of falling behind the other major economic players (Smith-Meyer, 2022). The ECB has committed to accepting the digital euro legislation as soon as it is proposed. It is expected to be proposed by the Commission by 2023, under Art.113 TFEU (Smith-Meyer, 2022).

In all of these varied perspectives, and countering proposals to the different mechanisms of what an envisioned ‘digital euro’ could be, there remains international consensus on one thing: regulated and secure. Perhaps it feels a bit misplaced then to call this project one of a crypto innovation, or a derivative of that, considering the core tenets of a libertarian envisioning of a cryptocurrency is one outside the confines of traditional banking and regulation. In the next phases of legislation and ideation, the ECB will have to consider the answers to those three major questions, questions of intense research, much of which are not yet known and decisions that need to be made. They have to take a stance. For if they don’t, they may very well switch their position from trailblazer to groupie within the blink of an eye.

Sources

Bank, European Central. “Central Bank Digital Currencies: Defining the Problems, Designing the Solutions.” European Central Bank, 18 Feb. 2022, https://www.ecb.europa.eu/press/key/date/2022/html/ecb.sp220218_1~938e881b13.en.html.

Bindseil, Ulrich. “The Case for CBDC… and the Digital Euro Project.” Pearson Institute for International Economics, 2022, https://www.piie.com/sites/default/files/documents/2022-03-09-ulirchppt.pdf. Presentation and powerpoint

Bindseil, Ulrich, and Fabio Panetta. “CBDC Remuneration in a World with Low or Negative Nominal Interest Rates | VOX, CEPR Policy Portal.” VOX, CEPR Policy Portal, 5 Oct. 2020, https://voxeu.org/article/cbdc-remuneration-world-low-or-negative-nominal-interest-rates.

Boonstra, Wim. “CBDC and the International Position of the Euro — RaboResearch.” RaboResearch — Economic Research, 22 Feb. 2022, https://economics.rabobank.com/publications/2022/february/cbdc-and-the-international-positi on-of-the-euro/.

Boucher, Jamie L., et al. “Central Banks Consider Digital Currency Pros and Cons in US and Europe | Insights | Skadden, Arps, Slate, Meagher & Flom LLP.” Skadden, Arps, Slate, Meagher & Flom LLP, https://www.skadden.com/insights/publications/2022/01/2022-insights/regulation-enforcemen t-and-investigations/central-banks-consider-digital-currency-pros-and-cons.

Claeys, Gregory, and Lionel Guetta-Jeanrenaud. “How Have the European Central Bank’s Negative Rates Been Passed on?” Bruegel, 7 July 2021, https://www.bruegel.org/2021/07/how-have-the-european-central-banks-negative-rates-been- passed-on/.

Edwards, John. “Bitcoin’s Price History.” Investopedia, Investopedia, 18 Dec. 2015,https://www.investopedia.com/articles/forex/121815/bitcoins-price-history.asp.

European Central Bank. “Working Paper Series The Digital Economy, Privacy, and CBDC.” European Central Bank: Eurosystem, May 2022, https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2662~fa8429a967.en.pdf. №2662

EUROPOL. “Cryptocurrencies: Tracing the Evolution of Criminal Finances.” EUROPOL, 2021,https://www.europol.europa.eu/cms/sites/default/files/documents/Europol%20Spotlight%20- %20Cryptocurrencies%20-%20Tracing%20the%20evolution%20of%20criminal%20finances .pdf.

Eyers, James. “Australia, US May Follow Europe on Digital Currencies.” Australian Financial Review, Australian Financial Review, 8 Mar. 2022, https://www.afr.com/companies/financial-services/australia-us-may-follow-europe-on-digital- currencies-20220307-p5a2f2.

Ferreira, Agata. “Europe Awaits Implementation of Regulatory Framework for Crypto Assets.” Cointelegraph, Cointelegraph, 1 May 2021, https://cointelegraph.com/news/europe-awaits-implementation-of-regulatory-framework-for-c rypto-assets.

Gerlach, Leopold, and John Salmon. “The Digital Euro — Taking Shape in 2022 — Lexology.” Lexology, Hogan Lovells, 12 Jan. 2022, https://www.lexology.com/library/detail.aspx?g=4fad6081-dabd-4112-8c32-228950957691.

Hayes, Adam. “Bank Run Definition.” Investopedia, Investopedia, 18 Nov. 2003,https://www.investopedia.com/terms/b/bankrun.asp.

Idel, Louisa. “The EU Is Fighting for Control over Cryptos. Citizens May See It as a Potential ‘a Power Grab’ | Euronews.” Euronews, 1 Sept. 2021, https://www.euronews.com/next/2021/09/01/the-eu-is-fighting-for-control-over-cryptos-citize ns-may-see-it-as-a-potential-a-power-gra.

— -. “The EU Is Fighting for Control over Cryptos. Citizens May See It as a Potential ‘a Power Grab’ | Euronews.” Euronews, 1 Sept. 2021, https://www.euronews.com/next/2021/09/01/the-eu-is-fighting-for-control-over-cryptos-citize ns-may-see-it-as-a-potential-a-power-gra.

Jamet, Jean-Francois, et al. “Monetary Policy and Financial Stability Implications of Central Bank Digital Currencies | VOX, CEPR Policy Portal.” VOX, CEPR Policy Portal, 13 Apr. 2022, https://voxeu.org/article/monetary-policy-and-financial-stability-implications-central-bank-di gital-currencies.

Kosse, Anneke, and Ilaria Mattei. “Gaining Momentum — Results of the 2021 BIS Survey on Central Bank Digital Currencies.” Bank for International Settlements, https://www.bis.org/publ/bppdf/bispap125.htm.

Panetta, Fabio. “Central Bank Digital Currencies: Defining the Problems, Designing the Solutions.” European Central Bank, 18 Feb. 2022, https://www.ecb.europa.eu/press/key/date/2022/html/ecb.sp220218_1~938e881b13.en.html#f ootnote.12.

Speech by Fabio Panetta, Member of the Executive Board of the ECB, to a panel discussion on central bank digital currencies at the US Monetary Policy Forum — -. “From the Payments Revolution to the Reinvention of Money.” European Central Bank, 27 Nov. 2020, https://www.ecb.europa.eu/press/key/date/2020/html/ecb.sp201127~a781c4e0fc.en.html. Speech by Fabio Panetta, Member of the Executive Board of the ECB, at the Deutsche Bundesbank conference on the “Future of Payments in Europe”

— -. “More than an Intellectual Game: Exploring the Monetary Policy and Financial Stability Implications of Central Bank Digital Currencies.” European Central Bank, 8 Apr. 2022, https://www.ecb.europa.eu/press/key/date/2022/html/ecb.sp220408~980e39957b.en.html. Opening speech by Fabio Panetta, Member of the Executive Board of the ECB, at the IESE Business School Banking Initiative Conference on Technology and Finance

Passacantando, Franco. “A Digital Euro in Search of an Identity | IAI Istituto Affari Internazionali.” IAI Istituto Affari Internazionali, 3 Feb. 2022, https://www.iai.it/en/pubblicazioni/digital-euro-search-identity.

PYMNTS. “CBDC Weekly: Digital Euro Could Launch in Four Years; Chile Looks Ahead; SWIFT Wants CBDC Business.” PYMTNS, 10 May 2022, https://www.pymnts.com/cbdc/2022/cbdc-weekly-digital-euro-could-launch-four-years-chile- looks-ahead-swift-wants-cbdc-business/.

— -. “European Commission’s Consultation on Digital Euro Goes Beyond CBDC.” PYMNTS, 14 Apr. 2022,https://www.pymnts.com/cbdc/2022/european-commissions-consultation-on-digital-euro-goe s-beyond-cbdc/.

Sarkar, Arijit. “Survey Finds Europeans Want Home Countries to Regulate Crypto, Not EU.” Cointelegraph, Cointelegraph, 1 Sept. 2021, https://cointelegraph.com/news/survey-finds-europeans-want-home-countries-to-regulate-cry pto-not-eu.

Smith, Ian. “Central Bank Digital Currencies: Which Countries Are Using, Launching or Piloting CBDCs? | Euronews.” Euronews, 9 Mar. 2022, https://www.euronews.com/next/2022/03/09/cbdcs-these-are-the-countries-are-using-launchi ng-or-piloting-their-own-digital-currencies.

Smith-Meyer, Bjarke. “Digital Euro Bill Due Early 2023 — POLITICO.” POLITICO, POLITICO, 9 Feb. 2022, https://www.politico.eu/article/digital-euro-bill-due-early-2023/.

Southwick, Reid. “Why the Rise of Bitcoin Could Be the First Shot in a Currency Revolution | CBC News.” CBC, 6 Mar. 2021, https://www.cbc.ca/news/business/bitcoin-currency-revolution-speculative-investment-1.593 2620.

Stolton, Samuel. “ECB Issues Stark Warning on Big Tech Cryptocurrency Projects — EURACTIV.Com.” Www.Euractiv.Com, EURACTIV, 11 Feb. 2021, https://www.euractiv.com/section/digital/news/ecb-issues-stark-warning-on-big-tech-cryptocu rrency-projects/.

Valero, Jorge. “Digital Euro’s ‘Moment of Truth’ to Come in April — EURACTIV.Com.” Www.Euractiv.Com, EURACTIV, 22 Jan. 2021, https://www.euractiv.com/section/economy-jobs/news/digital-euros-moment-of-truth-to-come -in-april/.

Walsh, David. “Majority of Europeans Want Their Countries to Regulate Crypto, Not the EU — Exclusive Euronews Poll.” Euronews, 1 Sept. 2021, https://www.euronews.com/next/2021/09/01/majority-of-europeans-want-their-countries-to-r egulate-crypto-not-the-eu-exclusive-euronew.

Wass, Sanne. “Slow US, Europe Progress in Digital Currencies Leaves Holes in Sanctions | S&P Global Market Intelligence.” S&P Global, 9 May 2022, https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/slow-us -europe-progress-in-digital-currencies-leaves-holes-in-sanctions-70045605.