The Digital Euro: the Future of Payments in the EU?
Lila Luhtanen, 6 minutes
First, it was contactless payments, then mobile payment services, and the latest innovation: "the digital euro". You may have seen or heard of the concept in the news. However, the actual meaning and future implications of this new payment system may be lost to many. Therefore, this article addresses precisely what the digital euro is, its background, as well as its advantages and possible disadvantages.
What is the digital euro?
The digital euro is being developed by the European Central Bank (ECB). In essence, it would provide anyone in the euro area with an electronic payment method. You can learn more about the ECB and its objectives here. Currently, there are two forms of money: public and private money. Public money is also sometimes referred to as central bank money. It includes banknotes and coins, and is issued by a public institution and thus backed by the public sector. In the euro area, the public institution in question is the ECB. Private money, on the other hand, is created by commercial banks. This is done when granting loans. Private money entails bank balances, savings, payments made with debit or credit cards, and online payment services. The ECB aims to bridge the gap between these two types of money by creating a currency with the benefits of publicly backed money, bringing value and stability, together with how people use money and pay these days. Therefore, the ECB would issue public money, just in electronic form, next to cash. Public money could be spent with a card or your phone, and it would be guaranteed and backed by the ECB. Therefore, essentially, the Digital Euro, as a digital system of payment, has the same properties as cash but in a digital format.
The background and necessity of the Digital Euro
The importance of cash and coins is steadily decreasing. Now more than ever, people are paying with their cards or phones. Especially during the Covid-19 pandemic, contactless and online payment use skyrocketed. This trend is unsurprising as digital money is very convenient for individuals and creates a wide array of possibilities for financial innovation and inclusion. Next to advances concerning payment methods, cryptocurrencies from private actors have taken center stage globally. Now, Central Bank Digital Currencies are being developed in states, like the US, and in the EU.
However, this trend also brings forward some risks. First, if, through inflation, the value of cash decreases, public money could lose its position as the monetary anchor in Europe. Consequently, central bank money could be threatened if people trust that private money can always be converted into central bank money. This would also jeopardize the euro itself. Globally, if other large economies introduce central bank digital currencies that can be used internationally, the euro's role could be undermined. Users may prefer to hold and transact with these alternative digital currencies, reducing the demand for euros. Second, the private sector must provide secure and riskless digital payments in case the use of digital currencies increases. However, private providers cannot provide similar authority to central bank money. Third, digital private sector solutions tend to be dominated by a few providers, commonly headquartered outside the European Union. This may increase the risk of non-European technologies and solutions dominating the European payments market.
Therefore, the ECB plans on launching this digital currency to respond to the growing need for secure and trusted electronic payments. Moreover, the ECB aims to bring stability to payment and economic systems. Lastly, the digital euro is thought to maintain trust in the Euro, strengthen the euro zone's monetary sovereignty, and promote competition and efficiency in Europe's payment sector.
Risks of the digital euro
A 2020 report by experts from the ECB as well as from the euro area's national banks on the digital euro conveys the possible risks of introducing the digital euro from the viewpoint of the Eurosystem.. The report identified the five following foreseeable threats.
The first risk concerns the areas of the banking sector, monetary policy, and financial stability. The digital euro could negatively affect financial stability by disrupting risk-free interest rates and challenging banks' intermediation role. Furthermore, depending on its attributes as an investment, the digital euro might have depositors switch their commercial bank deposits into central bank liabilities, which might raise banks' funding costs and, consequently, bank loans' interest rates. Furthermore, considering the role of the banking sector in financial intermediation, if the demand for the digital euro increases the banks' funding costs, they might have to lower the supply of credit. Economic activity could be hindered if this means higher prices for loaners. When savers have less trust in the banking sectors, liquid assets might be shifted quickly from commercial bank deposits to the digital euro if the hurdles to withdrawing money in the form of the digital euro are lower than for withdrawing cash. This could lead to an increased risk of bank runs and weaken financial stability.
The second risk concerns the impact of a digital euro on the profitability and risk-taking of the central bank; the digital euro might change the makeup of the euro system's balance sheet. This would have an impact on its risk exposure and profitability. Moreover, the Eurosystem might be at risk of financial liabilities by operating a retail payment system.
Third, considering the image of the ECB, there could be a loss of reputation caused by the implementation of the digital euro if, for instance, the implementation is delayed, the IT infrastructure proves to be unstable, or there are concerns about the legal basis for issuing the digital euro.
The fourth risk exists with the cross-border use of the digital euro. There are several risks to consider when deciding on the characteristics of the currency. The wide circulation of the euro internationally could impact capital flows and the euro's exchange rate. Consequently, the Eurosystem's monetary policy stance and transmission may be affected. In case non-EU residents wanted to rebalance their portfolios in favor of the digital euro, the size of the Eurosystem's balance sheet would grow. The risk lies in the fact that if such changes in the portfolios into the digital euro strengthen the euro's exchange rate, this may harm the competitiveness of firms in the eurozone. An additional concern involves the potential for the cross-border flow of a digital euro to inadvertently aid international criminal endeavors if not effectively regulated. A globally accessible digital euro could be an appealing tool for illicit purposes such as funding terrorism, facilitating money laundering, and enabling various forms of cross-border criminal operations. This risk extends to individuals both within and outside the euro area, highlighting the need for comprehensive control measures.
The fifth possible risk is that, as with any digital innovation, the digital euro may attract a risk of cyberattacks with financial and business implications of monetary and economic dimensions. These attacks may include fraud, data exfiltration, or fraud. This could hinder the use of the digital euro and lower the confidence in the data and the currency's value.
The next steps
The ECB has conducted investigations on the Digital Euro and its possible design and impact on the market since 2021, and this stage is expected to conclude in October 2023. The next stage of the process is the realization phase, which involves deliberations on whether the novel currency should actually be developed and, if so, how. This phase is expected to last around three years. At the same time as the investigations are conducted by the ECB, the European Commission is preparing the necessary legislative process for the currency's implementation. The Commission is expected to introduce a legislative proposal by mid-2023 on the digital euro and on the legal tender status of euro banknotes and coins. It could be that we are seeing history in the making regarding the future of payments. Therefore, the development of the digital euro is something to keep an eye on.
