The digital euro project: how will it impact the current financial system?

Digital euro explained: Is digital euro based on blockchain?

The advent of digital crypto assets like Bitcoin in 2008 and the underlying distributed ledger technology (DLT) has prompted central banks worldwide to consider digitizing the monetary system and introducing central bank digital currencies (CBDCs). The Bank of England was a forerunner in this trend, examining the possibility of introducing its own CBDC as early as 2014.

The concept has grown in popularity in recent years, with Meta (formerly Facebook) announcing in the summer of 2019 that it would create a digital DLT-based global crypto asset backed by numerous fiat currencies and government bonds.

Furthermore, DLTs, such as blockchain technology (a subset of DLTs), are frequently thought to constitute the technological foundation for digitizing the monetary system and adopting a CBDC in public discourse. The delivery and payment of assets can be organized on integrated platforms, which is a significant argument in favor of employing DLT.

A digital euro is one such project (based on blockchain) that would ensure that citizens in Europe have free access to a simple, generally acknowledged, safe and trusted means of payment in this digital era.

This article will explore the digital euro project, its impact on the future of Europe and the current financial system.

The current monetary system

The types of money in the current monetary system include cash, bank money and central bank reserves. Physical cash is the foundation of the existing monetary system. The only legal tender is cash, which can only be printed by central banks. Since the early 1970s, when the gold standard was abolished, central banks have generated currency through lending activities or the purchase of assets such as government bonds.

The term fiat money, which comes from the Latin phrase "let there be money," appropriately represents the ability of central banks to generate money at will. On the other hand, central banks issue currency in response to the expansion of commercial bank money and are driven by bank customer demand rather than proactively.

Bank money is a claim on a commercial bank for the payment of cash that is issued proactively by the bank. A bank client's account balance shows that the client can withdraw cash in the amount stated from the appropriate bank account.

However, according to the European Central Bank (ECB), the Eurozone's bank money is only covered by 13% cash. The bank's remaining assets are borrowers' claims and other assets. Therefore, holding bank money is risky: Bank customers are vulnerable to liquidity, creditor and market risks.

On the other hand, bank money is linked 1:1 to the value of cash and reserves, and it can be withdrawn at the same nominal value as cash. The individual bank establishes the interest rate on bank deposits. Still, other interest rates, such as bond interest, interbank rates and finally, the rate at which central bank reserves are refinanced, are upper bounds.

The central bank issues reserves, but they are not available to the general population. The holder of reserves is not vulnerable to liquidity or credit risk, as is the case with bank money, because reserves are a form of central bank money.

Central banks, unlike private banks, cannot go bankrupt by definition because they are the only entities that issue legal cash and, in principle, could even exist with negative equity. As a result, central bank reserves, like cash, are risk-free types of money. They are, however, digitally transferable, unlike cash. Instead, reserves earn interest and are paid out at the central bank's deposit rate.

Bank runs can occur when trust in the banking industry - and, as a result, in the money issued by banks - erodes. Bank customers remove funds from their checking accounts and convert them into cash in vast amounts in the event of a bank run.

Because banks must convert enormous quantities of their digital reserves into cash, bank runs can cause massive liquidity shortages. For example, banks rely on emergency loans from the central bank to meet the demand for money when they cannot sell other assets to generate more liquidity, depending on the intensity and duration of the bank run.

Considering the above scenario and to avoid any financial crises in the future, central banks around the world are working on CBDCs to provide more options with which citizens can transact, contributing to accessibility and inclusiveness.

The idea behind a digital euro

Central banks print money. The European Central Bank (ECB) is in charge of this in the Eurozone. Only your cash is issued by the ECB, out of the money that you have. The central bank does not issue the money in your bank account. You may lose the money in your bank account if your bank collapses.

In those circumstances, the Dutch Deposit Guarantee Scheme (such as in the Netherlands) will protect all or a portion of your funds. This means you won't have to be concerned about losing money in unpredictable times, such as a financial crisis. However, in the Netherlands and many other countries, the currency has played a lesser role in recent years.

In the previous ten years, electronic payments have grown dramatically. That is why the ECB and other central banks have been researching the prospects for cash that only exists in electronic form, or a digital euro, for some time. But, what would a digital euro mean?

The European Central Bank digital euro would still be a euro (digital euro coin and notes): It would function similarly to banknotes, but it would be a digital currency issued by the Eurosystem (the European Central Bank and national central banks) and available to all citizens and businesses. Moreover, a digital euro would not be a replacement for cash, but rather an addition to it. The Eurosystem will continue to ensure that you can get cash anywhere in the Eurozone.

Advantages of a blockchain-based euro

It is time to stop asking if there will be a digital euro and start considering its advantages, as explained below:

Programmability and automation of money

Smart contracts and peer-to-peer (micro) payments, for example, between machines, can be implemented in euros and do not require the use of volatile and/or uncontrolled crypto assets. Smart contracts would allow Internet of Things (IoT) devices linked to the DLT, including machinery, automobiles and sensors, to offer services on a pay-per-use basis. In the context of the machine economy, a DLT-based payment system is thus very promising.

DLT is also well-suited to equip millions of IoT devices with a computer chip and, as a result, their digital wallet. Devices would be able to send digital euros straight from wallet to wallet, and they would be able to receive and send money on their own.

Resistance to manipulation

Because transactions are kept on several computers simultaneously, it is impossible to falsify or change transaction data later. This resistance to manipulation has significant benefits, particularly in situations where all parties must have the same degree of knowledge but do not necessarily know and trust each other.

Security

Data is often stored centrally in the present financial system on the servers of a third party, such as a (central) bank. However, while using DLT, transaction data is saved on a massive number of computers simultaneously. Because there would be no single point of failure, decentralized data storage would make the system more resistant to hacker attacks.

Efficiency gains

Furthermore, significant efficiency gains could be realized in the case of a peer-to-peer DLT euro system. The payment system might be considerably simplified, eliminating the need for multiple intermediaries (e.g., clearinghouses).

Consequently, the payment system's expenses would be greatly reduced, and transactions would be processed much faster. Significant efficiency improvements, particularly for cross-border payments, would ensue.

International transfers from Germany to Argentina, for example, might take up to ten days and can cost up to 10% of the total amount sent in fees. Moreover, even between distinct currency zones, the usage of DLT technologies could enable fast settlement at meager transaction costs.

Will a central bank DLT system be structured like a Bitcoin network?

Most existing DLT networks, such as the Bitcoin blockchain, have a different structure than a DLT system developed for central banks. The central bank does not need to utilize a fully decentralized DLT system that runs entirely without mutual trust and through a distributed consensus mechanism because it inherits a high level of confidence.

The Bitcoin network has achieved a global, decentralized consensus on the executed transactions thanks to its "proof-of-work (PoW)" consensus mechanism. However, the Bitcoin network's PoW consensus process, the most secure and widely used to date, is energy-intensive and results in limited transaction throughput.

In contrast to the Bitcoin network, a central bank DLT system might be made up of many identifiable and accountable network nodes that achieve consensus on transactions according to particular standards.

These "permissioned" blockchains with known and trusted validators are also used by blockchain providers like Hyperledger or Corda by R3, which partner with central banks worldwide to test CBDC prototypes.

Such systems are incompatible with the vision and principles of cryptocurrency supporters, who advocate for an open monetary system that is not based on trust in third parties such as banks, central banks or governments.

Numerous drawbacks of cryptocurrencies, such as high energy consumption, scalability challenges and volatile prices, would be solved and the benefits of DLT would be implemented in the form of stable and trustworthy digital money.

Is there a euro stablecoin?

Tokenizing fiat money deposited at banks, e-money providers or other financial institutions to create "stablecoins" is the initial option for using DLT to transfer euros. To transmit values from person X to point Y, DLTs employ tokens. Each of these stablecoin tokens must be backed by specific amounts of money (or other assets) in the client's account.

The tokens must be fully backed by deposits, which keep the value of stablecoins stable in comparison to fiat currencies like the euro. Stablecoin holders must trust the token issuers that deposits fully back all tokens and that they can be withdrawn even if the tokens are liquidated.

Because of the present monetary system's two-tier structure, fiat-backed stablecoins on DLT can be backed by commercial or central bank money. This discrepancy appears to be unimportant to the end-user at first glance, as both types of money are denominated in euro.

Furthermore, deposit guarantee plans protect bank money, making it appear as safe as central bank money. However, in times of banking crises, this can make a considerable difference: bank deposits in the Eurozone are only guaranteed up to 100,000 euros by deposit guarantee schemes, and only a fraction of bank deposits are backed by central bank money, as detailed above.

Stablecoin ventures might potentially retain consumers' funds in an account with an intermediary or trustee, backed 100% by central bank money. This is achievable if the participating bank or payment service provider fully backs the stablecoin project's customers' account balances with reserves.

This option corresponds to a central bank deposit secured by intermediaries or trustees that can also be transferred using a DLT system. This type of stablecoin is called a synthetic CBDC, a stablecoin that indirectly accesses central bank money.

How would a digital euro impact the current financial system?

Money inventions have challenged and transformed the structure of financial systems throughout history. Innovations have sparked debates about the risks and benefits they offer and the role of central banks in restoring faith in money from time to time.

In this context, a digital euro would attempt to foster digitization while maintaining people's freedom of choice regarding how they pay and ensuring that their payments are competitive and secure. In addition, it will make the current financial system more secure, accessible and simple to use and promote financial inclusion. However, privacy protection would be a top priority, assisting in maintaining payment trust.

The digital euro will lower transaction costs and promote economic digitalization while ensuring that central bank money stays at the heart of the financial system, providing stability. A digital euro might potentially catalyze on a global scale. It might generate much-needed efficiency advantages in cross-border payments by providing interoperability with international digital currencies, including other CBDCs.

Surprisingly, a digital euro could be too successful. Its main strengths - safety and liquidity - could affect monetary and financial stability on three fronts if not adequately designed:

Effects on financial intermediation and capital allocation in normal times

A digital euro could have several implications for financial intermediation. First, it can draw payments activity from banks while also reducing their payments-related revenue and consumer information.

Secondly, it may potentially attract deposits, mainly if it was issued without restrictions on individual ownership. The public transferred vast sums of money from commercial banks to central banks at such enticing terms. The fear is that this will result in less stable and expensive finance, reduced bank profitability and, eventually, less lending, limiting real-economy financing.

Problems during crisis

A digital euro would provide access to a safe liquid asset that could be stored in vast quantities and at no cost, unlike cash and without design limits. Indeed, if not correctly structured, a digital euro in times of crisis might speed up "digital runs" from commercial banks to the central bank. This risk may even be self-fulfilling, causing savers to withdraw money from their bank accounts and exacerbating volatility in normal times.

Impact on the international monetary system

The introduction of a digital euro that is available to non-residents might make the single currency more appealing as a safe means of payment for cross-border retail transactions. In addition, it can reduce inefficiencies in cross-border payment infrastructures and make remittance transfers easier.

However, if a digital euro is not constructed to prevent it from being used as a form of investment, these advantages may come at the expense of amplifying international shocks.

Because a digital euro would be highly liquid, foreign investors would use it disproportionately and rebalance much more forcefully into or away from it in response to shocks, resulting in higher exchange rate volatility and a harsher impact on foreign financial conditions.

The digital euro and the future of Europe

The digital euro will be similar to banknotes, backed by the ECB, which is the strongest guarantee conceivable because the Central Bank cannot fail. It is a form of sovereign money. It will face competition from cryptocurrencies, which are not money and, above all, private company-created stablecoins.

However, banking intermediation, financial stability and the international financial system are three of the digital euro's significant issues, with no obvious answer in sight. The same applies to protecting its users' personal information. It's also essential to ensure that, unlike cryptocurrencies, the digital euro doesn't increase greenhouse gas emissions by consuming too much electricity. Therefore, the transition will be challenging, which is why it is critical to begin cautiously or on a trial basis.

The ECB revealed in mid-July 2021 that it is in the middle of a two-year investigation phase for the Europea CBDC, with a digital euro release date planned for 2026. It's a risky move for the payment sector, but it might lead to exciting new opportunities across Europe.

Source: Сointelegraph

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