The digital euro as we know it today

Wed 01 Mar 2023

“I see digital as the future of finance”. These are the words of the Executive Vice President of the European Commission (EC), Valdis Dombrovskis, voiced in the summer of 2020. He has undoubtedly been proven right as governments and central banks around the world have heightened their efforts to keep oversight of the digital transition and stay relevant in the future environment over the past few years.  According to the CBDC Tracker, there is a list of 135 projects on Central Bank Digital Currencies (CBDCs) globally as of February 2023, which are an additional proof of governments’ extensive undertakings in this area.  

CBDC is a form of digital money issued by the public sector (i.e., central banks) and, based on their accessibility, there is a retail CBDC and wholesale CBDC (rCBDC and wCBDC).  The rCBDC has cash-like functionalities for daily purchases and is accessible by the general public. It serves as digital access to legal tender and users gain accessibility either directly by central banks or via banks and other intermediaries. The wCBDC is only available to institutions which currently have access to reserve accounts at Central Banks and it can be conceptualised as tokenized central bank reserves. Both rCBDC and wCBDC are direct liabilities on the Central Bank’s balance sheet.

Digital euro: where we stand today?

In the summer of 2021, the European Central Bank announced its intent to start investigating the possibility of launching a Digital Euro. In Q4 2021, the Governing Council of the European Central Bank formally started the investigation phase of the Digital Euro project. This is a two-year phase which should conclude with a decision on commencing a realisation phase in Q3 2023. In the realisation phase, the technical solutions and necessary business arrangements will be developed and tested (prototyping and piloting of chosen designs), while in the meantime legislative developments enabling the issuance and governance of digital euro will take place. A final decision on the possible issuance will come at a later stage after a proposal of the EC is adopted by the European Parliament and the Council of the EU.

Retail digital euro: approved design features

Being a direct claim against the central bank, the digital euro will be recorded as a liability on the balance sheet of the Eurosystem, which will hold full control over its issuance and settlement. Still, supervised intermediaries will facilitate the distribution of the digital euro and carry out the contractual account management relationships with end users, including know-your-customer and anti-money laundering checks. The same hybrid model of access was adopted by the People’s Bank of China for the digital yuan (eCNY).

Credit institutions and payment service providers will be the direct counterparts for users and will be responsible for transaction management tasks like initiation, authentication, and validation. They would also facilitate and manage the digital euro wallets in addition to enabling funding and defunding of the wallets when the user wants to convert private money into digital euro. Their service provision will be supervised by the central banks and will follow a legislation, the first draft of which is expected to be released by the European Commission in Q2 2023.

For the distribution of the digital euro, the Eurosystem plans to implement a scheme, which would allow for payments to be always available for anyone, in any country, and cross-border. In order to distribute it, supervised entities will have to adhere to common standards and procedures, and there is already ongoing work on a possible rulebook for the above-mentioned scheme.

Even if the Eurosystem will be engaged in the management of supervised intermediaries, settlement of the transactions, as well as the issuance and redemption of digital euros, the ECB reported that they plan to minimise their engagement in the processing of users’ data. The avoidance of government surveillance is a major priority for European citizens and fortunately science today can successfully address this through cryptographic innovations such as zero-knowledge proofs and blind signatures. 

The ECB is designing the digital euro not as an investment asset, but for payment purposes only. Hence, quantitative limits on the holdings of individual users will be applied. In his introductory statement at the Committee on Economic and Monetary Affairs of the European Parliament on 15 June 2022, Fabio Panetta, member of the European Central Bank, mentioned that a limit of around 3,000 to 4,000 digital euro per capita is envisaged. This will serve as a safeguard to rule out digital bank runs and general mistrust in the financial and monetary system in the EU.

The ECB governing council has already approved for digital euro transactions to be available both online and offline, while existing digital payment options involving private money (e.g., credit cards) offer transfers only online. Online transactions will be validated by a third party and provide full transparency of data to intermediaries for AML/CFT purposes. Offline transactions will be based on a peer-to-peer validation solutions via secure hardware devices and will offer privacy of low-value proximity payments within regulator-approved limits. Full anonymity is not a viable option bearing in mind public policies regulating illicit activities. Privacy equal to that of the current private sector digital solutions is considered – identification when onboarding, AML/CFT checks, personal and transactional data not to be shared by intermediaries, unless required by law. For offline payments, only the sender and the beneficiary shall know that a transaction took place, until the hardware module is connected online.

The digital euro wallet will be funded and defunded around the clock, either with cash, or through bank accounts – both manually and automatically. The automated function shall be available at the user’s discretion only, and both waterfall and reverse waterfall functionalities shall be applied to ensure the holding limits set by the central bank are maintained and payments are possible even when asked amount exceeds current holdings. Deviations from the holding threshold, resulting from discretionary waterfall and reverse waterfall functionalities, should be limited to one calendar day, in order for remuneration-based tools not to be activated.

The decision regarding whether the digital euro will operate on permissioned blockchain, existing centralized databases, or a combination of both, has not yet been finalised.  It should be noted that by ruling out the idea of a digital euro on a permissionless blockchain, the ECB automatically removes the built-in advantages offered by such blockchains: security and resilience – no single point of failure exists, corruption and censorship resistance – no dependence on one or few members’ integrity.

Retail digital euro and commercial banks

In light of the above, credit institutions are well positioned to take the role of intermediaries in the distribution of the digital euro and the wallets’ management. Still, there are a few unknowns for banks and the potential impact that a CBDC will have on them. Owning rCBDC will allow the user a direct account with the central bank, something to which only credit institutions are presently entitled. This will initially shrink the balance sheet of commercial banks, as it will lead to a decrease in their deposits. In order to keep the deposits, banks will have to find a way to attract and keep people’s money (e.g., by raising deposits’ interest rates). To protect the current system, the regulator will place an initial cap on holdings of digital euro, and the idea of lower renumeration of CBDC holdings compared to private money deposits is being floated. Still, banks which successfully position themselves as the preferred interface service provider of digital wallets may come up to the other side as winners. New service provision as well as potential new on-chain products, derived from a government-backed digital currency, might be the way forward for the industry. In time, banks will need to change and adapt their business models to this new environment and most importantly they need to advance faster technologically – either organically, or through cooperation with fintech companies working on viable products.

Retail digital euro: investigated use cases

The ECB investigates four payments use cases for the digital euro at the moment: E-commerce, Physical store, Person-to-person, Government payments. This is in response to the fact that presently non-European payment schemes dominate digital payments in e-commerce and physical stores. According to an ECB Study on the payment attitudes of consumers in the euro area, from December 2022, person-to-person payments are dominated by cash. Still, this is a segment which is widely open to disruptions by peer-to-peer payment solutions (e.g., PayPal) and digital currencies. Additionally, the idea of a digital euro, stems from ECB’s efforts to preserve access to public money for people and to build and strengthen the autonomy of the Euro Area around a common digital identity. All of these will be in addition to the advantages provided using the technology – cost reduction of money transfers, financial inclusion, around the clock atomic settlement, automation – programmable payments, machine-to-machine payments – Internet of Things. All of these would support further innovation both in the public and the private sector.

A regulated “Euro on Chain” would undoubtedly be beneficial for the digital development of the Eurozone. Nevertheless, it is up to the regulatory drafts which will start coming out from the EC later this year, to provide an accommodative environment and seamless functionality for the digital euro. Ultimately, the process of implementing the digital euro idea, as well as the way the regulator builds it, will influence its acceptance by the public.