In the aftermath of the 2008 financial crisis, a technological and economic revolution quietly took root, giving rise to a new era for money. Fuelled by distrust in the traditional centralized financial system, the advent of cryptocurrencies and fintech companies promised a vision for a faster, more transparent, trustless, and inclusive financial landscape. However, the manner in which this revolution has been unfolding lately may surprise many. In the last years, financial innovation has been brought forward not only by private fintech companies but increasingly central banks worldwide have been showing interest in developing their own sets of digital currencies. As of September, 93 percent of central banks are exploring Central Bank Digital Currencies (CBDCs), and 58 percent consider that they are likely to or might possibly issue a retail CBDC in either the short or medium term. This interest has sparked skepticism, as what began as a movement steering personal finance away from traditional centralized systems is now being propelled by the very institutions it sought to disrupt. This intriguing twist raises the question about the intent of central banks in this new endeavour: are CBDCs the natural evolution of cash or a gateway to a mass-surveillance dystopia?
Digital Currencies 101
As of today, a myriad of different types of digital currencies exist in the market, but these can be simplified into three big families: cryptocurrencies, stablecoins, and CBDCs.
Cryptocurrencies, such as Bitcoin and Ethereum, operate on decentralized, peer-to-peer blockchain networks, relying on cryptographic algorithms to secure transactions. In essence, they lack a central authority and are subject to market-driven price volatility, meaning their price is driven by the prospect of increased implementation, supply, competing cryptocurrencies, and investor sentiment. Stablecoins provide the same crypto nature while maintaining a high degree of price stability as they are pegged to external assets, such as fiat currencies or commodities. This can be done either through an algorithmic smart contract to regulate the coin's supply in response to market demand, or through fiat-collateralization; for every unit of stablecoin in circulation, an equivalent amount in fiat currency is held in reserve. Finally, CBDCs represent digital forms of national currency issued and regulated by a central bank, presenting the potential for a government-backed digital currency with the stability of traditional fiat. CBDC holdings are securely stored in e-wallets, ensuring the safety of assets through advanced security measures such as encryption and authentication protocols, with their value guaranteed by the authority of the central bank. Payments in the CBDC ecosystem operate on a peer-to-peer basis, enabling direct transactions between users without the need for financial intermediaries like commercial banks.
The article will focus on the EU’s plan to implement a digital euro in the near future. For its purpose, when other forms of private money will be mentioned, these will refer to stablecoins, not cryptocurrencies, as they are mostly in line with the functions of money (store of value, unit of account, and medium of exchange).
Why would the ECB want to implement it?
The European Central Bank (ECB) has been at the forefront of CBDC development since early 2020 when the first Digital Euro report was published. Since then, the project has gained momentum and made constant progress. In Europe today, the main question about CBDCs is not if these will be implemented, but rather when, with 2026 as a possible launch period.
The main explanation for the ECB wanting to implement an e-Euro would be financial stability considerations. Indeed, central banks fear that the rise of fintech, stablecoins, and new digital payment options, could hinder their ability to control new monetary aggregates, and hence pass effective monetary policy. Moreover, the uncoordinated issuance and use of private money may lead to undesirable disruptions to the financial system and increase financial risks in the economy.
Secondly, payment systems, such as Visa and Mastercard, are sets of backbone technologies stuck in the 1970s: unreliable, slow, and expensive as a means of payment. In Europe, the aggregate cost of making retail payments is 0.96 percent of GDP, allowing oligopolists to benefit without those benefits accruing to the broad users of the system. An e-euro would, therefore, not only offer a safe store of value compared to new digital payment methods but would also offer faster, cheaper and more efficient means of payment compared to traditional payment methods. In simple terms, it would get rid of tollbooths and convert the network into a public highway system that everyone can use without any cost.
Lastly, by implementing an e-euro the ECB expects to increase financial inclusion in its economies as savings among the previously unbanked and underserved populations can be mobilized in CBDCs increasing their access to digital payments, but more importantly credit. While one could argue that the unbanked population is on the brink of disappearing, given the notable decrease from 8.2 percent in 2017 to 3.6 percent in 2021, this is overall weak and elitist point as of today still more than 10 million inhabitants of EU countries fall under this category.
How could this affect monetary policy?
The issuance of e-euros will impact key parts of the EU’s macroeconomic environment in two distinct manners. Firstly, upon issuance, it will change the tightness of financial conditions and secondly, in general, will change the degree of transmission of monetary policy.
To explain this this article will directly refer to IMF’s working paper, Implications of Central Bank Digital Currencies for Monetary Policy Transmission (Das et al, 2023).
The issuance and adoption of a digital euro will likely tighten financial conditions in Europe in the short term and medium term.
For example, the introduction of a digital euro should intensify competition for bank deposit funding. As CBDCs offer a secure store of value and an efficient payment method, individuals may opt for CBDCs over traditional bank deposits, resulting in a reduction of available deposit funding for banks (Figure 1). The extent of this impact hinges on how appealing CBDCs are as alternatives to deposits, particularly, but regardless, banks will need to increase interest rates to counterbalance the liquidity advantages of CBDCs. Higher deposit interest rates will likely tighten the economic environment.
Moreover, the difficulties encountered by banks to fund operations via demand deposits could lead to an increase in wholesale funding as an alternative. Typically, lending rates in these cases are higher, meaning that again the macroeconomic outlook might tighten in the short run.
These two effects will likely decrease bank profits, which itself would alter financial conditions as banks will have to adjust their behaviour in a changed macroeconomic environment. How they will do it is not so sure and will surely depend on the implementation regulation, design and the economic outlook in the next few years. Banks could either decide or be forced to tighten their lending standards by efficiently selecting sensible loans and avoiding non-performing loans, tightening conditions further. Clearly, by lowering bank profits CBDCs could also play a big role in mitigating incentivization issues and moral hazards in the banking sector.
Overall, monetary theory would suggest that in the short run issuance of e-euros could tighten financial conditions in Europe, leading to higher interest rates for consumers, businesses and banks themselves. However, the ECB, like with any other economic shock, will have the ability to adjust its policy instruments to mitigate and achieve its objectives as the macroeconomic environment evolves, meaning the changes would not be persistent.
Monetary Policy Transmission
More important will be the impact on the transmission of monetary policy that the adoption of a digital euro will have.
Monetary transmission operates through two main channels. The interest rate channel, where changes in the policy rate impact overall interest rates, influences aggregate demand through credit demand and borrower income. The bank lending channel, where changes in the policy rate affect banks' cost of funds, impacts their creditworthiness and ability to supply credit by adjusting lending rates and standards.
If we consider the probable scenario of heightened competition for bank deposit funding, it would reinforce the effectiveness of both the interest rate and bank lending channels. A more competitive banking sector improves the transmission from policy rates to deposit rates, thereby enhancing the impact of the interest rate channel, especially in situations where banks wield less market power. This increased competition also makes bank lending rates more responsive to changes in policy rates. The increase in wholesale funding further strengthens the bank lending channel, as wholesale funding costs exhibit greater sensitivity to central bank policy rates compared to retail deposits. Moreover, increased monetary autonomy resulting from reduced dollarization or cryptoization amplifies all transmission channels, thereby fostering a more robust effectiveness of monetary policy.
In an interest rate corridor system, like the one the ECB uses, also focusing on a market demand for CBDCs introduces complexity to forecasting the required liquidity for optimizing open market operations (OMO). Indeed, precise forecasting of banks' reserve requirements is crucial for adjusting the reserves lent by central banks OMOs. The introduction of CBDCs adds intricacy to liquidity estimates, particularly considering the potential irregularities and novelty associated with the demand for these new payment instruments. The volatility in demand may escalate, especially during times of crisis. Central banks are expected to enhance their forecasting accuracy over time and develop tools to mitigate the impact of forecasting errors.
Overall, the introduction of a CBDC by the ECB will likely improve the transmission of monetary policy in the Eurozone, but more importantly will succeed in its main aim, not lose control over new monetary aggregates.
At this point, it is important to acknowledge that while the general magnitude and direction of these effects can be studied, their actual impact will heavily depend on the final design and regulation of the CBDC digital euro. For instance, as of today, the ECB is considering implementing a 3,000 e-euro holding limit for each individual; exceeding this limit would trigger an automatic conversion of holdings into bank deposits. Moreover, it remains uncertain whether the ECB will have the authority to apply rates to these digital holdings.
If such rate application were to occur, it could, on one hand, reinforce the transmission of monetary policy, but on the other hand, it might be inconsistent with the assumption that CBDCs should be equivalent to cash, which traditionally carries a zero-rate property. The ECB has explicitly stated that the e-euro should not bear interest. Consequently, the potential for increased competition and wholesale funding effects is likely to be limited. This limitation stems from the expectation of a modest substitution of bank deposits for CBDCs due to a relatively low holding limit and the non-remunerative nature of digital currencies compared to bank deposits.
Surveillance & Cyber-security
Despite the many useful features an e-euro would bring to the individual consumer and the instruments it would give the ECB, prevailing sentiments suggest widespread apprehension, discontent, and mistrust toward its implementation. Privacy concerns and fear of centralization are key drivers of this skepticism. The notion that personal data and transaction histories could be stored on a blockchain with centralized control raises realistic fears that are challenging to dismiss, even when considering potential advantages for financial stability. This skepticism alongside a far-from-ideal communication from the ECB created an environment where CBDC advocation is certainly a difficult task for the ECB.
[CBDC protest in Amsterdam, February 2023]
To trace, or not to trace
While the ECB assures users of privacy-enhancing measures, such as offline digital payments with zero access to transaction data, other statements about online payments leaving traces on the blockchain raise concerns about complete anonymity. ECB President Lagarde's statement that "digital money leaves a trace on the blockchain, it will not be completely anonymous as is the case with a banknote", while honest, adds to the uncertainty. Additionally, reconciling ambitious anti-money laundering and anti-tax avoidance plans with minimal privacy and anonymity guarantees for individuals remains a perplexing challenge.
Despite growing pessimism, the new system will work very similarly to the current system where payments are being processed by commercial banks. Just like paying for an ice cream with your card today, would result in some of your data being shared with commercial banks, paying for an ice cream with digital euros will still send consumer data to commercial banks as they will have a role “as intermediaries to disseminate the digital euro”. Banks would analyse data and share it with CBDC users. Indeed, presenting a digital euro with complete anonymity would contrast the ambition of fighting money laundering, tax evasion and terrorism financing, however it would seem the ECB will not have access to user data directly as this will be in the new mandate for commercial banks. While the ECB asserts the impossibility of direct identification, doubts linger, leaving room for speculation about potential non-direct identification possibilities.
The Politics of CBDCs
The real problem with the political status of the digital euro more likely seems to be an increasing anti-institution sentiment and disillusionment in central authorities in Europe. Skepticism towards established institutions has grown, spanning from national governments to the financial system, and an arguably bureaucratically inefficient EU system. This skepticism extends to entities that are politically neutral and independent, such as the ECB. Recent socio-political events, such as increasing energy prices, the challenges posed by the COVID-19 pandemic, and the rise of populist movements in European countries, have certainly intensified this anti-institution mood, making reform implementation a harder task, even if these are sensible or required. There is an escalating demand for transparency, accountability, and systemic reform, reflecting a desire to address the perceived shortcomings of traditional structures.
Adding to the uncertainty, ECB decision-making if not poor has at least been questionable. The challenge lies in the complexity of working papers, often inaccessible to the average person, and the decision to engage primarily with business owners regarding the implementation of the digital euro rather than the general population and individual consumers. This approach leaves minimal room for the public to comprehend, relate to, and trust the proposal. The intricate nature of the documentation creates a barrier, hindering widespread understanding and buy-in from the broader community. By focusing solely on business owners, there is a risk of alienating the individual consumers who form a crucial part of the user base. A more inclusive and transparent communication strategy is vital to bridge this gap, ensuring that the benefits and implications of the digital euro are clearly communicated and understood by the entire population.
What is arguably the most frightening feature of CBDCs though are potential programmability features. While discussing the construction and implementation of a possible digital pound, Tom Mutton, fintech and CBDC director for the Bank of England (BoE), stated that e-pounds might have be programmable. This denotes the capability to integrate specific rules and conditions into the CBDC infrastructure, enabling the automatic execution of transactions based on predetermined criteria. This feature introduces a dynamic dimension to monetary and fiscal policies, allowing for the implementation of conditional payments and innovative financial solutions. Of all the conceivable scenarios for CBDCs, the one where central authorities dictate the what, when, and where of your purchases is undeniably the most alarming. It echoes dystopian narratives familiar from fiction, raising concerns about individual freedoms and privacy in the digital age. It is important to note however that the ECB compared to the BoE possesses a much higher degree of freedom and political independence. Thus, programmability seems very farfetched and a feature that as of today has never been discussed. Amidst the fervour and craziness in CBDC discussion and protests, it seems many people forget (or simply do not know) that the ECB mandate has nothing to do with politics, power and authority, but rather with keeping low and stable inflation for the benefit of Europe.
No CBDC, no problem
Even if the implementation of the digital euro will not materialize due to political and social considerations, it does not equate to comprehensive privacy protection from digital currencies. The global adoption of stablecoins for digital payments is on the rise and may become the primary medium of exchange if CBDC projects do not come to fruition. This financial institution will nevertheless gain users' personal data. For example, a major player in the stablecoin market is Tether, a Chinese-based company with significant market capitalization (89 billion USD). Despite being a private entity, Tether's ties, like those of most Chinese companies, with central authorities and the CCP are inseparable. This raises a crucial question: would individuals prefer sharing their data with an independent central bank like the ECB or with a powerful foreign central authority such as the CCP? The answers to such questions are deeply personal, highlighting the importance of considering data protection and privacy concerns amid the evolving landscape of digital currencies also in the absence of a digital euro.
As much as it would seem there is a dilemma between accepting new efficient monetary policy tools for the ECB and giving up a certain degree of privacy and anonymity in digital transactions; the problem with the status quo of a digital euro seems more linked to political disillusionment and anti-institution sentiment in Europe. The use of an European CBDC would surely ensure a higher degree of financial stability for the Eurozone in an evolving digital financial environment. One could only begin to imagine the problems created by a loss of monetary control aggregates in an economic union such as the EU. Over time, CBDCs will have the potential to uphold the convertibility between private and central bank money, particularly in regions where physical cash is losing prominence. While public money, fosters trust; private money fuels innovation. The preservation of this convertibility serves as a crucial "monetary anchor," contributing to the overall trust in the monetary system and ensuring the central bank's continued efficacy in conducting monetary policy. This does not mean we should put our privacy considerations aside, but perhaps we should not go searching for problems where none exist. A digital euro will likely not bring big changes to the way the financial system treats privacy, anonymity and individuality itself. It might be wiser to entrust the capable hands of monetary and financial experts to navigate these waters and bring about the future of money.