Digital Euro design can address risks to banks

15 februarie 2021

The risks to commercial banks if Europe launches a digital euro were explored by Fabio Panetta, board member of the European Central Bank (ECB), during a Bruegel online seminar. Panetta outlined three potential types of risks to banks from a central bank digital currency (CBDC).

In the broader debate and in some responses to ECB public consultation, a number of concerns have been raised about the potential impact of a digital euro on the financial system.

„Paradoxically, a digital euro may prove too successful, Panetta said. If it is not properly designed, its main strengths – safety and liquidity – could affect monetary and financial stability on three fronts: first, financial intermediation and capital allocation in normal times; second, financial stability in times of crisis; and third, the functioning of the international financial system.

Effects on financial intermediation and capital allocation in normal times

A digital euro could affect financial intermediation in several ways. It could attract payments activity from banks and reduce their payments-related income and customer information. It could also attract deposits, especially if it were offered without limits on individual holdings and at such attractive conditions that the public moved large amounts of deposits from commercial banks to central banks.

The concern is that this could lead to less stable and more costly funding, lower bank profitability and, ultimately, lower lending, constraining the financing of the real economy. I would make two points here.

First, the risk of bank disintermediation depends on the design features of a digital euro. We can and should design it in ways that prevent this risk. I will come back to this crucial issue in more detail.

Second, the ECB does not plan to interact directly with potentially hundreds of millions of users of a digital euro. We simply would not have the capacity or the resources to do so. Financial intermediaries – in particular banks – would provide the front-end services, as they do today for cash-related operations. We would provide safe money, while financial intermediaries would continue to offer additional services to users.

Furthermore, beyond such design adaptations, economic thinking on the possible impact of a digital euro on financial intermediation is not clear cut. In fact, recent analyses emphasise that we should look at the broader economic implications of adopting a CBDC.

One consideration is that introducing a CBDC is by itself neutral in terms of the allocation of capital in the economy. In fact, a shift from bank deposits into CBDC would merely change the composition of banks’ funding sources, with fewer private sector deposits and more central bank funding.

Another consideration is that a digital euro could improve the allocation of capital by facilitating access to payments and reducing transaction costs, thereby helping to unlock business opportunities. It could also enhance competition in banks’ funding markets. To the extent that funding markets are not perfectly competitive, a central bank digital currency could reduce the market power of commercial banks and improve contractual terms for customers, with little effect on the volume of outstanding deposits and loans.

Potential effects in times of crisis

The risks to financial intermediation of issuing a digital euro are potentially more pronounced in times of crisis. This is the second way in which a digital euro could affect the financial system.

A digital euro would give access to a safe liquid asset which – unlike cash and in the absence of design-related constraints – could potentially be held in large volumes and at no cost. Indeed, if not properly designed, in times of crisis a digital euro could accelerate “digital runs” away from commercial banks towards the central bank. This risk could even be self-fulfilling, leading savers to reduce their bank deposits and amplifying volatility in normal times too.

For this risk to materialise, a number of lines of defence – such as deposit insurance, supervision and the lender of last resort – would have to fail or be perceived to be insufficient in the light of how easy it would be to convert deposits into safe central bank money. Moreover, a digital euro could provide additional tools to counter such risks to financial stability. For example, it could provide the central bank with real-time information on deposit flows, enabling a swift reaction if needed.

But overall, the risk that a digital euro could have adverse effects in times of crisis cannot be ruled out. A digital euro should therefore be designed in a way that enables this risk to be strictly controlled, as I will discuss in more detail shortly.

Impact on the international monetary system

The third way in which a digital euro could have an impact on the financial system is at the cross-border level. Depending on whether it would be accessible to non-residents and interoperable with non-euro payment systems, a digital euro could also have far-reaching implications for the rest of the world.

A digital euro accessible to non-residents could make the single currency more attractive as a safe means of payment for retail transactions across borders. It could help tackle inefficiencies in cross-border payment infrastructures and make it easier to transfer remittances.

But if a digital euro were not designed in a way that prevented it from being used as a form of investment, these benefits would come with the risk of amplifying international shocks. The fact that a digital euro would be very liquid may lead to foreign investors using it disproportionately and rebalancing much more forcefully into or away from it in response to shocks. Indeed, recent research suggests that, in the presence of a CBDC, shocks could result in greater exchange rate fluctuations and have a stronger effect on foreign financial conditions. This, in turn, could force foreign central banks to become more responsive to international spillovers.

Conversely, these dynamics mean that the absence of a digital euro could make Europe more vulnerable to international developments: widespread adoption of digital currencies by foreign central banks could make the European economy and financial system more sensitive to shocks from abroad.

Design and policy options

To obtain the benefits of a digital euro – such as the ability to guarantee privacy in digital payments, financial inclusion and universal access – it would need to be carefully designed. Potential design features were reviewed in the Eurosystem’s report and will be assessed in depth by the Task Force that is studying the launch of a digital euro. Only when all issues have been addressed will we make a decision about whether or not to issue a digital euro.

The features that are necessary to preserve the stability of the financial system

A digital euro should be an efficient means of payment, domestically and internationally. But crucially, in order to preserve stability, it should be designed in a way that prevents it from being used as a form of investment. A number of possible design features could satisfy these principles.

One option would be to limit the amount of digital euro individual users can hold. This would prevent large inflows of bank deposits – as well as volatile portfolio inflows from abroad – into the central bank. One way of doing this, while allowing the digital euro to be used for large transactions, would be to require incoming funds in excess of a user’s limit to be redirected to a bank account. The link between private money and digital euro accounts would avoid fragmentation of a user’s liquidity and would also be useful for outgoing payments. Large outgoing transactions could be conducted by transferring a combination of digital euro and private money.

Another option would be to set a penalising remuneration on individual users’ digital euro holdings above a certain threshold. Up to that threshold, amounts held in digital euro would never be subject to negative interest rates and would thus never be treated less favourably than cash. Above that threshold, remuneration would be set so that larger digital euro holdings are only worthwhile to make larger payments and not on an ongoing basis as a form of investment.

In identifying the appropriate threshold, one would need to strike the right balance between unlocking the benefits of a digital euro as a means of payment and mitigating risks of disintermediation or even bank runs. As a yardstick, a threshold of €3,000 would be more than the amount of cash most citizens hold today and would be above the average monthly wage in most euro area countries.

Tiered remuneration could provide a less distorting way to disincentivise large digital euro holdings. At the same time, it could present implementation challenges. For example, in times of crisis it could be necessary to adjust the remuneration of the digital currency, but this could signal that the central bank is anticipating financial tensions, leading to self-fulfilling instability.

Similar design features would have to be applied to the use of a digital euro by non-residents. This would stop a digital euro replacing other forms of investment and facilitating currency substitution in countries outside the euro area. In any event, international cooperation on design, cross-border use and interoperability would be key to reap the potential benefits of CBDCs for cross-border payments, while addressing risks to the international financial system.

Conclusion

Just as banknotes were an important innovation for central banks and bank deposits gave commercial banks a greater role in intermediation, the ongoing digitalisation of money and payments is challenging the established structure of the financial system.

A digital euro represents a natural evolution in response to this transformation – not only to underpin efficiency and innovation, but also to preserve the role of the central bank in offering safe means of payment. Throughout history, this safety has proven to be crucial in maintaining public confidence in money and, ultimately, in the State. A key goal of a digital euro should therefore be to preserve a fine balance between sovereign and private money to ensure payments remain stable and efficient.

But as the past has taught us, if innovations in central bank money are not well designed, they can become a source of financial disruption. To avoid any unintended effects and reap the full benefits of a digital form of central bank money, we will carefully consider all aspects of its design.

Our recent public consultation on a digital euro is part of this exercise. In the spring we will publish an analysis of the replies we received. This analysis will provide important input into our decision, towards the middle of the year, about whether or not to formally launch a project to prepare for the issuance of a digital euro.

More details here: Speech by Fabio Panetta, Member of the Executive Board of the ECB, at a Bruegel online seminar

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Mihai Draghici – CEO PayByFace

„Dupa ce oamenii creeaza un cont PayByFace si au adaugat cardul, selfi-ul si PIN-ul, si au avut un pic de curaj sa se duca sa incerce, daca au incercat o data plata prin recunoastere faciala nu mai folosesc altceva (n.r. ca modalitate de plata). 80% dintre ei numai asta folosesc. Le place la nebunie.” 

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In 23 septembrie 2019, BNR a anuntat infiintarea unui Fintech Innovation Hub pentru a sustine inovatia in domeniul serviciilor financiare si de plata. In acest sens, care credeti ca ar trebui sa fie urmatorul pas al bancii centrale?