June 20, 2023 Digital Euro Update: The digital euro is expected to have a significant impact on the financial sector. 2023 is a crucial year in which decisions will be made on the implementation and possible issuance of the digital euro and will likely be a big topic of conversation at EBAday 2023. Review our deck for more information on the digital euro, including an overview of CBDC trends, potential use cases for the digital euro and the role of the private sector in the digital euro ecosystem.
Central bank digital currency (CBDC) has met with sustained skepticism, in particular from certain financial institutions. Opponents fear it may disrupt the banking system and undermine existing banks’ business models. Proponents argue that CBDC will equip the financial system with new capabilities and encourage diversification in payments. We believe the net effect of a CBDC will be largely positive, as it will offer an alternative medium to address new use cases, advance financial deepening, and signal support for financial innovation.
Let’s address some common concerns about CBDC
Certain financial institutions are not in favour of CBDC, mostly on the grounds that it may crowd out bank deposits and because of skepticism about its effectiveness to achieve its stated aims, including financial inclusion. The argument that national currencies are already digital is often advanced to question the necessity of a CBDC. Some critics also voice concern about privacy and illicit financing.
Arguments against CBDC often assume that a retail CBDC could be a close substitute for bank deposits and associated services. But the general public is unlikely to exchange bank deposits for CBDC if CBDC is seen as a close substitute, as consumers would be indifferent between holding CBDC and bank deposits. The perception that CBDC is a superior store of value given the safety of central bank money, and hence not a close substitute, could lead to a switch from bank deposits to CBDC. However, empirical evidence suggests that the general public is unlikely to act on safety grounds—even in times of distress, little movement of money can be observed between weak and strong banks, and between privately- and government-owned banks. The concern about a bank deposit flight is valid in theory, though considered unlikely to materialise in practice.
For proof we can look at money market funds, which are often considered equivalent to cash. These expanded rapidly in the U.S. from the mid-1990s through to the mid-2000s. But during the past 20 years, the ratio of bank deposits to money market funds increased from 1.9 to 3.4, indicating that bank deposits have increased significantly faster than money market funds. The adoption of money market funds may serve as preview of the impact of CBDC on deposit-type financial instruments.
The concern about bank disintermediation is also often viewed in relation to an undue expansion of the central bank’s balance sheet. Naturally, a significant increase in the propensity to hold central bank money would have a similar effect to that caused by an expansion of banknotes in circulation and reserves: an increase in the weight of the central bank relative to the rest of the financial system, and a fundamental fear that the role of government in finance is expanding. This is already the case amid the quantitative easing strategy pursued by some central banks; reserves held by the Bank of England increased from less than 0.3 percent of commercial banks’ liabilities in 2007 to 11 percent today. Changes to the size of a central bank’s balance sheet is a policy decision, as central banks always control the amount of central bank mediums in circulation but not necessarily their composition.
Banks claim that an erosion of bank deposits would impair their capacity to sustain their loan business and undermine economic activity. In principle, banks can extend loans irrespective of deposits and, while assets and liabilities naturally need to match, there is no direct link between the extension of loans and deposits. In the U.S., during the past 20 years, the ratio of credit to deposits has declined from 1.2 to 0.9, indicating that bank credit extension has slowed despite sustained robust deposit growth.
The role of central banks in financial inclusion remains ambiguous. While a safe payment medium is critical for financial inclusion, basic banking and insurance services are often regarded as significantly more important. Successful private sector solutions also exist to advance financial inclusion and the relevance of public sector involvement is therefore not clear. Financial inclusion is a complex undertaking and probably involves some public policy action, but most aspects of it may be outside the remit of central banks.
The argument that national currencies are already digital is a valid one. However, the innovation with CBDC is not that it is digital but that it is a digital token on a distributed ledger. Digital tokens enable instant settlement, reducing open positions and risk exposures. That gives them unique functions, including programmability, that conventional monies do not hold and that unlock new possibilities in payments. Further, the deferred settlement embedded in several current payment methods requires financial institutions to hold additional liquidity in various accounts like nostro/vostro. This could be significantly optimised using wholesale CBDC schemes.
The level of privacy CBDC can afford remains contentious. The discussion often is not specific about the need for privacy—from whom and to cover what? Like all digital mediums, CBDC is traceable. However, solutions can be found to ensure only needed information is being transferred, e.g., between merchant and payer. The level of privacy provided may also depend on the size of the transaction. While cash does not constitute the appropriate benchmark for privacy because of its physical properties, existing digital mediums do—and there are few arguments to suggest that CBDC could not provide the same level of privacy as a debit card, for example.
The distribution of CBDC will play a large role in the allocation of responsibilities to observe prudential safeguards. For retail CBDC, the distribution of CBDC through the banking system would vest provisions to observe know-your-customer and anti-money-laundering rules with the banks. The traceability of CBDC would indisputably equip the financial system to better detect and thwart illicit transactions.
Concerns from certain institutions about CBDC are reminiscent of historical opposition to the very notion of central banks. In the U.S., resistance to the establishment of a central bank was due in large part to opposition by the banks: “Another objection urged against the pending [money] bill is that the banks should issue the currency, and the argument is made that currency is the same thing as a bank account put into a liquid form” (New York Times, 15 October 1913). The money bill to establish the Federal Reserve System was resisted in part amid concerns that currency issued by a central bank—Federal Reserve notes—would replace existing bank deposits. The Federal Reserve Act of December 1913 was eventually based on a compromise of the “sectional” approach of the 12 Federal Reserve districts to mitigate the impact of a large single centralised government institution.
While financial institutions do face competitive and existential dangers, CBDC is unlikely to represent a major threat. It is a new format of central bank money and nothing more. It offers features to enhance efficiencies in payments and address new payments use cases that should benefit the banks and promote financial deepening. At the same time, banks will be required to meet new challenges to ensure they can be effective intermediaries of CBDC, extend needed infrastructures to end-clients and ensure a seamless integration with existing core-banking and payment systems. Central banks, as they can with banknotes, will always be able to take remedial measures if the adoption of CBDC is seen as inconsistent with set monetary policy objectives.
If you’d like to discuss the impact of CBDC on financial services in general or payments in particular, we would love to hear from you. Contact Sulabh here and Ousmène here.
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