Are you ready for the digital euro?

Analysis: the European Central Bank's interest in a new digital currency has been prompted by a number of factors

Very shortly, the European Central Bank (ECB) will decide on the introduction of a Central Bank Digital Currency (CBDC). According to Christine Lagarde, the president of the ECB, the digital euro could be finished in about four years.

So what is a digital euro, do we want it and what will it look like? While it looks like an online bank account in design, it's best comparable to digital cash money. The money in your bank account is commercial money and does not have the status of legal tender. That means that a shop can, in theory, refuse payment from your bank, but accept payments made through another bank. However, the digital euro would likely carry the status of legal tender, whic means it must be accepted when you go to pay for your coffee or groceries.

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While it is unlikely that a shop will refuse to take payment from your bank, the future is less certain. While cryptocurrencies are currently increasing in number, not many of them are currently used as money, but they have the potential to improve international trade and be used as payment. It is likely that there will be a few dominant cryptocurrencies when cryptocurrencies and in particular stablecoins (cryptocurrencies based upon fiat currency) become more popular and are used as payment.

But it is unlikely that all cryptocurrencies will be accepted equally and this is where the digital euro comes in. If a multitude of different currencies are used, the ECB is worried that it will lose its grip on monetary transmission. The ECB needs its transmission channels to carry out its primary task of price stability. The ECB cannot conduct monetary policy if the euro disappears from the Eurozone.

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The introduction of a digital euro could prevent such a scenario from happening. It would not be a cryptocurrency and would be based upon the ECB's ledger rather than the blockchain technology used by cryptocurrencies, thus allowing the ECB to remain control over the currency.

The underlying theory is simple, but the design is more complex. There are two categories of digital euro: wholesale and general-purpose. The wholesale is only accessible to financial institutions whilst the general-purpose one would be accessible to all consumers. A wholesale digital currency is easier to introduce, but it is not the primary objective of the ECB.

The ECB states that the digital euro should be available free for offline payments and able to be used by the most vulnerable groups. These requirements make a choice for wholesale digital currency unlikely. It is therefore more likely the ECB will opt for a form of general-purpose digital currency. This means that consumers will be able to access the digital euro, which can be distributed either through financial institutions or directly through the national central banks.

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Both options raise questions. When the digital euro is accessible through commercial banks, this can be introduced based upon the ECB’s authority to issue banknotes. This authority allows the ECB to issue banknotes for the Eurozone. In the past, legislation focused on physical banknotes but given the recent developments there is room to interpret the legislation to include digital notes. If the ECB issues digital currency through its authority to issue banknotes it raises the question of whether the accounts can be remunerated with interest.

Some academics have argued that the ECB's digital euro has to represent cash and cannot be used to generate interest (and this steer monetary policy). But in a recent judgement, the Court of Justice of the European Union connected monetary policy to the power to issue legal tender, therefore making it more likely that the digital euro accounts can carry interest rates.

The level of interest is difficult to determine, especially when considering the second aim of the digital euro to include the unbanked. When a consumer wants a bank account but is refused, they become "unbanked". While the number of unbanked in the EU is limited, the impact upon the individual is very serious. To improve access to a bank account for the vulnerable, the interest rate cannot be negative. This would decrease the accessibility for the vulnerable and would be contradictory to the accounts being "free". If the interest rate is too high, commercial banks might not be able to compete and face bank runs. This would be contradictory to the ECB’s primary aim of price stability.

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Furthermore, if the ECB wishes to decrease the number of unbanked in the EU, they will have to consider allowing for direct access through national central banks. The number of unbanked in Europe is so small that they do not impact price stability so to provide bank access is a socio-economic rather than a monetary aim.

At present, there is no legislation that provides authority for the ECB to open such accounts, but it is unlikely that such legislation will be introduced as the ECB would have a competitive advantage over commercial banks. Central banks are considered more trustworthy by the general public, thus providing a general preference for a central bank over a commercial bank account. This preference would undermine competition. The EU’s current policy is, furthermore, aimed at providing bank accounts through increased commercial competition.

Whereas we can soon expect the ECB to press forward with the digital euro, the design will be difficult to determine. The most likely route is a form of general-purpose digital currency with space for competition for commercial banks. However, the ECB have to work hard on explaining how the commercial banks can continue to compete.