The digital Euro - its benefits and challenges for banks

Siegfried Utzig, Association of German Banks, Keynote speech at CRYPTO ASSETS CONFERENCE 

31 October 2020

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Ladies and gentlemen,

I would first like to thank the organisers of the Crypto Assets Conference for this opportunity to speak to you today. You may be asking yourself: how could a representative of the Association of German Banks possibly have anything interesting to say about the innovative topics being discussed here at this conference. Banks are often considered far too conservative, unadventurous and outdated. But I can assure you, this is not at all the case. Banks are also in favour of change, especially when it comes to matters concerning the digital transformation. The Association of German Banks has welcomed firms from the fintech sector for many years now and represents the mutual interests of both banks and fintechs. In fact, some of the companies presenting themselves at this conference are extraordinary members of our association. 

So, of course, we follow with interest all the latest innovations in the financial sector and include them in our policies. For example, the association was one of the first to publish a position on Libra in 2019 and is still the only banking association to tackle the topic of a programmable euro and consider its future relevance. 

Libra was also a wake-up call for me personally; innovations that change the manifestation of money are rather rare. It was only in long discussions with colleagues who are more familiar with distributed ledger technology that I realised the disruptive power of this technology for our currency. Personally, and also in the banking association we came to the conclusion that DLT will only be able to unfold its great potential for the economy if central banks and banks apply it to money. The clear commitment of the banking association to a digital euro is based on this insight.

But we are also aware that the issue is only superficially about generating a more efficient system of making payments. Actually, DLT has the potential to turn the monetary order of the past three hundred years on its head. It is well known that during the 17th century, Europe gradually moved from a token-based monetary system – with metallic coins – to today’s account-based two-tier banking system with central banks and commercial banks, and with fiat money. 

DLT now looks to be taking us back down the path towards a token-based monetary system. From what we know so far, it is difficult to predict either its benefits or its costs to our economy and society. So, we have good reason to carefully study the potential impacts before putting these new forms of money into practice.

Seizing opportunities

If we begin by considering the opportunities that may come with the innovation of token-based forms of money – whether stablecoins or CBDC – there are many arguments in favour of us taking this step. The advantages have been listed in many publications, especially since the publication of the Libra White Paper. So there is no need for me to go into them in detail here. They generally mention the improved security and greater convenience when transferring funds, followed by the drastically reduced transaction costs, particularly for cross-border payments. Badly underestimated, in our view, is the importance of an appropriate form of money for the digitalisation of the economy. For the Association of German Banks, it is clear that digitalisation will only be successful if payment processes can be integrated into smart contracts, that is, if money - i.e. the euro – is programmable. One important application is machine-to-machine payment. 

Ladies and gentlemen,

This is probably nothing new for you and is not likely to cause any heated discussions outside expert circles. But, whether it was intentional or unintentional, Libra’s idea of a global stablecoin that would compete directly with national currencies has set the alarm bells ringing. In the months following the publication of Libra’s first white paper, more and more people became aware that the idea of token-based money would influence the stability of the international financial system and the monetary sovereignty of each and every country. 

It is therefore only natural that central banks around the world and the major international organisations of the financial system stepped up their activities concerning token-based money. They have recognised that Libra raised the key question of any monetary system – the question of citizens’ trust in the value of their money. Trust will also be the decisive factor determining whether or not people accept digital money and how successful it becomes. Digital money will therefore have an impact on society as a whole. 

At the recent IMF annual meeting, Fed Chairman Jerome Powell rightly identified the introduction of CBDC as one of those issues where it’s more important to get it right, than it is to be first. But Powell’s statement also shows that even the world’s most important central bank has no doubt that stablecoins and CBDC will play a leading role in the international monetary system.

CBDC should be introduced with care

Ladies and gentlemen,

From the banks’ point of view, the introduction of CBDC would be a serious, yet ultimately unavoidable intervention in the current monetary regime. Precisely how serious depends on a number of decisions that need to be taken on the technical design of CBDC and on how attractive CBDC is for users. Central banks will have to begin by answering a number of fundamental questions about the technical design of CBDC.

• Should CBDC be set up in a traditional account-based form, or should it take the form of a digital token?
• If a token should it be based on DLT?
• Should CBDC be interest-free, like cash, or should it be remunerated?
• Should CBDC be programmable or not?

Each of these decisions will lead to different forms of CBDC with different characteristics. However, the answers to the following two questions will have the most critical impact on the monetary system: 

• Should CBDC only be available to banks and other financial institutions or should it be a new form of money for everyone?

If the decision is that CBDC should be for general purpose then the second question is, 

• should the central bank itself be in charge of distributing and administering this new form of money or should this be a job for banks and financial service providers? 

The ECB has already made preliminary decisions on both issues, in its report of the second of October. In the coming months, it will investigate the feasibility of a general-purpose CBDC to be distributed to users via the existing financial system. 

So the ECB has decided it does not want CBDC to jeopardise the stability of the current monetary system, a system which gives only banks privileged access to central bank money and, by enabling the banking sector to generate money, ensures flexible and seamless financing of the economy. Of course, this decision was warmly welcomed by the banks. 

Nevertheless, this decision should not hide the fact that CBDC will demand a lot from the banks. To understand what this means, let’s take a closer look. You and I, all of us, only have access to central bank money through cash. It is a direct liability of the central bank – cost-effective and safe. By contrast, the balances on our bank accounts are merely claims on an individual bank and therefore also at risk of default. CBDC would be a digital alternative to cash for all of us, which, at least in terms of security – other things being equal – would be better than bank deposits. 

What happens after the ECB introduces the digital euro will depend on our own personal risk appetites and possibly other advantages the digital euro will offer. From today’s standpoint, we can therefore predict that money is likely to flow from bank deposits to CBDC, but, with the best will in the world, we don’t know how much it will be. 

What for us will probably just be a simple finger swipe on our smartphones, is likely to fundamentally change the way banks do business. Customer deposits are an important refinancing source for lending. If the volume of deposits falls, the bank will have to find an alternative refinancing source, and if they can’t do that, they will have to limit their volume of lending. At the very least, there is good chance that this will drive up interest rates on loans. The effects of CBDC on the banks will therefore throw up a whole series of questions on economic policy.

• Could the financing of the economy be impacted by the introduction of CBDC?
• Could CBDC ultimately have a negative effect on economic growth and employment?
• And, will the central bank end up having to intervene with monetary policy measures to neutralise the damaging effects of CBDC?

So you see, the decision to introduce a digital euro will have wide-ranging consequences that go far beyond the technological challenges involved. These will all have to be considered in detail and in terms of their significance for the economy and society.  

Ladies and gentlemen,

I’m quite sure that similar considerations prompted the ECB to propose in its report that the use of CBDC should, firstly, be limited to the function of money as a means of payment and, secondly, that there should be a maximum permissible amount. Especially since such a step could also counter the risk of digital bank run. 

Whether or not these proposed limitations will ultimately come into effect needs to be discussed more fully. Though it is true they would limit the direct negative influence on the banking system, this step would come at a price. The proposed limitations are nothing less than a restriction on the convertibility of the euro. 

And, again, this raises a number of questions:

• What restrictions on the existing monetary system can be justified in order to introduce CBDC without endangering monetary or financial stability?
• How can a stable balance between CBDC and the existing banking system be achieved?
• How can the central bank promote innovation and efficiency at the same time?

Certainly, a lot of further discussion and research is needed before these questions can be answered.

Nevertheless, my detailed description of the hurdles to CBDC should not be misunderstood as a plea against the introduction of a digital euro. On the contrary, Germany’s private banks see CBDC as a necessary instrument for successfully advancing the digitalisation of the European economy and shoring up its competitiveness. Furthermore, the digital euro is needed to ward off competitive attacks from other forms of money claiming to be credible alternatives as a medium of exchange and store of value in the eurozone. But, to quote Jerome Powell once more, this is precisely why it’s important to get it right.

Stablecoins – the future of money?

Ladies and gentlemen, 

This leads us nicely on to other token-based forms of money, namely stablecoins. They, too, represent a new challenge for the European banking system. They are an attempt to ensure confidence in the stability of a cryptotoken – something bitcoin with blockchain technology alone could not achieve – by backing it with legal tender or government securities. In short, it is not blockchain that will make stablecoins like Libra money, but the backing of the token with fiat-money.

Nevertheless, with the advancement of DLT into the realm of money and currency, new forms of competition are emerging, because DLT will manifest itself in many different forms. Policymakers and the economy are therefore faced with complex regulatory and practical challenges from the new forms of money made possible by this technology. 

The Libra association has in its second white paper, published in April of this year, accepted this state sovereignty; there will be no global currency operating independently of central banks, at least not from Libra.

Enthusiasts from the blockchain scene may be disappointed about this about-turn. But the announcement of single-currency stablecoins and the possibility of linking Libra to smart contracts could still help Libra achieve a breakthrough, as long as a euro-Libra remains a profitable business model in a world with negative interest rates. At any rate, assuming this is the case, a programmable euro could become a reality with Libra. How much room would be left for other providers of a programmable euro is uncertain. But a euro-Libra would certainly present the banking sector in Germany and Europe with a much greater challenge than the currency-basket Libra.

Options available to the banks

Ladies and gentlemen,

Up to now, I have largely described the appearance of new token-based forms of money as a threat to the current banking system. And, objectively, this is the case. Banks provide the lion’s share of financial infrastructure, particularly in Germany. If the banks were to suffer damage, so would this infrastructure, with negative consequences for investment and asset formation in Germany. The potential benefits of a more efficient payment system with stablecoins, such as Libra, must be set against the cost of potentially destabilising the financial infrastructure. 

If both CBDCs and stablecoins are going to place an additional burden on banking, then in return, the banks should play to their strengths, one of which is undoubtedly in payments. And, in conjunction with the ECB, they should look to promote improvements in the efficiency of the payment system. Much can be done to increase the speed and availability of instant-payment mechanisms and allow them to be included in smart contracts, for example.  

However, should CBDC and Libra become a reality, the expected loss of bank deposits may put extra pressure on banks to change their business models in terms of how they finance their lending. In order to compete with these innovative forms of money, they will have to adapt the attractiveness of bank deposits and the existing payment system to the new benchmark. To achieve this, the banks have a number of options at their disposal. And I am sure they will use them. The message to new competitors therefore is, technological innovation on its own is not enough to guarantee economic success.

The banks will certainly consider the fact that DLT-based smart contracts are set to play a rapidly growing role in the economy. And, as a result, the demand for a programmable payment system will also grow. It will certainly be possible for a while to meet this need using account-based, instant-payment solutions. But demand for token-based forms of payment will probably grow rapidly. 

The Bundesbank has repeatedly pointed out that, in a market economy, the primary task of private actors is to develop innovative payment solutions. So, if banks want to continue to have a share in a digitalised economy, they are called upon to develop token-based forms of money themselves. And from today’s perspective, this is the real challenge for the banking sector. 

A euro-token from the banking sector would have to be freely convertible, like today’s bank money, and this will only be possible with a stablecoin. But this means that, as far as we know right now, the token will have to be fully covered, unlike today’s bank deposits. The banks could achieve this with securities, mortgage loans, corporate loans or central bank money. The convertibility of a euro-token from the banking sector would therefore tend to have the same effects on the banks’ fundamental business as CBDC or Libra. So, the obstacles in the way of a stablecoin issued by banks are considerable. Banks will have to decide whether or not they will take on these challenges and create their own stablecoin, and we certainly don’t know what variant they are likely to go for.

The regulatory framework will need changing

Ladies and gentlemen,

Irrespective of the decision-making process within the banking sector, it is vital that the banks and their new competitors get to compete on a level playing field. This means that the existing rules and regulations for traditional financial institutions should also apply to the new technology-based financial service providers, according to the well-known principle of “same risk, same rule”. The European Commission has put forward some initial recommendations in its Proposal for a Regulation on Markets in Crypto-Assets (MiCA). The details will be discussed over the coming weeks and months. 

From the banks’ point of view, it is particularly important to ensure that the existing regulatory conditions are applied to market entrants in a way that does not lead to unwanted regulatory arbitrage. The challenge here will be to ensure that regulation does not, at the same time, restrict the scope for innovation. Because innovation is the driving force behind digital transformation, for banks too. 

So, in summary then, I should say that there will be no stopping the digitalisation of money. Neither form of money – private or public – will be able to dodge this development. But in all money matters, rigour has priority over speed. Those who promise a golden future from the various forms of digital money will only be acting in good faith if they have first analysed and openly disclosed the effects it will have on the monetary order. Digital money, in particular that based on DLT, may be a technical challenge that can be overcome. However, digital money must not become a regulatory burden that jeopardises the functioning of the market economy.