The European Central Bank will decide this summer whether to continue its plans for digitalizing the euro. With bankers pushing back, the major advantage of a digital euro has gained little attention, writes Igor Pejic.
Igor Pejic is an author, keynote speaker and banker. His book “Blockchain Babel” was a Financial Times Book of the Month and won the Independent Press Award 2020 for the best book on technology.
The European Central Bank and others have been looking into so-called CBDCs (central bank digital currencies) for a couple of years. When in June 2019 Facebook announced its Libra project – a digital coin supposed to be bound to a basket of currencies – state efforts were kicked into high gear. No government wanted its money-printing monopoly challenged.
As of this year, 86% of central banks actively work on CBDCs. Their benefits are many, but do any of them apply to the EU and justify the ECB putting the dollar onto the blockchain?
First, let’s clarify what CBDCs are. Just like cash or reserve money, they are a form of central bank money. They are pegged 1:1 to the country’s fiat currency, but CBDCs are more than just a digital representation of a euro or a pound.
Most projects technologically benefit from the advantages of blockchains and distributed ledger technology. It is also important to note what CBDCs are not. They have nothing to do with the recent surge in crypto-prices; in fact CBDCs use centralized blockchains which are managed by institutions of trust.
This means that states and central banks can control the network, while at the same time reaching unprecedented transaction capacities. Bitcoin can handle 7-8 transactions per second; the Chinese CBDC pilot handles far more than 200,000 transactions pin the same time.
Today the major driver for CBDCs is financial inclusion. This was the reason the Bahamas became the first country to digitalize their currency, now known as the sand dollar. It is also why China hopes that its initiative called DCEP (Digital Currency Electronic Payment) will give the large rural population access to the financial system.
Citizens can receive, hold, and send digitalized yuan via app and wallet. Bank accounts become superfluous. Places where the payment infrastructure is underdeveloped, can leapfrog credit cards and bank account. It is no wonder that seven out of eight central banks successfully looking into CBDCs are from emerging economies.
The second argument in favor of CBDC is enhanced payment efficiency, domestic as well as cross-border. While true, this impact is overblown.
Most major-currency pilots and proofs-of-concept point towards a wholesale model, meaning that central banks mint new money but don’t issue it directly to the citizens. It is the commercial banks that manage those accounts, ergo disintermediation is limited in scope.
Moreover, proponents muse that CBDCs will aid the fight against money-laundering, terrorism financing, and sanctions evasion. While China is motivated to link a digital yuan to its controverse social credit system, this is a frail argument for the Western world.
All legitimate state interests can be achieved with today’s means of electronic money movement. Wire transfers to North Korea are just as impossible as Visa-payments to drug-dealers. Cash is still around for a reason and there is no doubt a digital euro would coexist with the physical one.
Then there is the financial hegemony reasoning. First, with CBDCs Europe’s and America’s adversaries could circumvent the SWIFT-network that allows more than 11,000 financial institutions to move money around the world.
Second, China could use a digitalized yuan to push forward its effort to turn it into a major reserve currency. With its Belt and Road Initiative it extended over 1 trillion USD in loans for critical infrastructure to countries along the ancient Silk Road.
In total, other countries now owe China 5 trillion USD. Yet the currency used to issue those loans is predominantly the dollar, not the yuan. The dollar makes up more than 60% of the world’s reserves, the euro more than 20%, and the yuan languishes behind even the pound and the yen.
A successful CBDC in China could challenge that ratio, primarily thanks to the Chinese technosphere. Companies such as a Tencent Financial have a large footprint in South-East Asian economies and they are already merging their tech and finance know-how. Once the yuan is issued on the blockchain, they could make it easily available to its customers.
Despite all of this, most politicians and bankers believe that tinkering with the euro might do more harm than good. Access to financial services is a minor issue and payment costs within the EU can be slashed without CBDCs.
Sure, the case for digitalising fiat currency is clear for developing countries, but does the EU really need to consider CBDCs? Yes, because of something called the programmability of payments.
In a truly digitalized economy money will have to be issued and moved seamlessly between banks, companies, individuals, and most importantly machines. According to current estimates the internet of things will connect 24 billion devices by 2030, the EU accounting for 23% of that market.
Payments in the internet of things, machine-to-machine transactions, and pay-per-use models all require programmable payments, meaning the possibility to algorithmically specify rules for future transactions.
This is possible with so-called smart contracts, a feature of advanced blockchains. Smart contracts are computer protocols with cryptographically coded business-logic capable of executing transactions autonomously.
Conventional networks cannot do this adequately, but neither can classic crypto tokens (e.g. bitcoin or Ether) nor stablecoins that are pegged to a fiat currency (e.g. Libra/Diem) according to an analysis by the German Bundesbank. While some stablecoins solved issues of scalability and volatility, interoperability and legal uncertainty remain powerful show-stoppers.
The only viable alternative is tokenized commercial bank money, but to reap the rewards of programmable money this would require massive coordination and joint standards between the banks.
Hence, central bank digital currency remains the best shot to synchronize cash flows with the flow of services and pave the way to a new economy. For this reason, every currency that seeks to expand its footprint in the years to come will need to be digitalized.