For years the European Central Bank has been promising Europe and the world that a digital Euro would eventually be introduced into circulation. So far it has been nothing but hot air, but that could soon change. The European Commission has officially put the Digital Euro on its action calendar and Central Banks, like the ECB are actively publishing reports left and right on the soon to come new CBDC.
But what is a Central Bank Digital Currency or digital Euro and how does it differ from a simple digital SEPA transfer of Euro currency? Let’s get into it.
We have the technology
The difference lies mainly in the technology behind it. Before electronic systems were invented, all our money was analouge, based on printed paper and minted coins. We still use cash today, but all over the world, the majority of transactions have become primarily digital. When we transfer money digitally, we speak of EFT, Electronic Fund Transfer. This includes actions such as direct deposits, wire transfers and even using an ATM, as we pick up real cash and reduce the digital number in our account.
But when we speak of digital currencies, we mean currencies based on DLT (Distributed Ledger Technology), which is the underlying technology of crypto-assets. Colloquially, people refer to assets such as BitCoin as crypto-currencies. However, that is incorrect, as currencies, by law, can only be issued or approved by central banks and financial authorities and fall under heavy financial regulations. That is one of the reasons why BitCoin and many other crypto-assets were able to amass such high value per unit and constantly fluctuate, worrying those who invest in them. Crypto-assets are not based on real assets and their value can change in an instant.
A new approach to more stable crypto-assets has been to create so called StableCoins. These assets usually have real-world assets backing them up, e.g. they can use the US Dollar or the Euro and for each issued coin a corresponding amount of real currency must be deposited to ensure the stability of the StableCoins’ value.
Now digital currencies are also based on DLT, but they are supposed to only be issued by Central Banks and regulated by financial legislation. A digital Euro would in effect be exchanged 1:1 between regular Euro, but usable entirely digitally.
Now you might be asking yourself: Why do we need that? What is the point of having a crypto-currency instead of hard cash if the value is exactly the same?
Why banks exist
The answer is relatively simple: Your money would finally be yours.
Remember when I talked about EFT? When you deposit money via an ATM into your account, you give up your own hard cash and you receive a number in your bank account. But that number doesn’t actually mean anything. Legally speaking, you don’t have any money. The bank has all the money, you have simply given it to the bank with the promise that they will pay you back, at your convenience if the funds are available. That is also why there are ATM limits. Because your money on the screen doesn’t actually correspond to real Euro bills available right this second. When a bank goes under, all that promised money (minus the state guarantee) also goes away, as many have experienced between 2008 and 2012.
The reason we have entered into this now rather one-sided agreement is historic in nature. Back when most people were extremely poor, a few wealthy aristocrats in several countries all came to the same conclusions: No one should be poor, but the poor are too uneducated to lift themselves up. If we give them money, most will just spend it on quick pleasures, not on what they need to make more money. So let us make an institution where people can deposit some of their savings over time. As more and more people pay into the bank, the bank becomes increasingly capable of paying out substantial amounts as loans. The loans have heavy interest rates and fixed repayments attached, so that the borrowers have to spend the money wisely in such a way that they make more money back than what they originally borrowed. This way the poor gradually are able to lift themselves up. And for those not brave enough to get a loan yet, we will pay them a small percentage of what they deposit every year as interest, which we can afford to do because of the money we gain from the loan back payments and heavy interest. Eventually this system expanded and banks also started to invest the deposited money on the financial markets to further increase their available capital.
The advantages of digital currencies
A noble endeavour overall, but if you want to truly own your money and not keep everything under your mattress, a digital currency would ensure that your value never disappears. Because the digital currency works without the aid of banks. Every single piece in the chain has the information on every other piece. Every transaction, every account balance, it is all decentralised into every coin in circulation. This makes transfers incredibly fast, safe and secure. Your coins cannot be hacked away, or stolen (mind you, your accounts can still be hacked and stolen) and they cannot suddenly be lost if a financial crisis hits. And for the first time, citizens would have direct access to central bank money, rather than just the numbers banks assign them in their accounts. If banks go under, but everyone’s money is safe in digital currencies, suddenly a bailout with our own money doesn’t sound particularly prudent anymore, now does it?
It would have many more advantages, such as increased competition for banks, who would have to offer better incentives and services to compete with direct digital currencies; inclusion for homeless people and accessibility of the currency to worldwide customers and investors, who wish to use the Euro and invest in it and no longer would have as many barriers to trading with the European currency. This would also lead to stable income for the governments whose currencies are being used, hence why the race between China and the EU is on, about who will be the first to issue their digital currency. At the same time, financial crises would become less prevalent, due to the reduced ability of banks to hand out loans for risky projects.
Of course, a complete decline of the banking sector is unrealistic and not to be desired either. The noble premise of banking is still alive and as important as ever today, but banks will have to adjust their current business models to compete, when inevitably the digital currencies will take centre stage.
But a digital Euro would also change things dramatically behind the scenes. As the EU is currently delving into the possibilities and risks behind them, two emerging dangers need to be addressed.
- Digital currencies need to be issued and controlled by central banks, not private companies. Initiatives such as Libra, while certainly interesting in concept, would pose a great danger for competition. When one consortium of US-tech companies controls the world’s financial transaction services for crypto-currencies, we can no longer speak of a competitive market. They would have the power to reject companies from transaction services if they wanted them to fail and would profit so immensely from their system that no other company could hope to compete with them ever again.
- Financial crime is rampant worldwide today. We are currently allowing criminals to use mixing services to mask their crypto-transactions. If we want to fight financial crime, we need to use DLT to its fullest and ensure the transparency of each and every transaction. This will have far reaching consequences for society as a whole, but will make black market trades, money laundering and terrorist financing next to impossible. The alternative would be a blank cheque for criminals, who could abuse the digital Euro to fund all their schemes without a care in the world.
It may seem like a small leap forward for finance, but in reality digital currencies will be the catalyst for far reaching changes around the globe. It is up to the EU to introduce the digital Euro fast, but with a lot of care and diligence, taking all the necessary precautions and most importantly: We ought to have a long-term plan.