Exploring the Impact of the Digital Euro on Euro Area Banks

Cash is used less and less for payments in the modern economy, as people are increasingly paying digitally. In a digital world, cash could become marginalised as a means of payment. Against this backdrop, central banks explore the possibility of introducing retail Central Bank Digital Currencies (CBDCs) aiming to preserve the role of public money as a monetary anchor and address potential threats arising from initiatives for a new type of money (ie, commercial digital currencies).

In this context, the European Central Bank’s (ECB) initiative to explore the possibility of introducing its own CBDC, called ‘digital euro,’ would be a turning point for the EU monetary system. A digital euro would be a new form of central bank money allowing households and businesses for the first time to use central bank money to make electronic payments. The digital euro would function as an electronic means of retail payments complementing, rather than replacing, cash.

In 2021, the ECB launched a 2-year investigation phase into a digital euro project to identify the optimal design of a digital euro. At the end of this phase (October 2023), the ECB had determined the key principles for some features of the digital euro and decided to start the next phase of the digital euro project: the preparation phase. In 2026, once the preparation phase is completed, the ECB will decide whether a digital euro should be issued. This depends also on the EU legislative developments, namely whether co-legislators will agree on the European Commission’s proposal for a Regulation on the establishment of the digital euro, which will shape the core characteristics of a digital euro (eg, legal tender status).

In its initial releases, the digital euro would be accessible only to euro area residents, merchants and governments/public authorities. Users could choose their digital euro services provider (eg, bank). The digital euro would offer both online and offline functionalities and could be used for i) person-to-person (P2P) payments, ii) point-of-sale (POS) payments, iii) e-commerce payments, and iv) payments to and from government(s).

Households and businesses could obtain the digital euro through a conversion from banknotes or bank deposits. The impact of the digital euro on the euro area banking sector will hinge on both the level of take-up and whether this will come from a conversion of banknotes or bank deposits. In the first case, users could convert banknotes to digital euro through banks, which would not be financially affected as they would act solely as distributing agents. On the contrary, the substitution of deposits with digital euro would affect banks. To accommodate deposit reduction, banks could use their excess reserves at the Eurosystem, where available. However, in case of significant outflows, banks would have to take more structural measures to address the deposit reduction and continue meeting regulatory liquidity requirements. Banks would have to i) increase deposit rates to disincentivize depositors from converting deposits into digital euro, ii) replace lost deposits with more central bank funding, iii) increase long-term (secured/unsecured) market funding or iv) decrease lending to the economy (deleverage).

Reduction in customer deposits, which is a cheap and stable funding source for banks, would increase banks’ funding costs if that outflow were compensated by an increase in more expensive funding sources, such as central bank funding and/or market funding. Thus, banks’ funding would become more unstable and costly, affecting both their profitability and their lending capacity.

The level of the digital euro take-up would be affected by i) the attractiveness of the digital euro to users based on its design features, ii) the banks’ reaction to the introduction of the digital euro (eg, increase in deposit rates), iii) the prevailing economic and financial conditions at the time of issuance, and iv) the safeguards applied by the Eurosystem to control its take-up.

Therefore, the ECB is moving towards the introduction of some safeguards to limit the take-up of the digital euro to the extent necessary to ensure that it functions as a means of payment rather than a form of investment. Thus, the ECB argues for the adoption of quantitative limits on digital euro holdings to control individual take-up and to limit the speed at which bank deposits are converted into digital euro. Individuals would be subject to a uniform holding limit, which is not yet defined. Although a limit of 3,000 euro has been mentioned in speeches and papers of ECB officials, the ECB has clarified that the limit will be set closer to the possible launch date to reflect the economic conditions prevailing at the time. A ‘waterfall’ functionality would allow the digital euro holdings exceeding the threshold limit (ie, excess amount arising from incoming payments) to be automatically transferred to a bank account held by the payee. A ‘reverse waterfall’ functionality would ensure that users could make a payment even if the amount exceeds their current digital euro funds, as additional liquidity would be pulled from their bank account. Merchants, governments, and public authorities would have zero-holding limits (ie, not able to accumulate digital euro holdings) and any payments received/made in digital euro would be transferred to/by their bank account based on the ‘waterfall’/‘reverse waterfall’ functionality described above.

A significant substitution of bank deposits with the digital euro could have an adverse impact on the role of banks in maturity transformation with significant implications for the amount and cost of credit that banks provide to the economy. Therefore, the ECB has placed particular emphasis on the safeguards to control the take-up of the digital euro, particularly in the transition phase. The safeguards should be calibrated in such a manner to strike the right balance between mitigating the risks from a large and rapid take-up of the digital euro and ensuring a substantial level of usage, which is necessary to achieve the policy objectives of the digital euro. Based on the ECB’s preliminary analyses, total digital euro holdings of up to 1.5 trillion euro would not have negative impact on the financial system and monetary policy. It seems that a threshold of 3,000 euro for natural persons along with a zero-holding limit for merchants and governments is aligned with the above target for total digital euro holdings, reducing the risk for significant deposit outflows from banks and the resulting risk for banking disintermediation.

Nikos Maragopoulos is an Associate Researcher at the European Banking Institute.