Executive summary

The digital euro is an innovative answer from the European Central Bank to the emergence of decentralized currencies such as Bitcoin and private initiatives such as Libra. Developing an institutional digital currency that can efficiently compete with existing experiments requires a deep understanding of the drivers and promises of this emerging industry.

Nyctale, as a European digital assets analytics provider, is closely following the progress of the European Union, and other governments, on Central-Bank Digital Currencies (CBDCs). Having monitored the development of the digital asset industry since early 2016, we believe to be able to provide valuable feedback to European financial institutions to better position the digital euro initiative within the existing decentralized economy.

Even if the European Commission aims to move away from blockchain and crypto-assets, the digital euro must be considered as a new form of crypto-asset. It can not leave out the current blockchain industry mostly built around public and open-source networks which are platforms hosting the most known crypto-assets and crypto-currencies.

For the past few years, many financial innovations have been conceived on public blockchain networks such as Ethereum, Tezos, and Cardano. Specifically, the decentralized finance (DeFi) area has leveraged the use of crypto-assets and peer-to-peer (P2P) exchanges to build an open-source financial infrastructure. Although working “in the grey” for now, many recent FinTech innovations have been developed there and are gaining increasing interest from institutional investors and other financial actors.

The digital euro could become the tool of choice for traditional financial institutions to build and interact with decentralized financial services. The FinTech industry is currently being transformed by decentralized technologies and is waiting for an institutional digital euro to interact with decentralized products in a fully regulated and compliant way. The European Commission needs to decide how this can happen in the Eurozone. An institutional digital euro, be it a CBDC or a stablecoin managed by private banks, would represent a key element to foster innovation in the decentralized economy and to generate adoption from the traditional financial industry.

The strategic, technical, and operational choices which will be made by the European Commission will have a severe impact on the competitiveness of the European financial industry worldwide, including the FinTech area and the decentralized economy. Crypto-assets, stablecoins, and CBDCs must converge in terms of technologies used to create new bridges between traditional finance and the decentralized economy. The future digital euro (CBDC) managed by the European Central Bank needs to be interoperable with coming stablecoin initiatives set up by private financial institutions, which for some of them will run on public blockchain networks to build strong synergies with the decentralized economy. Ignoring this aspect may prevent the digital euro to reach mass adoption and restraints it from generating significant value for European citizens.

A digital euro to disrupt the payment industry in the Eurozone

In the following paragraphs, we highlight and dissect several sections of the Report on the digital euro from the European Central Bank. We decided to focus on the elements that best reflect, from our point of view, the most important and critical dimensions of the digital euro.

Digital euro’s objectives

The report says:

"The digital euro will be designed to become a safe digital asset with advanced functionalities. It could create synergies with private payment solutions and contribute to a more innovative, competitive and resilient European payment system.

It could provide state-of-the-art payment services that reflect people’s changing needs and actively promote innovation in the field of retail payments, complementing private payment solutions. It could increase choice, competition and accessibility with regard to digital payments, supporting financial inclusion."

The digital euro needs to create synergies with payment solutions, without being limited to the ones that are coming from the private sector. For a few years, decentralized initiatives have been exploring new ways to approach payment systems.

In the future, people will be able to rely on public, private and decentralized solutions to deal with digital payments, and the success of the digital euro will be tightly linked with its ability to interact with all types of payment solutions. An example is already given by the rollout of the Republic of China’s digital yuan, DCEP, which will reportedly be compatible with major payment networks within the country such as WeChat Pay and Alipay.

The report says:

"The issuance of a digital euro may be a way to foster the digitalisation of the economy, supporting the development of innovative European solutions in all kinds of industries.

A digital euro available to the general public would support the digitalisation of the financial sector and, hence, of the broader economy. It could also reduce costs for payment service providers by making their business processes more efficient and supportive of new business models."

The process of digitalization of our economy is a megatrend which will affect the financial sector for the next 10 to 20 years at least. It’s impossible to anticipate all its implications and the final outcomes for the financial industry. The digital euro will be introduced in an ever-changing environment where disruptive innovations might appear at a high frequency.

For it to be successful and to remain competitive in this evolving landscape, the digital euro must be based on flexible and self-evolving technologies. It is impossible to design an infrastructure that can last forever, but it’s possible to choose open-source technologies that will keep evolving and becoming standards in the decentralized economy.

Policy strategy and operational implications

The report says:

"The issuance of a digital euro would help to preserve European autonomy in such a strategic sector as retail payments; it could then represent a building block for a European solution for point-of-sale and online payments.

A digital euro without access restrictions would allow international use. However, given the serious risks that this would entail, a cooperative approach among central banks issuing CBDCs is preferable.

A digital euro with restricted access could still be used internationally if specific groups of non-EU citizens are allowed to access it, for example when visiting euro area countries, and thereafter to use it."

The European Central Bank is presenting the digital euro as a way to protect its domestic payment industry not willing to compete with foreign currencies at the international level. It lets the door open for additional cooperation with other central banks, however, restricting its access mainly to EU citizens.

Without considering the implications of this strategic positioning, implementing a restriction of access to such a digital currency will represent a potential brake on wider adoption as well as the inclusion of international citizens, preventing international use in a globalized world,  be it for payment or investment purposes. Further, it might increase complexity in the user experience and thereby reduce the attractiveness of this solution even to EU citizens.

The report says:

"A digital euro could be issued to facilitate the development by supervised intermediaries of a full range of pan-European end-user solutions accessible to consumers. These end-users solutions could be used for the distribution of both commercial money and central bank money.

The excessive use of the digital euro as a form of investment and the associated risk of sudden large shifts from bank deposits to the digital euro should be avoided. In this sense, the Eurosystem might consider introducing tools to limit the use of a digital euro to prevent excessive shifts of commercial bank money into digital euro.

The amount of digital euro that individual users could hold would be kept within a range such that the overall value of the digital euro in circulation would remain below an aggregate threshold deemed reasonable. The Eurosystem may want to restrict the scope of individuals/entities that can access digital euro services. The possibility of holding digital euro could be limited, for example, to residents in a certain jurisdiction, or to retail users, etc."

The digital euro initiative is a significant investment to develop an innovative financial infrastructure that may also serve the needs of private financial institutions. In other words, all the development initiated by the European Central Bank might also be used for private banks to emit private digital currencies, namely crypto-euros in the form of stablecoins.

But the European Central Bank is afraid of potential disintermediation of the banking sector: if the digital euro was to become too successful too quickly, it would become a choice of preference for end-users which would unsettle commercial banks. That’s why the Eurosystem is considering the introduction of tools and measures to contain the usage of the digital euro and protect the banking industry.

While we understand the reasons behind this consideration, the proposed solutions seem to be in contradiction with the initial objective of promoting innovation in the field of retail payment. The digital euro should not be conceived to become a commercial form of money. The Eurozone will keep dealing with different forms of money, coming from the central bank and private institutions. But the FinTech industry needs a commercial digital euro to embrace decentralized technologies. This highlights the importance of finding synergies with private financial institutions to create extensions to the future digital euro in the form of euro stablecoins managed by private banks.

The European financial market needs and expects an institutional form of digital euro to be massively used for retail and investment purposes. It’s a requirement for FinTech to continue innovating within the traditional finance world, introducing efficient and resilient financial and payment services.

This can not happen with the Central Bank digital euro but needs to be managed with private financial institutions. Potential usage restrictions on the future digital euro are totally understandable if end-users can interact with another form of digital euro, managed by private entities or decentralized communities, in accordance with the coming European Commission's Regulation of Markets in Crypto-assets (MiCA).

All efforts by the European Central Bank should be directly coordinated with the private sector and the decentralized economy to bring a massively used digital euro to the retail and investment market. It doesn’t need to be central bank money, but the European Central Bank needs to ensure the interoperability between its digital euro and other digital currencies to create better synergies with the FinTech and decentralized industries. This would efficiently promote innovation in the retail payment and financial industry.

The report says:

"Crypto-assets are not a liability of any entity, thus there is no reliable framework to sustain their value and to protect their direct holders. These assets are mostly unregulated, which poses high risks to the users. Their price is highly volatile because crypto-assets lack any intrinsic value, which means that they trade like a speculative commodity. These characteristics limit the use of crypto-assets to only a limited set of investors and make their market illiquid; this in turn implies that users might fail to convert their crypto-asset holdings back into the amount of euro they initially invested. Regardless of the technology used for a digital euro, its nature – i.e. the fact that it is a risk-free liability of the central bank – makes it fundamentally different from crypto-assets."

The European Central Bank does not want its digital euro to be compared to crypto-assets. And the arguments above make sense if we only consider assets like Bitcoin. But the crypto-asset industry has over the last few years produced many different types and categories of assets and tokens. It’s a serious mistake to simplify the overall crypto-asset industry to only what Bitcoin represents.

In the near future, there will be regulated crypto-assets that will represent a liability to different entities, with a reliable framework to sustain their value and protect their investors. The volatility in price will decrease when our understanding of this new asset class will increase in parallel to the growing usage and adoption of these decentralized products and services. The European Central Bank can distance itself from Bitcoin, but cannot leave out the entire crypto-asset industry.

Moreover, these two different communities both have things to learn from each other. The crypto-asset industry needs to be regulated, and it’s important to develop a valuation framework to better understand, analyze, and monitor the development of the decentralized economy. Speculation will naturally decrease with the growing maturity of this industry. And traditional financial institutions need to better incorporate these new collaborative and communitarian trends. They need to incorporate open-source and decentralized technologies to bring more transparency, efficiency, and resilience within our financial infrastructure.

The report says:

"Any type of design must fulfil a number of principles and requirements including accessibility, robustness, safety, efficiency and privacy – while complying with relevant legislation.

The architecture of the system underlying the digital euro should be flexible and easy to expand, with standardised open interfaces between system components, so as to support possible future payment needs and easy integration of new types of device over time.

The digital euro should keep pace with state-of-the-art technology at all times in order to best address the needs of the market as regards, among other attributes, usability, convenience, speed, cost efficiency and programmability. It should be made available through standard interoperable front-end solutions throughout the entire euro area and should be interoperable with private payment solutions."

From our point of view, it’s hard to see how to comply with these specifications without developing infrastructure on top of open-source technologies. A private blockchain infrastructure inspired by the most recognized distributed networks would ensure that all these criteria are met without compromising two key aspects that are not clearly mentioned here: a self-evolving ability and the composability dimension for innovative products and services to be directly built on this digital euro infrastructure.

The report says:

"Solutions for end-user access to a digital euro infrastructure could either be hardware or software-based, or a combination thereof. In any case, front-end access solutions need strong customer authentication and identification.

An electronic payment that is not confirmed online can still be considered final by relying on “trusted hardware” modules. Offline functionality avoids the sharing of transaction details with parties other than the payer and payee, enabling the digital euro to become a complement to cash and providing a back-up payment solution that is available in extreme situations.

An infrastructure with some decentralisation could be used to provide a bearer digital euro, where either end users, or supervised intermediaries acting on their behalf, would verify any payment. An infrastructure with such a decentralised control and information management could foster innovation in the type of service provided to end users.

A decentralised infrastructure could allow end users to transfer holdings of the bearer digital euro among them with no need to mandate a third party to play any role in the transaction. This approach could be implemented in two ways: either via distributed ledger technology (DLT) protocols or by means of local storage."

Hardware wallets and secured cold storage solutions already exist for most public blockchain networks. Some payment terminals are accepting crypto-assets transactions thanks to the innovation effort provided by existing actors. The crypto-assets industry and its associated decentralized economy are providing a continuous development effort to increase the security and efficiency of digital assets.

Building the digital euro on a distributed ledger technology will enable the European Central Bank to benefit from the effort provided by the overall blockchain industry in the last few years. Missing the opportunity to embrace open source technologies and existing standards built by decentralized communities could be a fatal mistake when willing to sustain the competitiveness of our financial industry and ensure its ability to evolve and innovate in line with the most promising developments currently performed all around the world.

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