Does the ECB Work on a Blockchain-based Digital Euro?

Central bank digital currencies (CBDCs) are coming. A recent study by the Bank for International Settlements (BIS) shows that 10% of worldwide central banks intend to issue a retail CBDC in the short term and 20% in the medium term. However, introducing a CBDC imposes potential threats for data privacy and financial stability. Opponents argue that providing generally accessible central bank money can lead to financial instabilities and disintermediation of commercial banks. Moreover, many fear that such a digital CBDC would lead to new surveillance possibilities by the central bank and could undermine data privacy. In this article, we discuss possible ways to address these threats, which have been proposed by the European Central Bank (ECB) in two recent publications. We further discuss the use of distributed ledger technology (DLT) for the issuance of a CBDC. Authors: Manuel Klein, Jonas Gross, Philipp Sandner

Introduction

Central bank digital currencies (CBDC) are currently a hot topic. A report recently issued by the Bank for International Settlements (BIS) shows that central banks of around one-fifth of the global population are likely to issue a CBDC in the next three years. CBDCs represent a digital form of central bank money and can feature various design principles e.g., related to the payment of interests, the access to CBDC, the operational setup and the choice of the technology. The advent of crypto assets coming along with tremendous advantages, such as programmable transactions, cost efficiency, high transaction speed and further efficiency gains, have led many central banks to analyze how fiat currencies could entail these advantages in order to facilitate the adoption by regular businesses and citizens.

Figure 1: Motivations for issuing a retail CBDC. Source: Central bank survey on CBDCs (BIS, 2020).

ECB addresses anonymity concerns

The authors present a concrete retail and cash-like CBDC prototype that (partially) guarantees anonymous payments while accounting for anti money laundering (AML) regulations implemented on a DLT system. It discusses a potential solution for AML compliance where a user’s identity and transaction history is not revealed to the central bank and an AML authority. With this paper, the ECB addresses an important trade-off between anonymous payments and the use of money for illicit activities. Of course, it is desirable for society to detect illicit activities, such as terror financing and money laundering. But it is also desirable from a citizen’s perspective to be able to — at least to a certain extent — conduct anonymous payments, which is currently possible for all cash transactions.

ECB addresses financial stability concerns

The second recently published paper also focuses on a retail CBDC system. It addresses the problem that commercial banks could become disintermediated and bank runs could emerge. The underlying threat is that a retail CBDC would constitute risk-free digital Money, whereas bank deposits bear credit risk, liquidity risk, and market risk. Moreover, bank deposits are only secured up to 100,000 Euro through deposit insurance schemes. Citizens could therefore decide to opt-out on bank deposits and transfer their liquidity into a risk-free account at the central bank to hold their money in CBDC.

Figure 2: Interest rate design of the proposed CBDC system. Source: Bindseil (2020).

Should a CBDC be blockchain-based?

We showed that the ECB is actively engaged in analyzing the benefits and risks of a CBDC and described possible design principles and features of a retail CBDC. Since central banks aim for stabilizing the current money and financial system, the question of which technology should be used for the introduction of a CBDC is not necessarily the main focus of their research. Issuing a CBDC does not necessarily imply using DLT, such as blockchain technology, even if this technological choice is often assumed in the public debate. Hence, it is imaginable for a CBDC to be issued either via a centralized database system (probably the case in Sweden) or via a distributed ledger technology (as in China). The retail CBDC prototype of the ECB guaranteeing partly anonymous payments will be set up on the Corda DLT. Using DLT to issue a CBDC can be beneficial in various dimensions:

  • Security: Due to the underlying cryptography, DLT systems are typically very secure and hard to hack. This mechanism makes transactions very secure and operationally resilient.
  • Speed: Today, in the classical payment systems, transactions, especially in form of cross-border payments, are typically not efficient. According to data from the World Bank, transaction fees on average amount to 7% of the transaction value and take several days to process. These limitations can be addressed by using a CBDC operating on a DLT system featuring cryptography and energy-efficient consensus mechanisms, such as proof of stake or proof of authority.
  • Smart contracts: A blockchain-based CBDC would make the Euro programmable. Euro-denominated smart contracts would make it possible that IoT devices, such as machines, cars and sensors, can offer services directly on a pay-per-use basis including leasing and factoring. The implications of such a digital fiat currency are especially promising in the context of the machine economy. It is estimated that more than 20 billion devices will be connected to the Internet in 2025 — three times as many devices as there are people currently living on earth. Some of these devices will also be integrated into payment networks. These networks will soon cover hundreds of millions of devices, such as cars, sensors and machines. Blockchain technology is best suited for equipping millions of devices with a computer chip and, with it, with their own wallet. Consequently, a device will be able to receive payments and transfer money — and produce SAP-based accounting records and invoices in Euro denomination. For these millions of devices, blockchain technology can easily provide the opportunity to participate in a payment network and integrate these devices into automated business processes (e.g. through smart contracts).

Conclusion

The latest survey by the BIS shows that we can expect the first central banks to issue a retail CBDC in the next few years. However, introducing such a retail CBDC poses risks for data privacy of clients and for financial stability. However, if designed properly, these risk factors can be mitigated as proposed in the two ECB publications: Anonymity in digital payments can be reached by using DLT in combination with anonymity vouchers while the proposed Tier 2 CBDC system is well-suited to maintain financial stability. We highly welcome that the ECB is heavily researching CBDC and addresses this important aspects also by experimenting with DLT. Using DLT for the implementation of CBDC can have tremendous benefits for transaction privacy, speed, security and automation.

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Authors

Manuel Klein is a consultant at a leading provider of financial data and analytic applications for investment management and investment banking professionals. Services are used by the top 10 global investment banks and 95 of the top 100 asset managers. Moreover, since 2015, he has been actively engaged at the NGO Monetative for which he has been giving speeches at several banks, conferences and universities both nationally and internationally. The NGO provides education about the structure and problems of the current monetary system and advocates a “100% CBDC”, “sovereign money” or “Vollgeld” system. You can contact him via mail (manuel.klein@monetative.de) or via LinkedIn (https://www.linkedin.com/in/manuel-klein/).

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