Digital Euro – implications for EU Financial Institutions outside of Eurozone

European CBDC

Digital euro, as an example of a Central Bank Digital Currency ("CBDC"), is often discussed amongst other innovative digital payment methods, especially those based on blockchain and crypto-assets. One should expect, however, that digital euro will be primarily designed as a centralised payment system, with the European Central Bank ("ECB") holding the main role. Except for several functionalities and interoperability with distributed ledger technology, the digital euro will probably not have much in common with cryptocurrencies. It is also explicitly excluded from Markets In Crypto- Assets Regulation (MiCAR), the new EU law for crypto.

Where is the value?

There is no doubt that cash as a means of payment is in sharp decline. Digital payments take over the market, along with rapid development of online commerce. This is not going unnoticed by central institutions and is raising the need for a new position for central banks in the digital economy. As we can see in the Digital Euro Regulation[1] ("Regulation") proposal's explanatory memorandum, one of reasons for action is growing importance of so-called commercial digital currencies (commercial banks' digital money, stablecoins, e-money), where central bank money remains largely 'analogue'. With the new system, the ECB wants to increase its role in the electronic payments system.

Digital euro is intended to serve in particular as a solution that meets the needs of Internet of Things (IoT), Industry 4.0 and Web3 (decentralised applications). Machine-to-machine payments (M2M), smart-contract-like conditional payments and offline digital payments seem to be the most interesting features. Digital euro's business value is controversial, as its critics point out that most of the features are already covered by existing solutions. On the other hand, given its mandatory status and, therefore, its potential scale, the digital euro could prove to be a success.

Challenges and opportunities for financial institutions

The decision to enter into next phase of Digital Euro project has already been taken. As the legislation process continues, the project still triggers a number of uncertainties - in the long term it may significantly reshape the EU's payments system.

EU banks and payment institutions need to understand their new position in the digital euro system, which will be focused more on handling the relation with the end user, than operating the core systems. Given the new role, excellent user experience will become even more important competitive advantage in the financial sector.

Offline payments are seen as an essential tool for increasing digital inclusion, by extending access to online payments to more customers. Still, digital euro is not intended to replace cash. The introduction of offline payments will only make it possible to process transactions in real time without access to the Internet. The new system is designed to duplicate existing systems of euro digital payments. That may raise some challenges, as the commercial banks will potentially have to deal with an outflow of deposits, causing structural changes in banks' balance sheets[2]. Before the solution can achieve widespread success, commercial banks ought to consider its limitations, especially in terms of the required technological and investment efforts. Planned architecture of the digital euro system also raises questions about whether the role of the commercial banks will be reduced. Commercial banks, acting as an intermediary between the user and the core ECB system, will be able to offer services such as the user interface, KYC, the exchange of digital euro into cash, cash withdrawals and authorization of offline payment devices. They will also be able to act as intermediaries for financial entities lacking access to ECB systems, allowing them to participate in the system.

Privacy is the main concern for the potential users. In the proposed Regulation, it is emphasized that the introduction of the system must adhere to rules defined in the General Data Protection Regulation (GDPR). Numerous exceptions, however, raise concerns regarding one's capability to uphold their privacy. Careful consideration should be given to information storage, in order to address potential data protection and privacy challenges.

Digital Euro in NEMC

Financial institutions from Non-Eurozone Member Countries[3], according to the current draft Regulation, will be able to provide digital euro services to the users residing in the Eurozone and to the guests of the Eurozone. Such possibility will be limited within domestic markets. NEMC financial institutions will be able to distribute the digital euro to local users only after the appropriate agreement is reached between their respective national central bank and the ECB. Decision-making between each national bank and ECB will, undoubtedly, be a matter of negotiations, potentially delaying wider adoption of digital euro in NEMC. Thus, wider adoption of digital euro in NEMC needs to wait for political decisions and consensus. Even if such agreement is reached, distribution of digital euro without joining eurozone will still be limited, as it may not lead to circumvention of the Eurozone convergence criteria.

OC Comment

The introduction of digital euro provides a myriad of challenges and prospects for payment institutions, banks, and users alike. NEMC financial institutions have to consider "when?" and "how?" of participating in the system. Eurozone financial institutions only need to ponder "how," as participation in the system will be mandatory. Regardless, commercial banks have to conduct a thorough cost analysis of the system's implementation. The digital euro, despite numerous controversies, appears to offer a solution to the requirement for a more straightforward and adaptable digital payments structure. If implemented cautiously, the digital euro has the capability to generate novel prospects for the finance sector, leading to advantages for both financial institutions and clients.

[1] Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on the establishment of the digital euro, COM/2023/369 final

[2] https://bank.pl/u-kogo-i-jakie-obawy-budzi-cyfrowe-euro/?id=452751&catid=33333, access 03.01.2024

[3] As of January 2024 the list of such countries includes: Bulgaria, Czech Republic, Denmark, Hungary, Poland, Romania, Sweden.