The digitalisation of the monetary system is accelerating, and the ECB is considering the creation of a digital euro. If pursued, this would be a significant change with a range of potential challenges and benefits. Innovation is creating exciting opportunities for banks and customers, but institutions need to watch out for emerging risks - and make sure they’re ready to meet changing supervisory expectations.
In recent years, the payment landscape has been in the process of rapid change. The increasing digitalisation of financial services, the rise of crypto-currencies offered by private foreign actors, plus the physical restrictions that have come from the COVID-19 pandemic have all accelerated a general consumer shift away from cash. This changing landscape poses fundamental challenges for central banks accustomed to supervising payments, issuing currency and controlling the money supply. It also raises questions for current banking models, as commercial banks seek to accelerate product innovation and compete with digital payment providers.
In response to this emerging banking trend, January 2020 saw the ECB form a High-Level Task Force to advance work on the possibility of creating a central bank digital currency (CBDC) in the euro area – in other words, a digital euro. The Task Force published its main findings in October 2020, analysing the possible benefits and risks associated with a digital euro. In this article we explore some of the potential challenges for this concept and consider what actions commercial banks should consider taking as they contemplate new digital offerings.
A future digital euro would exist in addition to physical notes and coins and the balances held in the ECB’s reserve accounts – a digital form of the same currency, issued and guaranteed by the ECB and the national central banks of Member States. Ownership would be recorded centrally, reducing fraud and allowing for instantaneous payments. For users, a digital euro would combine the convenience and security of digital currencies with the regulation and stability of central bank money. It would therefore be a credible alternative in a fast-changing digital environment.
From an economic perspective, the introduction of a digital euro would help to level the playing field in payments, offering interoperability with private payment solutions provided by banks, non-bank intermediaries and fintechs, and with foreign digital currencies, including other CBDCs. For example, the Bank of England on 19 April 2021 started their own exploration of the digital pound, and in China the digital yuan is already in a pilot phase. As the use of private currencies such as Diem (formally Libra) and other CBDCs grows, a digital euro would allow Europe to keep up with the 21st century digital world and help ensure that European citizens’ finances are not left vulnerable to the actions of foreign powers, or to private companies collecting data on their spending habits.
In fact, in the results of the public consultation on the digital euro (conducted by the ECB and published on 14 April 2021), contributions were received from 8,221 stakeholders, including citizens, firms and industry associations – a record for ECB public consultations. Privacy questions raised by digital currencies were amongst the most requested features of a digital euro, encompassing:
- Privacy (43% of replies)
- Security (18% of replies)
- Usability across the euro area (11% of replies).
The ECB’s interest in issuing a digital euro overlaps with initiatives by commercial banks to use a more extensive range of technology. Over the last year, many banks have entered into alliances with key cloud providers such as Amazon Web Services, Google or Microsoft, while others are beginning to harness the Distributed Ledger Technologies. Some banks are even issuing their own “stablecoins”, such as the JPM Coin.
Many of the concerns raised in the ECB’s public consultation are also applicable to banks’ efforts to develop their digital payments activities. The ECB noted this in its Supervisory Priorities for 2021, which underline that supervisors will be assessing banks’ accelerating processes of digital transformation as part of the business model assessment. Where appropriate, they may engage in structured supervisory dialogue with bank management on the oversight of this response.
Banks looking to develop their capabilities in the digital space should be aware of the key risks that mirror the concerns brought up in the ECB’s public consultation above. These include, amongst others:
- Potential misuse of personal information in financial payments. New technologies could also pose governance and operational issues, especially in situations of fractional ownership of digital assets.
- Increase in cyberattacks perpetrated to profit from fraud, extortion or data mining, with potential financial and business implications in a number of areas.
- A lack of suitable legal frameworks which could encourage scams and hacks, harming investors and discouraging the market.
- The possibility that the anonymity of new digital technologies could create new risks associated with money laundering and terrorist financing.
These types of risk are often new, and together with a lack of regulatory alignment and the decentralised anonymous nature of many digital technology platforms, this means there are few common standards or codes of conduct for development in the digital space. We recommend that, at a minimum, banks should:
- Review developments in digitalisation made during 2020 and 2021, identifying any strategic, operational or regulatory gaps. To prepare for increased supervisory scrutiny, banks should ensure there is appropriate oversight and documentation of their plans to develop in the digital space and should discuss their strategies in advance with Joint Supervisory Teams.
- Participate in the ECB’s cyber resilience strategy by becoming involved in intelligence sharing initiatives and market-wide crisis communication exercises, and by engaging proactively on digitalisation topics.
- Assess their current ability to address ICT risks and to ensure a high level of digital operational resilience appropriate to the needs, size and complexity of their business. It is important that banks comply as well with principles to manage third-party risk and maintain a clear register of outsourcing arrangements, not only at an individual level but also at the individual, sub-consolidated and consolidated levels.
The ECB published the detailed results of the public consultation on 14 April 2021, and this will be important in deciding whether or not to formally launch a digital euro project. In either case, the inclusion of disruptive digital innovation and non-bank competition as a key risk driver into 2021 SSM priorities and the potential effects of digital currencies on banks’ business models mean that the ECB will likely keep a close eye on banks’ initiatives in this area. As we move into the next phases of the COVID-19 pandemic, it is clear that digitalisation is here to stay – banks which have not already started to incorporate these new technologies into their future strategic plans should begin now.