How Digital Currencies Could Shape the Future of Finance – by Prof. Diane Pierret

08 July 2024

If introduced, the digital euro would serve as an alternative to cash, complementing banknotes and coins while providing an additional payment method backed by the ECB. How will the advent of the digital euro impact banks and the conduct of monetary policy in Europe?

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The European Central Bank (ECB) has embarked on a preparatory phase to lay foundations for the potential issuance of a digital euro. If introduced, the digital euro would serve as an alternative to cash, complementing banknotes and coins while providing an additional payment method backed by the ECB. How will the advent of the digital euro impact banks and the conduct of monetary policy in Europe?

This article is an opinion paper written by Diane Pierret. It was also published in Silicon Luxembourg and Forbes Luxembourg in French.

Digital Euro and Other Digital Currencies

A Central Bank Digital Currency (CBDC) like the digital euro is a digital payment instrument that is, in fact, a direct liability of the central bank. In practical terms, it means that the digital euro will be a new alternative for customers to pay with public money, that is money issued and guaranteed by the central bank. As of today, there is no digital public money available to customers. Physical banknotes are the only mean of payment they can use that is issued by the central bank. A CBDC like the digital euro will introduce an alternative to use public money digitally.

However, central banks stress that this is an alternative payment instrument that will not fully substitute cash or deposit accounts. Customers will then have the option to pay with their credit or debit cards, digital euros or “normal euros” (i.e., banknotes).

With the introduction of digital euros, customers who want to start using them will transfer money from their deposit accounts at commercial banks to the ECB in exchange for digital euros. Therefore, it may seem that commercial banks would lose funding due to these transfers of deposits from commercial banks to the ECB. The loss of funding could be detrimental for banks and the economy as it could reduce their lending capacity. However, in one of her papers, Prof. Martina Fraschini from the Finance Department of the University of Luxembourg, demonstrates that this outcome depends on monetary policy and the extent to which banks hold excess reserves at the central bank.

SciLux podcast – Diane Pierret, assistant professor of Finance

A Risk Depending on Monetary Policy

Banks have reserve requirements introduced for financial stability purposes, defining the amount of cash a bank needs to deposit at the central bank. Intuitively, a bank holds excess reserves whenever its reserves (i.e., deposits at the central bank) exceed its requirements. When customers want to transfer money from their deposit accounts to get digital euros, the commercial bank needs to transfer resources to the ECB to settle this transaction.

The same thing happens when customers withdraw banknotes. When commercial banks hold excess reserves at the ECB, they can simply “swap” the excess reserves (a deposit at the ECB) into a digital euro account (another deposit at the ECB) for their customers. This way, the banks do not lose funding, and there are no negative outcomes for their lending activity.

The amount of excess reserves held by banks depends on monetary policy. Under quantitative easing, the central bank expands its balance sheet by purchasing assets to boost the economy. The operation is financed by creating excess reserves.

Digital Euro and Reverting Post-Crisis Monetary Policy

Since the financial crisis, the European sovereign debt crisis, and the pandemic, the ECB has expanded its balance sheet to record levels. Martina’s paper highlights that if the digital euro is introduced after a period of quantitative easing and commercial banks convert a significant amount of excess reserves into digital euros, the ECB might struggle to revert its monetary policy.

In fact, if the ECB were to sell assets to shrink its balance sheet (i.e., implementing quantitative tightening, that is the reversion of quantitative easing), it would entail closing many digital euro accounts held by customers. This operation would be much more challenging than withdrawing excess reserves in an economy without the digital euro. In other words, if the demand for digital euros is substantial and many excess reserves are converted into digital euros, the ECB might be unable to engage in monetary tightening, its main tool for stabilizing prices and combating inflation.

On The International Agenda

Interestingly, Martina discussed these findings with ECB President Christine Lagarde when she was a finalist for the ECB’s Young Economist Prize in 2022. Moreover, Martina’s work on CBDCs has garnered attention in other notable forums. Last January, at the annual meeting of the American Finance Association, Prof. Philip Dybvig, Nobel Laureate in Economics in 2022, commented on her paper describing how banks would optimally respond to the introduction of a central bank digital currency.

Even though there is no official date yet, a vote on the digital euro is in the agenda for the newly elected European Parliament. Understanding the underlying economic mechanisms of introducing a central bank digital currency is of the utmost importance for the vote and for a potential future legislation.

Professor Diane Pierret is assistant professor at the Department of Finance at the University of Luxembourg.

Her research in the field of empirical banking focuses on the regulatory stress testing practices, consequences of unconventional central bank interventions, sovereign-bank linkages, bank profitability and monetary policy, and the interaction between solvency and liquidity regulations.

Diane Pierret is also research affiliate of the Centre for Economic Policy Research (CEPR).

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