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Digital Euro: Risks include threats to financial stability and costs for commercial players

The European Central Bank possibly building a digital euro is a complex mission. This article examines its downsides, including hazards to financial stability, challenges to banks, and the dilemma of the central bank's dual role.

Financial sector stakeholders have expressed their concerns about a series of risks that could be realized as the European Central Bank (ECB) prepares for launching a digital euro.

The project comes with challenges, including:

  • Threats to financial stability
  • Hazards regarding loan availability and smaller banks
  • Costs for commercial players
  • The central bank’s dual role

Possible deposit outflows could destabilize the financial system

Financial system stability refers to its capacity to withstand shock. Banks are central to our current monetary system, and their robust capital and liquidity buffers are the primary reason for their resilience. One of the biggest risks of the digital euro project is that it could negatively impact the amount of money in European commercial banks’ buffers.

A recent study by Copenhagen Economics found that with a holding limit of 3000 digital euros per person, the new currency could lead to an outflow of a whopping 739 billion euros of bank deposits in Europe.

The deposit outflow would lead to hefty losses in banks’ total household deposit base (10%) and total bank liabilities (3%). The effects on highly-impacted institutions, e.g., smaller banks, would be enormous.

The CEO of Finance Finland, Arno Ahosniemi, highlights the possible complications for smaller banks. For them, deposits represent a crucial and cost-effective source of funding. Mass conversion of funds into digital euros could directly limit the ability of smaller banks to issue loans, which negatively influences economic activity.

Limiting holdings to 500 euros per person would confine the loss in deposits to 139 billion. However, it’s important to note that a lower holding limit would highly impact the adoption and usability of the new currency.

The digital euro would entail significant costs to commercial players

The large-scale project would incur significant expenses for the European Union. However, it would also lay heavy costs on commercial banks, payment service providers, and merchants.

The digital euro would present recurring expenditures to private financial market players long after its launch. Although the virtual currency is predicted to eventually decrease consumer prices due to smaller transaction costs, there’s a risk that the cost of implementation would counteract the positive change.

Furthermore, the expenses would primarily fall on banks. Banks would be mandated to distribute and include the currency in their service portfolios. Because of this, the current, carefully curated consumer experiences in banking would be highly affected and need reconstruction. Apps, web services, the processing and recording of transactions, fraud prevention, and Know-Your-Customer procedures, for example, would all be influenced. The costs for banks could significantly affect their innovation resources, leading to decreased quality of service and options for consumers – completely counteracting the EU’s mission of increasing innovation with the new currency.

Overall, the potential for financial losses with each digital euro transaction has raised concerns about the scheme’s sustainability.

The ECB entering the payments market it oversees could be problematic

Lastly, one of the digital euro risks lies in the dual role played by the European Central Bank. Traditionally tasked with overseeing commercial banks, the ECB’s entry into the digital euro space would position it as a direct competitor to these institutions – potentially causing disruption and conflict.

Aura Salla, a member of the coalition in Finland and the former Head of EU Affairs at Meta, has been vocal about the ECB’s confusing role. “The supervisor of credit institutions is looking to mess with the market by building a new payment system. This should be seriously questioned”, says Salla. “I am very concerned about the European Central Bank’s role in the digital euro project.”

Finland’s stance on the digital euro

Salla is part of the Finnish Parliament’s Grand Committee, considering Finland’s stance on the new currency. Salla describes the current Finnish position as “cautiously positive.” Her background adds valuable insight into the conversation, since she has experience from the technology industry’s failed attempts to create a digital currency. Facebook eventually shelved its Libra project due to regulatory challenges.

While Finland acknowledges the potential benefits of the digital euro, the practicalities of seamlessly integrating the currency into the existing financial system remain challenging. “Concrete answers on how the digital euro would function in practice are needed”, Salla concludes.

Salla’s concerns echo a broader conversation surrounding the European Central Bank’s venture. Stakeholders call for risk mitigation safeguards to be included into the scope of the new currency.

Despite critical considerations, Head of Department at the Bank of FinlandPäivi Heikkinen, notes that the central bank can’t afford to ignore the evolving financial landscape and must balance its evaluations with timely introductions of new payment methods.

Is the project too risky?

If well implemented, the digital euro has the potential to offer a secure, regulated, and stable alternative that aligns with the goals of PSD2 while enjoying the trust associated with government-backed currencies.

However, the ECB should test digital euro’s viability against various risk scenarios and periods of stress in the financial system. Risk mitigation will be pivotal in shaping a virtual currency that fosters a stable financial ecosystem.

Read more: Digital euro’s main benefits comprise plunging payment costs and increased security
Read more: Functionality of the new digital euro will focus on effortless consumer use

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European Central Bank: Financial Stability Review, May 2023
Copenhagen Economics: Effects of a digital euro on financial stability and consumer welfare
The European Banking Federation: Copenhagen Economics study on the impact of a digital euro on financial stability and consumer welfare
Finance Finland: Member of Parliament Aura Salla on the digital euro: Why is the ECB messing with the market by building a new payment system?