European Central Bank President Christine Lagarde recently told lawmakers that inflation was easing, but warned of geopolitical risk and trade concerns. She also took the opportunity to reiterate the need for a digital euro, which she said would ensure a degree of digital independence: “payments are the backbone of our economy, and Europe cannot afford to be overly dependent on external providers”.

Lagarde’s concerns are not surprising, given geopolitical conditions, and that ways that payment technologies and behaviours are evolving. In the euro area, the use of cash to make in-store payments declined from a 79% share of al payments to 59% between 2016 and 2022. In some countries, such as Denmark, the trend is especially pronounced, with a significant majority of customers opting not to use physical cash. Moreover, EU policy research suggests, payment service providers increasingly only issue cards issued by international payment schemes, a state of affairs that “calls into question market efficiency in terms of costs, competition and governance, as European payment service providers have little or no influence on the market’s development.”

Add broader geopolitical questions about the global economic order (and the challenge posed by cryptocurrencies) and we can understand the impetus for policymakers to maintain a degree of control over money and payments.

Enter the central bank digital currency (CBDC), a digital version of a country (or area’s) fiat currency. Unlike Bitcoin or other cryptocurrencies, CBDCs are legal tender and are equivalent in value to the existing fiat currency. In other words, a digital euro is, for all intents and purposes, a euro. A digital pound would be a pound. And so on.

And rather than replacing existing fiat, digital currencies are touted as a supplementary form of the local currency that can be used to make digital payments.

The meaning of money

But there would be practical differences. And these could have profound consequences. The way that CBDCs are designed is crucial. The specifications of an official digital currency will determine the effects digital currencies could have on banking and the entire financial system. Get it wrong and you could seriously disrupt the economy.

Precipitating a bank run

What if the central bank created easy-to-access, free digital wallets that let any resident safely store their digital currency and make instant, free transfers or payments. Would they still need banks?

And suppose the CBDC was interest bearing, so that holders earned a return on their saved digital assets. In that scenario, it would be rational to move your cash saving out of your bank and into your digital wallet. Banks could see a downturn in deposits. In the short term, strong incentive to move cash deposits to digital wallets could initiate a bank run. A sufficiently disruptive CBDC design might see banks becoming obsolete altogether.

The end of fractional reserve banking?

The threat of bank disintermediation sounds like an existential concern for bank execs. But what does it matter to the rest of us? For one thing, banks don’t just hold our money; under the fractional reserve banking system, they create it. Disrupting that process would be a fundamental re-ordering of the monetary system, with reverberations across the economy. In principle, money supply could dry up, immobilising investment and halting growth.

This simplified sketch is by no means exhaustive. (For a thorough overview, see this Federal Reserve Board paper for a summary of the research on the macroeconomic consequences of CBDC). The point is that money doesn’t simply exist: the technologies and policy decisions that influence the money supply and the very nature of money play a critical role in shaping the broader economy and, consequently, our daily lives.

Status quo anxiety

CBDCs threaten to profoundly transform our economy, for better or worse. But will they? A European Central Bank working paper points out a critical distinction. We should consider not just the theoretical implications of CBDCs, but also how digital currencies are actually being developed by central banks. As the paper points out, “all central banks working on CBDC have announced that CBDC would not be remunerated, that holdings would be limited, and that CBDC issuance would aim to preserve the roles of central bank money in retail payments in a digitalised world”.

In other words, CBDCs – as mooted by central banks – won’t bear interest and there would be limits to how much digital currency an individual could hold in their (non-bank) wallet.

The paper also suggests that residents’ digital currency and bank holdings would effectively constitute a single pool of funds, with accounts holders easily transferring cash between those accounts. In the ECB’s proposed approach, if your CBDC wallet’s holdings exceed the permitted value, the funds would automatically be transferred to your designated bank account. And similarly, if your CBDC account’s funds are inadequate to perform a transaction, funds could be automatically transferred from the designated bank account.

Considering the generally conservative character of central banks, these proposals are not surprising. CBDCs may be cutting edge, but in an age of disruptive tech – and where innovations like cryptocurrencies pose a challenge to central bank power – merely keeping things broadly the same may require more intervention.

New frontiers of monetary policy

At the same time, we should not downplay the transformative potential of CBDCs. Digital currencies could give central banks more precise and innovative monetary policy options. For instance, a stimulus program could take the form of central banks directly adding digital cash to residents’ digital wallets (as a form of ‘helicopter money’).

Programmable CBDCs confer even more flexibility. Central banks could program stimulus payments that have a built-in expiry, so recipients are incentivised to spend the cash. Or payments could be programmed so they can only be used for certain goods or services.

Moreover, as the ECB paper itself acknowledges, central banks reserve the right to introduce new features to CBDCs in the future. The technology introduces wide-ranging new possibilities, whatever the current policy choices.

The buck stops where?

Digital currencies also raise new questions about sovereignty and power. So far, we’ve presented CBDC account limits as a prudent measure to mitigate disruption to the financial system. But who should determine those limits, central banks or lawmakers? In other words, is it a political question or an extension of central bank’s monetary policy independent? The issue is already a source of tension in Europe. It’s a salutary reminder that technology, politics and monetary policy don’t exist in isolation.

All opinions, news, research, analysis, prices or other information is provided as general market commentary and not as investment advice and all potential results discussed are not guaranteed to be achieved. The information may have been derived from publicly available sources, company reports, personal research, or surveys. Past performance is not indicative of future performance. Trading carries risk of capital loss. Service available to professional clients only.