The concept of a digital equivalent to hard currency, regulated by central banks, is gaining global traction, with even the European Central Bank tinkering with a digital euro, as ECB executives the first issuances as early as 2027. Consequently, researchers are scrutinising its potential impact on bank deposits and monetary policy implementation to anticipate any unintended consequences, given that these are direct concerns for central banks.

Necessity

But why are digital currencies even needed? Convenience and cross-platform applicability are the prime reasons. For example, one can make person-to-person or person-to-business payments in cash, in other words, a digitally ‘offline payment’, but not suitable for ‘online’ transactions such as e-commerce payments and bank transfers. In contrast, while debit and credit cards are suitable for online purchases, person-to-person direct payments are not possible. Thus, comes into play retail central bank digital currency (rCBDC), to be available to the general public and business entities. In the case of a digital euro, they would be available for both offline and online transactions, at all times, 24/7. For central banks, this would save costs on printing, issuance, distribution, holding reserves, removing unusable notes from circulation, and so on.

So, in practice, a digital euro or any other rCBDC would represent an additional format of payment, which, based on convenience and customer preferences, could replace cash and/or card payments for goods and services. But it would also mean that, just like people keep cash and then spend it as needed, they would need to withdraw money from their bank accounts in the form of CBDC and keep it in a digital wallet.

Concern 1: bank deposits

Would rCBDC lead to a flight of deposits from banks? This is one of the major concerns of the banks, which would then limit their loan and other business capacities. ECB researchers Enea Caccia, Jens Tapking and Thomas Vlassopoulos look closely at this aspect, focusing in particular on the impact of rCBDCs on bank deposits and reserves. They argue in a published on 15 April 2024 that if bank deposits are conveniently converted into rCBDC, there would be less incentive for individuals to hold more rCBDC than needed. In other words, taking out cash from ATMs often leads to excess withdrawal than one needs, but if converting those amounts to rCBDCs is an easier and faster option, then people would withdraw only what is needed. This, in effect, might even lead to more money left in banks compared to the public holding of cash option.

Concern 2: monetary policy implementation

One of the primary responsibilities of central banks, aside from printing and regulating currency, is to manage monetary policy to safeguard the value of money. This includes adjusting interest rates to stimulate or dampen demand in response to factors like inflation or shifts in consumption and investment patterns. These adjustments affect the reserves held by the banking sector with the central bank. Therefore, when households and businesses would hold and use rCBDC reserves, it is expected to mirror the impact of physical banknotes on bank reserves. This consideration is crucial for financial stability and effective monetary policy transmission.

Additionally, in a banking crisis, an rCBDC could result in a significant loss of bank deposits, as depositors can withdraw large amounts in a very short period. To avoid this, a limit on the amount of rCBDC any individual user could hold is likely to be a critical feature. For the digital euro, a €3,000 to €4,000 holding limit per person is envisioned. Such a limit would have a two-faced effect. First, while the amounts are convenient for most day-to-day transactions, they are likely to replace cash holdings instead of additional withdrawals. Secondly, for monetary policy purposes, a zero-remunerated digital euro, even at the lowest ECB policy rate of -0.5% (between September 2019 and July 2022), would only be equivalent to €15 in savings a year compared to a negatively remunerated bank account equivalent to the ECB policy rate. In other words, a 0.5% savings on a €3,000 limit would not have a deterring effect on monetary policy transmission. In contrast, holding a zero remunerated rCBDC to its maximum limit has no added incentive compared to a positively remunerated bank account or savings. Thus, it is expected that people would withdraw rCBDCs only to the amounts that are needed.

In summary, while facilitating commerce and consumption, fine-tuning remuneration and holding limits of rCBDCs as merely a replacement of the more traditional kind, namely banknotes, would not have any significant impact on monetary policy implementation. However, the economist trio cautioned that if individuals en masse choose to exchange a portion of their traditional bank deposits for the newly introduced rCBDCs, financial institutions will face the task of financing this conversion. This means that banks will need to draw upon their reserves held with the central bank to facilitate the transition from conventional deposits to digital currency. This process entails reallocating resources within the banking system to accommodate the demand for rCBDC while ensuring the stability and liquidity of the financial sector.

This article was published for the Delano Finance newsletter, the weekly source for financial news in Luxembourg. .