The digital euro and its impact on banking

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To understand the digital euro, it is important to know what central bank money (also called public money) is. In Europe, banknotes and coins are the only form of central bank money available to the public. Central bank money is issued by public institutions. Private money is a currency created by commercial banks, for example, when a loan is granted. Central Bank Digital Currencies (CBDCs) aim to add a digital variant to central bank money.

Globally, Central Bank Digital Currencies are a hot topic among central banks. Over the last few years, a growing amount of these banks started research, prototyping, and pilot projects either by themselves or together with partners (e.g., Project Stella is a collaboration of the Federal Reserve, Bank of England, and European Central Bank).

The European Central Bank (ECB) is currently researching the potential of a CBDC. Together with the national central banks within the euro region, an internal working group and an external working group, consisting of industry experts^[i] and private companies^[ii], are working towards the development of a euro zone CBDC: the digital euro. Since the ECB announced their research of the digital euro in 2020, the direction and considerations of the digital euro as a concept have become increasingly clear as a growing body of research is being released. In this article we aim to answer what impact the introduction of a digital euro could have on commercial banks.

In the past decade we have seen the rise of a third type of money, i.e., the commercial digital currency, including distributed ledger technology (DLT)-based currencies such as ‘unstable’ cryptocurrencies (e.g., Bitcoin) and so-called stablecoins (incl. Facebook/Meta’s cancelled Diem/Libra), which have currently amassed a total value of over EUR 150 billion, up from EUR 115 billion last year. A currency not issued by a public institution taking the role of conventional payment method within the eurozone would negatively affect the extent to which the ECB would be able to execute monetary policy, and thus the monetary sovereignty of countries in the eurozone. Consequently, this problem creates a serious risk with a potentially high impact on commercial banks because a commercial currency will likely be less predictable than public or private money. Which in turn may actually increase the systemic risk of the whole financial sector.

In a speech to the US (United States) Monetary Policy Forum, ECB’s Fabio Panetta, member of the Executive Board of the ECB,  said that as a result of the rise of commercial currencies, banknotes could lose their role as a reference value in payments, undermining the integrity of the monetary system^[i]. The direct threat from commercial digital currencies to monetary sovereignty is currently limited due to their comparatively limited use as a payment method. A serious stablecoin initiative that aimed to become a proper alternative to common payment methods, ‘the Diem’, has also been cancelled by initiator Facebook (now Meta) in early 2022, after running into many regulatory roadblocks put up by the EU (European Union) and US governments. All Diem’s assets have been sold to a technology partner. This shows that government regulation is a way to prevent such initiatives from posing a threat to the eurozone’s monetary sovereignty. This regulatory pressure would also apply to other digital currencies (i.e., digital currencies not necessarily based on DLT (Distributed Ledger Technology)). Chinese payment methods WeChat Pay and Alipay gained a strong footing in the Chinese payment market. However, new legislation has been introduced by the Chinese government to prevent monopolies and duopolies in the payment market.

The threat of commercial digital currencies in the eurozone should not be exaggerated. If there is a threat of a commercial digital currency taking a significant share of payment volume processed in the eurozone, this could potentially be addressed through a CBDC according to the ECB.

A retail CBDC could provide a competitive alternative to any other digital currency currently trying to take a piece of the market, making the barrier of entry to the payment market potentially higher and lowering the threat of new entrants.

More interesting, cryptocurrencies are developing a new underlying infrastructure for settlements. Similarly, the Bank for International Settlements (BIS) recognizes that CBDCs have the unique possibility to do this as well. ^[ii] This could mean that CBDCs will not have to rely on incumbent and expensive systems, which would improve settlement finality, liquidity, and integrity of a potential CBDC.

The ECB launched the digital euro project in 2020 in order to preserve the role of central bank money in the digital age. The digital euro project focuses on a retail CBDC opposed to for example Project Jasper (initiative of the Bank of Canada, Monetary Authority of Singapore, Bank of England, together with private companies like HSBC and KPMG UK^[i]) or Project Jura (initiative of the Bank for International Settlements and the central banks of France and Switzerland), which are projects focusing on a wholesale CBDC. A retail CBDC allows access for all citizens and businesses to universally accepted means of payment, whereas a wholesale CBDC would be restricted to interbank payments and financial settlement processes. The ECB addresses three main reasons for the digital euro project:^[ii]

• Public money could ultimately lose its role as the monetary anchor in Europe if the use of cash continues to decline.
• Private providers cannot truly replicate the role of central bank money. Without a strong monetary anchor, it would create confusion about what qualifies as money.
• The digital private sector is dominated by a handful of providers that are headquartered outside of the European Union. This could exacerbate the risk of the European payments market being dominated by non-European solutions and technologies.

In addition to these main reasons, the ECB also addresses more intelligible motives for their EU citizens^[iii]:

• To be accepted, a digital euro must provide a benefit to users. Research has shown that what customers value most is broad acceptance, ease of use, low cost, high speed, security, and consumer protection, while merchants are looking for low cost, ease of use and integration with existing systems.
• Privacy protection must be of the highest standard, and users should be able to choose how much information they want to disclose – but always in compliance with the applicable law.

Widespread distribution should also benefit those parts of the population that previously have had no or insufficient access to financial services to make and receive payments, thereby enhancing financial inclusion (One can argue if financial inclusion is a real issue in the eurozone).

The number of publications on CBDC by the ECB has been increasing over the years. To begin with sixteen publications in 2020, followed by twenty-six in 2021 and in the first ten months of 2022 they released another fourteen publications. In these publications, the ECB has repeatedly made it clear that a digital euro will^[i]:

• be cash-like and complement cash, but not replace it;
• be linked to the euro;
• be available for all citizens and firms within the euro area.

The ECB is now in their investigation phase, which will continue throughout 2022. They also announced an implementation date of around 2024. During these years, significant architectural choices will have to be made. The ambition to achieve a universally accepted payment method for both online and physical stores across Europe^[ii] suggests that they aim to use the existing infrastructure, or at least the existing end-user interfaces/point-of-sale systems. The ECB announced they will work with five external companies to develop a potential user interface: Amazon, Nexi, Worldline, CaixaBank and the European Payments Initiative (EPI) ^[iii]. This would suggest that the ECB is opting for a hybrid system, where commercial banks will fulfill a significant role within the CBDC ecosystem.

Offline and/or online digital euro?

The ECB is experimenting both with centralized and decentralized solutions such as DLT. Even if it is not going to be blockchain or DLT-based, the digital euro could still be a token-based/value-based design. Since in a token-based design the token itself represents value, the token-based design can enable offline payment functionality. The ability to perform offline payments is a cash-like feature that adds an actual use case to the digital euro. This is something that the ECB has hinted at multiple times: 

From an inclusive perspective, it is desirable to have the digital euro function both in an online and offline environment. An online digital euro can easily cater to temporarily offline scenarios through the use of tokens as a store of value. This would introduce some risk of fraud; however this should be detectible once devices reconnect to the network. When there is a desire to have a digital euro that can function fully offline as well, things get more complex. Fraud will be much harder to avoid in a purely offline scenario. Therefore, it would be likely that there would be a maximum transaction amount for an offline transaction.

This offline functionality can also be viewed from a growing privacy perspective emerging from consultations and focus groups held by the ECB. It became clear that privacy is a highly regarded aspect that needs to be in place for a successful digital euro.

There are voluntary and involuntary unbanked/financially excluded people. If opening a(n) (offline) digital euro wallet is more accessible than opening a bank account, this may enable involuntarily unbanked people to become banked. Those who are voluntarily financially excluded, however, would still have to open an account with a bank, unless it becomes a possibility to open a digital euro wallet without performing KYC (Know Your Client). Accounts without KYC might make fraud detection and prevention more difficult. Severe restrictions on the functionality of the wallet might be required, something that for example the wallet for Sand Dollar CBDC in the Bahamas has implemented. Depending on the restrictions, the benefit of a digital euro wallet over cash might become less favorable.

In summary, it is still unclear whether, when and how the digital euro will be implemented in the current payment landscape. Most likely a hybrid scenario will be rolled out: this would use the existing roles for the commercial banks and central banks in the context of a digital euro (i.e., central banks do not have to deal with KYC/onboarding, commercial banks retain a gatekeeping function). A fully offline solution will be more complex to roll out due to the obligation to combat financial crime, hence an online digital euro will likely be rolled out before an offline digital euro. An offline digital euro could potentially be an add-on to the online digital euro variant.

It will, however, have a notable impact on commercial banks when it is implemented. In order to address this upcoming challenge, the following chapter will try to shed light on the implications for commercial banks.

Considering the current state of the digital euro and its direction, commercial banks will need to adapt in order to be able to provide the digital euro-related services that are expected of them. We will highlight three fronts where adaptations need to take place: Finance & Risk, IT & Operations, and HR & Marketing.

Finance & Risk

Facilitating digital euro wallets for consumers would directly affect liquidity and potential capital requirements, in turn affecting reporting, treasury, and risk requirements. Liquidity as the core agent of change is related to maintaining sufficient digital euro balance in order to satisfy the demand of their customers. This could take the shape of either just-in-time delivery of digital euros by means of real-time exchange of fiat euro currency with digital euro at the Central Bank or maintaining a digital euro reserve that can be called upon. If not all banks will or can connect to the digital euro systems, these unconnected banks would be dependent on correspondent banking. This would reinforce the need of a reserve for such a bank in case issues arise in the service provisioning between the two banks.

As merchants receive digital euros but may not be allowed to maintain a balance over a certain threshold, commercial banks in an acquiring role would need to exchange the digital euros received by the merchant for fiat currency at short notice. This would help in balancing out the digital euro demand from consumers, but periodic balancing to optimize liquidity would in practice always be a necessity. Furthermore, depending on the ability to lend digital euros (e.g., by enabling customers to maintain a negative balance), commercial banks would need to reevaluate their capital requirements. This would go hand-in-hand with changes to the bank’s risk models (less stable funding).

Combined, the above would require changes in regulatory reporting as well. Any future requirements regarding reporting related to digital euro are not yet defined, however, current digital euro holdings would need to be included. A bank’s treasury system will need to be able to accommodate for these changes. As the digital euro functionalities and characteristics are being developed now by the ECB, KPMG advises key stakeholders of the financial system to participate in the discussions ongoing in the market.

IT & Operations

Maintaining digital euro wallets as part of a two-tier (or ‘hybrid’) model will require commercial banks to fulfill a role as gatekeeper. This requires extensive KYC and AML (Anti Money Laundering) capabilities, in addition to those they currently have or are currently developing. When opening a wallet, customers will need to perform KYC. When looking at the inclusion principle, however, there might also be an option for a minimum KYC wallet (or even zero KYC) to ensure that there are minimal barriers to adoption for the currently unbanked. Such wallets would probably have restricted functionality (e.g., no P2P payments, low value transactions only, no e-commerce transactions).

Commercial banks will need to ensure that all digital euro-specific privacy requirements are met, even during transaction monitoring and filtering. Also, depending on potential implementations of an offline digital euro, transaction monitoring may need to be performed ex-post. This has the potential to create additional complexity in the bank’s AML and KYC capability with which many banks are already struggling to keep up.

Any digital euro holding thresholds would also need to be enforced: if commercial banks cannot verify how much digital euro a customer is holding at other financial institutions, it would be trivial for customers to exceed the maximum digital euro holding threshold by opening wallets at multiple banks. This would become even more complex in the case of offline digital euro wallets.

KPMG foresees that there will be a need for a reliable and secure IT infrastructure on which banks can build their digital euro functionality, related to integration with the Central Bank digital euro infrastructure, wallet opening functionality, treasury changes, risk modeling, ATM interfaces and infrastructure, and integration with mobile banking platforms. The digital euro will require additional functionalities and IT changes from commercial banks. It is recommended to keep this in mind when creating multi-year strategy plans.

HR & Marketing

Before digital euro wallets can be implemented, the right knowledge is required. Commercial banks will need to hire and train the right talent. With many other financial institutions also eager to hire similar talent, this will not turn out to be a trivial task. KPMG believes commercial banks should already have started creating an internal proposition team focused on the digital euro, as the future thought leaders on the digital euro are rising now.

Next to internal employees, European citizens will need to be educated in order to support the adoption of the digital euro as well. Education and marketing are strongly intertwined and users will need to be informed about the existence of the digital euro, educated in how it works, informed on where the digital euro is accepted, and whether their bank supports it. It remains a question whether the ECB, local governments, commercial banks, or an independent third party should be the best option to facilitate the education on this subject, in order to include as many Europeans as possible, including those who are less inclined to support the EU as a unified institution.

KPMG believes that visibly positioning oneself in the market as the most favorable bank to maintain a digital euro wallet will allow a bank to steer its brand further towards a bank of the future: digitally enabled and customer centric. 

1. How can a commercial bank prepare for a digital euro that is to come?
2. What desired and undesired impact could the digital euro have on a commercial bank?
3. What partners do commercial banks need to engage in their digital euro ecosystem?
4. How does the digital euro wallet affect the risk system of the bank?
5. What additional legislation will the digital euro bring for commercial banks?
6. How will the liquidity for the CBDC be safeguarded? And what will be the role of a commercial bank?
7. What kind of expertise does a commercial bank need to possess in order to implement and execute the digital euro?
8. Who will be responsible for guiding and educating EU citizens in using the digital euro wallet?
9. What costs will be involved with implementing a digital euro?
10. When will a commercial bank need to start preparing for the digital euro?

Reinoud van den Wall Bake

Senior Manager, Digital Strategy

KPMG in the Netherlands

Wouter Montanus

Manager, Digital Strategy

KPMG in the Netherlands

Jan Blomme

Senior Consultant, Digital Strategy

KPMG in the Netherlands

Levi Kamsteeg

Consultant, Digital Strategy

KPMG in the Netherlands