Digital Euro

Will the digital euro offer added value for banks and the German retail sector?

Typically, many of the topics that industry experts consider exciting are of absolutely no interest to the majority of society. This is particularly the case when it comes to nerdy payment topics that have no overlap with the banking industry. However, the digital euro, i.e. the European central bank currency or also known as the Central Bank Digital Currency (“CBDC”), is not such a niche topic, but rather the question of whether a further, legal and entirely digital means of payment should be made available in addition to cash. Of course, it is now possible to write another article on the reasons why the introduction of the digital euro makes sense or does not make sense, or to summarise the current status of the development of the regulations. However, there are already numerous publications on this subject and the content should therefore be familiar to you as a recipient in one way or another.

For this reason, we would like to take a different approach and address the question of what impact the digital euro could have on German banks, apart from the predicted liquidity problems resulting from the migration of the bank’s book money deposits to the digital euro account. In addition, we also examine the impact on the retail sector and payment service providers that are necessary for the successful introduction of the digital euro. These considerations are particularly interesting from our point of view, as the ECB and the German banking landscape have not yet formulated a solid reason for this currency. Apart from this, we consider the original intention of European legislators to distance themselves from the increasing influence of payment market leaders on the other side of the Atlantic, such as VISA or Mastercard, and the desire for a digital Europe.

Before answering this question, however, we would like to briefly introduce the topic and explain what exactly the digital euro is all about and which participants are affected by its introduction.

What is a digital euro and what isn’t?

According to the ECB, the digital euro would be an “electronic means of payment that is available to everyone free of charge. Like cash today, you could use a digital euro anywhere in the eurozone, and it would be secure and private.” Derived from this definition, the digital euro should be a legal tender analogue to today’s cash – which is particularly popular among the German population – with all its advantages and disadvantages. To fulfil this, retailers must accept the digital euro both online and offline using a wallet solution or a card, with very few exceptions (shops that do not currently accept card payments, generate less than EUR 2 million in turnover and have fewer than 10 employees).

The digital euro is not a cryptocurrency, which BaFin classifies as a digital financial instrument and can be used for payments as well as for investment and speculation. Apart from the Markets in Crypto-Assets Regulation (MiCA), cryptocurrencies have a low level of regulation, are very volatile and do not have deposit protection, which places them at the high-risk end of the scale compared to a central bank digital currency such as the digital euro. Transactions are carried out using decentralised authorisation methods by drawing on the computing power of individual users The digital euro is intended exclusively as a means of payment, which is authorised on a central platform called the digital Euro Service Platform (“DESP”) and, according to the ECB’s current plans, stored on a centralised blockchain.

Who is affected by the introduction of a digital euro?

 Like the familiar four-party model in credit card acquiring, the digital euro also provides for clear participants and their tasks.

The most prominent participant in the digital euro is the European Central Bank, which defines the rules for participation in the digital euro and in this way assumes a role analogous to that of the European Payments Council (EPC) in the SEPA scheme. In addition, the ECB provides the authorisation platform (DESP) for processing transactions and the corresponding interfaces for banks and service providers.

In addition to the ECB, there are also the commercial banks of the payer and the payee. These act as intermediaries between the ECB and their own customers and, following successful registration, take over the KYC/AML process on behalf of the ECB and integrate the interfaces into their core banking systems, payment transaction logics (funding/defunding/waterfall (reverse)) and online banking applications.

On the acceptance side, the service providers, which include network operators, acquirers and payment service providers, are positioning themselves to prepare for the legally mandatory acceptance of the digital euro for merchants and to roll out acceptance to the (virtual) terminals after connection to the ECB’s authorisation platform.

However, the focus should be on the user, who should ultimately use the ECB’s solution or the ECB’s interfaces embedded in online banking to help the central bank currency succeed.

What influence does the digital euro have on participants in Germany?

As the digital euro is currently only intended as a means of payment in the retail banking segment (retail CBDC) and therefore does not take mass payment transactions (wholesale CBDC) into account, the success of the digital euro depends on consumers. Apart from the fever dreams of some internal bank PR departments, only 43% of German citizens are familiar with the term digital euro, according to the Bundesbank. Almost 80% of a representative sample of the Bundesbank do not consider the digital euro to be useful or actively oppose its use and fear dystopian scenarios reminiscent of George Orwell’s “1984” due to the supposed loss of anonymity. However, anonymity and data protection are just two symptoms that symbolise German consumers’ rejection of the digital currency and demonstrate that the desire to introduce the digital euro is more political in nature and less demanded by the actual user.

The consequences of the discrepancy between the government’s desire for use and the requirements profile of consumers are illustrated using existing solutions. Contrary to the ambitions of national central banks, established CBDCs such as the eNeira (Nigeria), the Jam-Dex (Jamaica) or the Sand Dollar (Bahamas) have a very low usage and acceptance rate. Reasons for this include a lack of trust in the government of the countries, low acceptance in trade and the widespread use of alternative payment methods, such as cryptocurrencies. Several years after the introduction of CBDCs, it can be concluded that the low uptake among the population is due to the fact that government solutions were presented for problems that were not perceived as a problem by the citizens and that actual existing and addressed needs were not taken into account at government level when designing the CBDCs. A counterexample is the Chinese e-yuan, which is becoming increasingly widespread among consumers and traders. The scope of application of the e-yuan was expanded in the summer of 2023 when the Shanghai Clearing House, a clearing house for financial services under the Chinese central bank, began clearing and settling the digital yuan for commodities trading, thus taking a further step towards the institutional introduction of the Chinese central bank’s digital currency.

In the event that the digital euro is accepted by the European population, this would have a strong impact on the banks’ business model, given that acceptance by retailers is not based on standard market criteria but on the state obligation. This could result in a possible shift in transaction figures towards the digital euro, whose transaction processing is free of charge for the consumer. In addition, the acceptance of the digital euro incurs costs that can only be refinanced proportionally via a transaction fee charged by the payment service provider.

Initially, German banks will have to come to terms with their new role as an extended arm of the ECB, as they will have to carry out the KYC and AML processes based on the master data of all customers with an existing contractual relationship. Despite the fact that the bank only carries out this process on behalf of the ECB, it will, as far as is currently known, bear the resulting investment for staff development and implementation costs. The consumer can subsequently top up the digital euro wallet by SEPA transfer from the current account and view balances via the ECB app or the information transferred to the online banking of the bank via the ECB interface. At the POS and in e-commerce, payments are made with the wallet or a card. It is currently not known who will assume the issuing obligations apart from the processing service and whether there will possibly be a co-badge as a supplement to existing cards. However, it is known that payment service providers are allowed to charge a transaction-based fee and a fee for possible transaction risks. Nevertheless, the desire for banks to participate in these transaction-based fees is foreseeable. In this context, it is worth mentioning that wero (European Payment Initiative) is set to launch as a private-sector wallet solution in 2024 and initial considerations regarding the embedding of the digital euro in the wero ecosystem are being publicly discussed. Such a partnership is particularly strategically interesting from wero’s perspective, as the spread of the wero wallet within the European currency area could be increased by integrating the digital euro as a legal tender.

It is currently not known how participating banks can refinance the costs incurred for the introduction and operation of the digital euro. As the services classified as basic services according to the ECB, which include payment transactions, customer onboarding and the operation of the wallet, are to be provided free of charge, the costs incurred can only be refinanced via a share of the merchant fee.

Questions remain unanswered not only for banks, but also for service providers who are to map the acceptance side of the digital euro. Like the banks, network operators, payment service providers and acquirers must connect to the ECB’s authorization platform and have acceptance tested and approved at (virtual) terminals before it can be rolled out to over a million physical devices. Unlike the banks, however, payment service providers are allowed to charge a standard market transaction-based fee. As acquiring processing in the traditional sense is no longer required, the investments made can certainly be compensated for with one or two cleverly implemented service fees. Nevertheless, it is questionable how service providers from the traditional acquiring world can respond to the challenges of the digital euro, such as the instant processing of transactions and an account-to-account infrastructure. Furthermore, it remains to be seen whether network operators and acquirers will be able to apply their original business model to the digital euro if transaction processing and merchant payout are the responsibility of the ECB and the payment service provider takes on the tasks of infrastructure provider and customer service center for the digital euro. In particular, the support of customers and merchants during ongoing operations and in the event of a disruption or malfunction is critical to success and the corresponding responsibilities must be conclusively clarified before the market launch. From a purely technical point of view, the introduction of wero with the digital euro as the balance on the wallet might actually be the most charming solution. After all, PayPal is also doing very well with the staged wallet approach and a little inspiration wouldn’t hurt.

Ultimately, retailers will also have to come to terms with the legally binding acceptance of the European means of payment. Even if a new means of payment initially looks like an unnecessary fragmentation of the European payment market from a retail perspective, there may also be advantages. For example, the costs for intra-European transactions could be reduced by using the digital euro instead of the established payment systems. In addition, the costs for cash handling would be reduced. Customers who still want to pay with cash can easily use this as a payment method. Retail companies could also continue to strengthen their customer loyalty by paying out cash at the point of sale. Nevertheless, it should be noted that the ECB’s current plans stipulate that the balance on each merchant wallet must always be set to €0.00 in order to comply with money laundering regulations and to ensure that the maximum holding limit is not exceeded. This can lead to an increase in accounting items on the merchant’s respective account and can become costly without a corresponding revenue pooling solution from the payment service providers. However, a closer look at the members within the Rulebook Development Group reveals that there are enough representatives of European payment service providers to ensure that these points are addressed and the relevant interests are represented. As private individuals are only allowed to hold one digital euro wallet, it is easier to check the maximum holding limit and comply with the digital euro rulebook.

By when should the relevant questions be clarified?

Following the completion of the investigation phase for the introduction of the digital euro in October 2023, which included the development of the functions, the technical requirements for the digital central bank currency and the rights and obligations of the participants, the preparatory phase will now follow. In this phase, minimum requirements for user-friendliness, relevant brand and communication standards, the process and procedure for certification, including the necessary testing and authorisation procedures, internal regulations and risk management will be included in the current draft of the regulations. With the completion of this phase, nothing stands in the way of piloting the digital euro – assuming that the EU Commission is in favour of a digital euro.

Does the digital euro represent a real alternative to existing payment methods for consumers?

Regardless of whether the digital central bank currency is introduced, the question is how consumers will react to it. The added value of the digital euro is not tangible for many consumers, as cash, debit and credit cards are perceived as sufficient for everyday use.  Many people are unaware of the difference between e-money and a digital euro and, on closer inspection of everyday use, there is no real differentiator. The argument of secure deposits in central bank money also misses the reality of many people’s lives, as they have deposit protection up to a sum of €100,000 at their bank and the deposits there earn interest. In addition to this, consumers have been adjusting to the advantages of familiar payment methods and their use for years. Credit cards are often used to circumvent liquidity bottlenecks, unlawfully authorised transactions are reclaimed with the help of chargebacks and value-added services create benefits in the form of insurance, cashback solutions, loyalty programmes or discount campaigns. Cash is anonymous and is accepted without exception within the currency union in which a digital euro would be used. It is still unclear what real problem the digital euro solves and whether consumers will have to use another wallet in addition to solutions such as Apple Pay, PayPal, Klarna and others, or whether EPI will become the successful staged wallet.

From today’s perspective, a digital currency is the prototype for an experiment that could result in very interesting aspects for a more digital Europe. However, it is unclear whether the digital euro will experience the use that the ECB is currently hoping for, which use cases will dominate, which payment methods will suffer or even gain, and it will only be possible to make a final assessment after the market launch.