The digital euro – right questions, wrong answer?

Central banks the world over have piled into central bank digital currency (CBDC) research and piloting. Problems identified by central banks are real and justify a response. Yet it is actually far from clear that CBDC is always the best solution to address the problems raised. Particularly in Europe, other policy responses may yield the same or better outcomes. This article looks at four prominent justifications for CBDC in the Eurozone: the need for access to public money in a digital world, the threat of large online platforms, excess dependency on non-EU payment solutions, and geopolitical considerations.

The European Central Bank Central (ECB) argues that “it is imperative to ensure that [people] continue to have access to central bank money” in an increasingly digital world. Public money is needed as a ‘monetary anchor’” (ECB 2022). But is it indeed the case that “private” money (such as bank accounts we all know and use today) can only function if people have access to central bank-issued money, such as banknotes and coins? The ECB-commissioned Kantar study (2022) into people’s payment habits struggled with the fact that many people don’t realise, understand or care about the difference between central bank and commercial bank-issued money. So perhaps people are perfectly happy to pay with digital “private” money, knowing that the central bank continues to be at the centre of the system, with a wide array of tools to guarantee the stability of money.

Large platforms are ideally positioned to integrate CBDC services into their payment system

The initial motivation for central banks to consider CBDC was to counter the threat of bigtech platforms issuing their own currency. Yet bigtechs issuing stablecoin not denominated in domestic currency, can effectively be addressed by regulation. The EU’s Markets in Crypto Assets Regulation (MiCAR) does exactly that, preventing such coins from becoming too large in payments. Meanwhile, domestically denominated stablecoins will require an e-money or banking license. Hence financial stability can be preserved by the full force of existing supervisory tools, and these coins are subject to domestic monetary policy as well. So why should CBDC be preferable over a well-regulated domestically denominated stablecoin?

But how then to prevent large online platforms from deploying digital currencies to increase user lock-in and further strengthen their dominant position? Well, legislative initiatives such as the Digital Markets Act seek to address this. And it is important to realise that platforms do not derive their lock-in power from issuing their own currency. Instead, they thrive by providing seamlessly integrated payments as part of an impeccable customer experience. As the BIS notes in a recent paper, a “core aspect of big tech business models is to run easy-to-use payment systems” (BIS 2022). In other words, it’s not about the underlying currency, it’s about the payment infrastructure on top of it. This means that a CBDC could in fact play into large platforms’ hands! Most of them are already licensed to act as Payment Service Provider. They are ideally positioned to integrate CBDC services into their payment systems, roll out solutions across Europe and thus further optimise their customer experience.

The digital euro is also positioned as a tool to avoid or reduce dependency on a small number of non-EU-based solutions. Yet here too the question arises whether the goal justifies the means. How is adding another form of digital currency going to help reducing existing dependencies? A CBDC will still need an infrastructure to actually use it for payments. A better targeted response to the concern of excess dependency would be to develop an alternative EU-based payment scheme for digital and online payments. Such a scheme could then process commercial bank money, stablecoin and even crypto payments – no CBDC needed.

Finally, an opportunity identified by policymakers is the possible use of CBDC as a tool to strengthen the euro’s position on global trading and financial markets. Yet a CBDC focused on a domestic retail audience, such as the digital euro, is unlikely to make an impact on such global markets. To strengthen the international role of the euro, a focus on large-value, cross-border and cross-currency payments would be needed.

Indeed the ECB and other central banks are looking into what is called “wholesale CBDC”, while private parties are also investigating digital currency platforms backed by central bank reserves. Yet wholesale digital currencies have very different characteristics and requirements than the retail variety. They are therefore generally treated as separate projects.

In short, while central banks and policymakers have put a number of very valid concerns on the agenda, it is highly doubtful whether a retail-focused CBDC is a sufficient or even necessary answer.

Article first appeared in Eurofi "Views" Magazine, August 2022.

Ethereum Proof-of-Stake may be a step towards broader adoption

The Ethereum blockchain is on the verge of a major and risky upgrade. This upgrade, if successful, would greatly reduce electricity use. This, in turn, would increase Ethereum’s acceptability to policymakers and financial institutions

An ambitious upgrade to the world’s second most important blockchain

After a long period of anticipation, and if final tests go well, the world’s second blockchain Ethereum will probably transition from “proof of work” (PoW) to “proof of stake” (PoS) later this month. This means that transactions on the Ethereum blockchain will no longer be recorded by miners that spend a lot of computing power to prove they worked hard to verify transactions. After “the merge”, transactions will be processed by validators, that have staked Ether (in other words, put collateral in escrow) that can be forfeited if it turns out they were acting in bad faith.

The discussion about the pros and cons of PoS vs PoW is almost as old as Bitcoin, and we can’t represent all arguments here. What we’re interested in, is that this transition to PoS may over time increase the acceptability of Ethereum, and all of the apps built on top of it, for policymakers and regulators. This in turn may provide a boost to traditional financial institutions’ willingness to develop Ethereum-based services.

Ethereum is not the first blockchain to adopt PoS. But it is generally considered the most important blockchain after Bitcoin, and Ethereum is a key building block of the decentralised finance universe. Moreover, Ethereum won’t go down for scheduled maintenance over the weekend to upgrade the network. Instead, as describes it, the new PoS-engine will be hot-swapped in mid-flight. A flight which hosts a variety of apps, tokens and platforms. What could go wrong?

The stakes for the upgrade are high

Indeed, while the Ethereum community has spent a lot of time testing PoS (the PoS testing ground called “beacon chain” has been running since December 2020), implementing such a fundamental upgrade while the network keeps running, is ambitious. As anyone who has ever tried to quickly upgrade the operating system on their computer will know, there are almost always unexpected hiccups that end up taking much more time than anticipated. We expect leading Ethereum developers to be pulling all-nighters glued to their screens during the upgrade.

Another question during the upgrade is how Ethereum miners will respond. They have invested in dedicated hardware, typically GPUs, that can no longer be used for mining Ethereum after the upgrade to PoS. Some miners may decide to continue the PoW-based blockchain, creating a “fork”. Such a duplication of the blockchain with all its tokens creates a variety of problems e.g. for exchanges and traders. Luckily, the crypto community has gained experience managing such forks over the years.

A successful upgrade would make Ethereum much more acceptable…

Describing all these challenges, you may start to wonder why Ethereum embarked on this project at all. Apart from improved scalability, the main reason is a drastic reduction in electricity consumption. claims a 99.95% reduction in electricity consumption following the switch to PoS.

An important non-technical consequence of this great reduction in electricity need is that it may render Ethereum more palatable to policymakers and regulators. When the European Parliament discussed the EU’s incoming Markets in Crypto Assets Regulation earlier this year, sustainability was an important topic. Policymakers are uncomfortable with the PoW consensus mechanism’s high electricity use. To be sure, the pros and cons of PoW vs PoS are food for a fundamental and often heated debate, which has many more nuances than the –admittedly impressive– kWh figures suggest. We cannot do justice to this debate in this short piece. It is clear though that the switch to PoS removes power consumption as a problem for regulators. This, in turn, removes one stumbling block for traditional financial institutions and other companies to offer Ethereum-based services, although other obstacles may remain.

…though Proof-of-Stake is not the answer to life, the universe and everything either

So what’s not to like about PoS? Apart from migration risks, PoS has its own challenges. For example, its code is much more complex than PoW. This may create new vulnerabilities. Hackers will certainly be exploring the new infrastructure for flaws. Another issue is that PoS creates a new form of inequality. With PoW, there once was a sense that everybody can join in and start mining. With PoS, in contrast, the “wealthy” can stake a lot of Ethereum and reap most of the validation rewards, further increasing their wealth. Yet the reality is more nuanced. PoS staking pools do provide opportunities for those with less Ether to spare. And with PoW on the other hand, the days that an old laptop was sufficient for mining, are long gone.

Some people worry about increased possibilities for censorship by PoS validators. Yet in principle, PoW miners could apply censorship as well. It is also not evident that PoS will lead to a more concentrated validator landscape than PoW, where miners have been cooperating in mining pools for a long time. In the end, it’s less the technology that makes the difference, but rather the attitude –and regulation– of those using it. More generally, there is a tradeoff between censorship resistance and the application of anti-money laundering and sanctions policies which are required to render cryptocurrency acceptable to regulators. In the end, compromises need to be struck here.

Ethereum’s upcoming migration from PoW to PoS may be the biggest planned event in cryptoland this year. The migration itself and its aftermath carry risks, and will be closely watched within the crypto community. A successful migration would be a compliment to the Ethereum community’s ability to manage big events. It would also remove an important obstacle to acceptability of Ethereum to regulators and hence development of Ethereum-based services by traditional financial institutions.

First appeared on ING THINK