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Last month was a big one for blockchain. The mighty European Central Bank (ECB) announced it would use a distributing ledger technology (DLT) for settlements, creating a blockchain-style platform for settlements in central bank money. One that’s interoperable with the existing TARGET Services, which is a cross-border payment system.
Though a roadmap, deadlines and full technology details are not yet available, the ECB’s aim is to create one “as soon as feasible”.
Additionally, the ECB is developing plans to build a system for settling DLT-based transactions in central bank money that will include foreign exchange.
“We are embracing innovation without compromising on safety and stability,” said ECB Executive Board member Piero Cipollone, who oversees the initiative. “This is an important contribution to enhancing European financial market efficiency through innovation. Our approach will pay due attention to the Eurosystem’s goal of achieving a more harmonised and integrated European financial ecosystem.”
Why go to all this effort? The ECB said it wants to innovate safely in a stable way while also improving financial market efficiency.
But Jordan Kalaitzoglou, Professor in Finance at Audencia Business School, says sovereignty is another motivation. Or at least a benefit. “Monetary integration a couple of decades ago introduced a common denominator (of value) to all transactions within the Euro member states, which was further enhanced by the Capital Markets Union being the natural evolution that promotes marketplace integration,” he explained.
Though that created a common token – the Euro – settlement is performed separately. “The introduction of a DLT-based clearing mechanism is the natural next step that will complete the package,” he said, where everything can be managed in a single unified environment. “In this, the EU, as a sovereign entity, can have full control without relying on external (to the EU) entities.”
Either way, the ECB hopes this step into the world of blockchain will lead to serious benefits. Distributed ledger technology is decentralised and verifiable, which means interactions with the ECB can be recorded and checked in a standard way. Without the need for a central depository.
And this does come with a host of advantages, including fewer errors and being fully accessible to everyone taking part. “Initially, DLT will be introduced centrally, referring only to the ‘printing money’ services of the ECB – interactions with central bank money,” Kalaitzoglou said. “This is the equivalent of digitizing the mechanics of money circulation.”
Settlement is just one part of these financial systems, but once in place it enables further steps towards modernising central bank interactions – and more.
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All of this will enable CBDCs, or central bank digital currencies. “In my opinion it is not necessarily an essential evolution, but it is definitely a harmonization of a dated settlement system with modern technology,” said Kalaitzoglou.
“Should the digital currencies become a universally acceptable denomination system, a DLT-based settlement would be needed. I believe that they will continuously gain market share and thus, acting now, is a preparatory action to accommodate the ‘future needs’ of a digital-currency based system.”
Excitement in CBDCs soared back in 2019, when Facebook announced its own digital currency, Libra. Libra was famously short-lived, disintegrating by 2022. However, its mere existence along with fears over the People’s Bank of China creating its own CBDC sparked concern that existing central banks would be left in the dust.
There have been CBDCs before. Ecuador launched Sistema de Dinero Electrónico in 2014, but it shut down four years later amid a country-wide financial collapse. Ecuador now uses the US dollar. Cambodia sort of created one, but it was more of a faster payments system. And the Bahamas has its own, the Sand Dollar.
A CDBC doesn’t require blockchain to run – Ecuador didn’t use one – as there are other ledger systems. But, regardless of the underlying technologies, Kalaitzoglou sees digital currencies as the end game. “I strongly believe that this would be a natural evolution, if not the ultimate objective of this initiative,” he said.
Having digital currencies on a DLT offers visibility, he explains, and the ensuing benefits must be of interest to governments. “All interactions are recorded and accessible by the participants of the settlement,” said Kalaitzoglou.
“Depending on the design of the DLT platform, governments and tax authorities can access all transactions with evident benefits to national or European taxes. Consequently, national governments have the incentive to adopt a CBDC and consequently a DLT-based clearing mechanism.”
However, as Kalaitzoglou notes, there were benefits to the analogue way of doing business. “The ‘old money system is based on coins and banknotes that offer anonymity,” he said. That brings freedom of resources but also translates to a lack of traceability, leaving such systems susceptible to tax evasion.
Digital currencies, on the other hand, require a digital ID or digital wallet – and that inherently sacrifices anonymity. “This can help with taxes, but all facets of consumption would be available to the authorities,” he noted. “An issue of trust and a moral hazard are issues that will eventually need to be discussed openly.”
The shift to CBDCs also challenges the “very existence of intermediaries” he said. “Currently, the plan is to keep the interactions of central banks with the ECB intact, with the only difference of introducing digital denomination and settlement (DLTs).”
That leaves the “money printing” function in place, with the ECB overseeing central banks who then work with intermediaries such as banks. Who then deal with the rest of us. But a further shift to DLTs and digital wallets means we may not need all of those intermediaries in the future – and that could have serious implications on how we organise economies and currencies.
Kalaitzoglou points out that intermediaries have a role when it comes to managing risk and liquidity, among other useful services. That means we, and the ECB, need to ensure these new systems are carefully designed to address such challenges. “So, although the emergence of CBDCs and DLTs (now on ECB but ultimately in public) seems to be the way to go, its design is what will determine whether the final outcome will be positive,” he concluded.
