As the European Central Bank prepares to launch the investigation phase into a potential digital euro (D€) next month, Ian Hall takes stock of eurozone central banks’ digital currency explorations to date
Central bankers need to ‘roll up their sleeves’ and ‘accelerate work on the nitty-gritty’ of central bank digital currency (CBDC) design.
So urged Benoît Coeuré at the Eurofi Financial Forum a couple of weeks ago. The Bank for International Settlements (BIS) Innovation Hub head went on to say that central banks worldwide were “stepping up efforts to prepare the ground for digital cash”.
The European Central Bank (ECB) is one of the most influential organisations doing precisely that. The Frankfurt-based authority announced in July that an ‘investigation phase’ into a potential digital euro – or ‘D€’ as per an increasing number of references – would run for 24 months.
‘We will look at how a digital euro could be designed and how it could be distributed to merchants and citizens, as well as the impact it would have on the market and the changes to European legislation that might be needed,’ the ECB states.
Once the investigation phase – which will get underway in October – has concluded, the ECB will decide whether or not to start developing a D€. ‘We would then create and test possible solutions, working together with banks and companies which could provide the technology and the payment services,’ the authority explains.
What do you think of it so far?
Technical explorations – or, if you prefer, nitty-gritty – have already been pretty extensive within the Eurosystem, which comprises the ECB and the 19 national central banks of the European Union (EU) member states that use the euro.
The pre-summer holiday season saw a mini-flurry of publications from some of the Eurosystem’s most CBDC-engaged central banks, which had spent the previous six-plus months investigating different aspects of a potential D€’s design (and then reporting back to the ECB).
Their research sometimes involved private companies, academia and/or co-experimenting with their fellow central banks. For example, blockchain and digital ID-focused experimentation led by Estonia’s central bank (Eesti Pank) saw co-working with the central banks of Spain, Greece, Ireland, Latvia, the Netherlands, Italy and Germany (as well as the ECB itself).
Broadly speaking, the multiple central bank-led endeavours have brought positive news for D€ enthusiasts. ‘The experimental work that has been done so far has shown that there are no major technological restrictions to issuing a digital euro’, the ECB stated in its ‘Digital euro experimentation scope and key learnings’ nine-page document (also published in July).
As the ECB rolls the turf for its investigation phase, a delve into the aforementioned research (which ran across four workstreams) unearths numerous questions (and quirks) likely to keep CBDC explorers busy over the next couple of years. These range from ID-related concerns that groups such as ‘foreign students’ could be excluded from D€ use through to the relevance of Europe’s semi-conductor manufacturing problems.
Estonia’s blockchain verdict
The Eesti Pank-led workstream focused on examining the suitability of the KSI Blockchain, a core technology of the Baltic country’s renowned e-government systems, for supporting the digital money infrastructure of a central bank (for example, the D€).
‘The experiment established that a novel blockchain-based solution could in theory support almost unlimited numbers of payments being processed at the same time with a very large money supply and with a smaller carbon footprint than the card-payment system,’ said Eesti Pank in a press release on its conclusions, adding that the blockchain-based solution ‘would also permit a good balance between privacy and the need to meet anti-money laundering [AML] requirements.’
Its experimentation – which saw digital payments made between people with digital identities from Estonia, Latvia, Lithuania and Spain – overcame some of what are described as ‘earlier bottlenecks’ in blockchain technology, such as low performance and high energy costs.
‘This technology does not set any essential limits on the size of the money supply. The system is able to handle the entire supply of euros in circulation and more, and there are no limits on the number of money-holders or on the number of payments made simultaneously,’ Eesti Pank stated.
‘The digital euro system built during the test handled over 300,000 simultaneous payments a second and the money reached the payee in less than two seconds. The estimated carbon footprint of the new system was smaller than that of the card payment system currently in use.’
‘Potential interoperability constraints’ with eID
Eesti Pank’s research also focused on ‘eID’ (electronic identification) matters. The EU’s eIDAS (‘electronic identification and trust services’) regulation is important here.
Its 17-page report stated that its research had showed that eIDAS-compliant eID solutions and certificates could support the core principles and key requirements of a D€, such as privacy. However, it warns of ‘potential interoperability constraints’ given inconsistent implementation of eIDAS. ‘The European Commission’s proposed update to the eIDAS regulation may help address some of these obstacles,’ it states.
‘Identities accredited using the current eIDAS standard alone do not contain sufficient information to automate all the AML and KYC [know your customer] checks,’ it continues.
‘A national eID may for instance not be sufficient for determining whether a given person is a euro-area resident, as it may not provide incontestable evidence of the current address of the individual, since the address shown in a national ID may not be up to date. Other potential alternatives such as population registers, electoral registers or tax rolls might help address these shortcomings, but a lack of standardisation or the potential exclusion of certain groups like foreign students may prove important limitations.’
One practical approach could be to require an ‘updated proof of address’ as part of the authentication process every time a payment transaction with the D€ is initiated, it states. ‘The choice of accreditation that is considered valid evidence of address may vary by jurisdiction. The cost and operational implications of this approach need to be explored further.’
‘Pan-European uptake of national eID schemes notified under the eIDAS regulation appears to be very limited in practice because the interoperability of national eIDAS nodes is only partial, national eIDs have a modest footprint, and there is quite a narrow range of public and private services that these nodes connect to,’ it continues.
The Estonian report adds that ‘another notable shortcoming’ is the exclusion of non-EU citizens because there is no mutual recognition of eID schemes outside Europe. As a result, existing eIDAS-compliant eID solutions could potentially fall short in meeting the Eurosystem’s policies and objectives, in particular that the D€ be widely accessible.
But is there light at the end of the tunnel? The Eesti Pank-led experimentation successfully integrated an interoperability (‘custodial’) layer within the D€ proof-of-concept infrastructure to tackle this constraint of existing eID solutions. In the medium-term, recently proposed EU digital ID regulation ‘may help address some of these issues’, it says.
Banca d’Italia: ‘still some open questions’
A Banca d’Italia-led contribution explored a possible D€ solution based on the integration of an account-based platform with a distributed ledger technology (DLT)-based one.
‘The integration of these two components would make it possible to reap the benefits of two complementary solutions, reciprocally balancing their advantages and disadvantages, as regards, for instance, privacy,’ Italy’s central bank states in its summary.
Its research (weighing in at 70 pages) describes D€ architecture based on the scaling up of pan-European instant payments settlement platform TIPS (TARGET Instant Payment Settlement) integrated with token-based systems that are either based on DLT such as the ‘itCoin’ platform – a blockchain-based back-end infrastructure, based on bitcoin technology and prototyped by Banca d’Italia – or based on different digital representations of money, such as ‘eCash’ (a token-based payment scheme).
‘It is worth underlining that there are still some open questions that require an in-depth analysis of the regulatory and legal aspects, in particular those related to the token-based system, such as the possibility of introducing limits on wallet capacity and on convertibility into another type of money,’ the report concluded.
Bundesbank’s hardware analysis raises challenges
Bundesbank-led explorations focused on the potential implementation of a ‘hardware bearer instrument’ (HBI), while a Banque de France (BdF)-led workstream focused on how to combine centralised technology with distributed platform(s) based on DLT (the BdF’s findings are summarised in ‘Digital Euro experiment: Combined feasibility – Tiered model’).
The Bundesbank examined whether existing hardware solutions could be adapted for a D€ or new specific solutions and standards are required; and how could cash-like features could be made available and usable offline. It is particularly interesting on offline operation and security issues.
One conclusion was that ‘state-of-the-art technology is not able to perform an indefinitely long chain of consecutive offline payments in a secure way (i.e. ensuring that no double spending of funds occurs)’. This reinforces the Eurosystem’s stance that a D€ should not replace but rather complement cash, the Bundesbank’s 10-page summary states.
The Bundesbank report goes on to state that it is possible to perform a ‘limited number’ of offline transactions ‘without severe security concerns’. But there are concerns and challenges to overcome. ‘Although it is impossible to avoid a device eventually being compromised, all measures should be taken to compel potentially compromised devices to interact with other devices that go online frequently. Pure offline operation raises concerns derived from the risk of total system collapse when a first wallet is compromised, which could be mitigated by going online regularly,’ the report states.
Initial analysis showed that offline transactions can be sufficiently secure. ‘However, it is impossible to discount an attack vector via physical tampering or via software weaknesses. The former risk should be mitigated by independent assessment and tests and the latter via rigorous audits,’ the report asserts. ‘However, even if successful, the potential damage would be limited as it would force an attacker to remain offline in all further transactions as an online connection would reveal the compromising of the system. Possible solutions might incentivise users to reconcile often as a way of protecting the network’.
The report concludes that the implementation of a D€ as an HBI is feasible but that ‘the extent to which cash-like features can be incorporated into an HBI is limited by technology, security and legal considerations’. In addition, it states that ‘a set of technical and legal challenges will need to be addressed by central banks, industry and academia to ensure that hardware solutions are implemented safely and in compliance with the regulations’.
The hot topic of European semi-conductor sovereignty is also mentioned, with the report pointing out that the current ‘limited presence of semi-conductor manufacturers in the EU means a potential dependency on a non-European provider’.
Frankfurt gearing up for the ‘investigation phase’
So what else is there to know ahead of the launch of the investigation phase next month? First, there has been further ECB CBDC technical output (beyond the above workstreams):
Second, like most central banks, the ECB has been ‘staffing up’ on CBDC. For example, its Directorate General Market Infrastructure & Payments just last week closed an (extended) search for ‘senior payments industry experts to provide high-level consultancy services’ for the D€ project.
The ECB has also just closed (on 13 September) a call for expressions of interest in membership of the Digital Euro Market Advisory Group (which was announced in July).
In the meantime, central bankers’ pronouncements on CBDC keep coming. Bundesbank president Jens Weidmann last week, in a speech delivered at a conference (co-organised with the People’s Bank of China, a relative CBDC frontrunner), said the design of a potential D€ is “still vague”.
“It may not be a jack-of-all-trades,” Weidmann said. “To my mind, a gradual approach might make sense given the risks involved – that means a digital euro with a specific set of features and the option to add further functionalities later.”
Politically, and of course technically, you could say that the ‘nitty-gritty’ has really only just begun in Europe.
=>>> Global Government Fintech’s dedicated ‘Digital Currencies’ section <==