This year is a pivotal one for the European Central Bank. Years of investigation into creating a digital euro will finally culminate in a decision to proceed with its production in October 2023.
While it won’t be the end of the story, it will be a significant moment for CBDCs. Ahead of the US and UK, the EU has been extremely vocal about its investigation into the digital euro, despite many EU citizens still voicing concerns.
In late May 2023, the ECB published a report on the prototyping exercise from July 2022 to February 2023. It’s a critical moment for the future of the digital euro as it nears the possible launch of a pilot.
Exploring front-end and back-end functions, both online and offline, the exercise aimed to span the full range of use cases that could be important to the currency’s future usage.
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Payments could remain private
Like a jigsaw puzzle, the ECB’s prototyping exercise divided the creation of the digital euro into pieces that would eventually make up the whole CBDC.
A settlement engine dubbed N€XT was created on the back-end to process digital euro payment and funding/defunding transactions. Opting for an unspent transaction output (UTXO) data model in place of a distributed ledger, the engine can be accessed via a web-based API.
The ECB stated that the UXTOs refer to a digital representation of an asset that can only be spent once in its entirety in one payment, similar to banknotes in the physical world. This differed from a balance-based approach that records the changes in a holding balance according to the transactions made.
Privacy has been a significant concern for the critics of the CBDC. The UTXO model developed for the N€XT engine allowed for one-time addresses to be generated and transactions without knowing the identity and associated balances of individuals’ wallets. Therefore, privacy could be maintained.
However, the ECB noted that additional checks for holding limits would have to be implemented for this option to be functional. The holy grail of 3,000 euros seems to be the latest benchmark, limiting usage and, potentially, adoption.
Online front-end showed success
According to the ECB investigation into the front-end interaction with the CBDC was executed with success.
Five use cases were addressed by industry players, spanning peer-to-peer payments, peer-to-merchant, and e-commerce. The front-end solutions were developed and tested to fit seamlessly with the back-end engine, utilizing QR codes, contactless technology, and request-to-pay functions.
Two critical pieces of infrastructure also arose, forming the building blocks of the use case solutions.
Self-custody wallets used extensively in the DeFi space may have found their place within CBDC interactions. The ECB mentioned consumers’ potential use of private keys in the report but highlighted a need for custodial services where the intermediary would hold keys.
In addition, a prototype was explored for customer due diligence, allowing consumers to engage in different “tiers” according to how much identity information they were willing to share. The tiers referred to the differing allowances for transaction values for both particular transactions and the number of transactions executed over some time. Lower levels of transactions could require less information, which would gradually increase according to the tier.
Offline use could still be a challenge
While exploration for online usage was seemingly a success, the currency’s viability as a contender to cash and card payments still hangs in the balance. Offline use continues to be elusive.
Offline functionality is a significant component of CBDC design, which could affect adoption. A Bank of International Settlements (BIS) study found that 49% of central banks consider offline payments with retail CBDC vital. In comparison, another 49% deemed it to be advantageous.
“CBDC systems, like all digital payment systems, must work for everyone in society, whenever and wherever individuals and businesses need them,” said Beju Shah, Head of the BIS Innovation Hub Nordic Centre. “The ability to pay when offline could provide a layer of resilience, as well as supporting inclusion, accessibility, and privacy objectives.”
However, the ECB’s exercise report was inconclusive as to whether it was possible.
“The prototyping exercise has delivered valuable insights into the technical choices for a potential digital euro system. Nevertheless, owing to the short time frame, open questions remain,” read the report.
The exercise allowed the development of a prototype for offline payments, updating consumers’ balances when reconnected to the internet. While it showed that the prototype could function offline and that online and offline functioning could be interoperable using a balance-based system, significant challenges remain.
In addition to variations according to the platform and mobile phone provider, the report suggested that additional challenges may surface.
Among the areas the ECB deemed problematic were the limitations of the technology available and the absence of security standards that encompass both the hardware and software aspects of a possible solution.
Other entities have also engaged in research to formulate possible solutions. In early May, BIS also published a handbook stating how CBDCs could work offline, “intended to serve as a guide for central banks considering offline payments capabilities.”
BIS highlighted the complications of developing an offline CBDC, stating, “The types and suitability of a solution for offline payments will vary by country depending on local requirements.” The organization noted that its development would implement several security, technology, and operational considerations.
“There is no size fits all,” read the handbook. “In some cases, central banks may need to work within the limitations of a solution. No solution will likely be an exact fit, and some compromises or trade-offs may need to be made.”
While many of the digital euro components seem to fit in place, could this be the sticking point that upends its implementation?
