On Wednesday, the European Central Bank took a crucial step toward a digital euro by accepting a "research phase" that might lead to the implementation of a virtual currency by the middle of the decade.

The next stage will take 24 months and will solve key design and distribution challenges, according to the European Central Bank.

The decision, it added, "will not prejudge any future decision on the hypothetical issuing of a digital euro, which will only occur later." In any case, a digital euro would supplement, rather than replace, cash.” The next phase, according to Executive Board member Fabio Panetta, will be implementation, which will take around three years.

President Christine Lagarde has expressed interest in a central bank digital currency, and the European Central Bank has cautioned that failing to do so might jeopardise the bloc's monetary autonomy as payment providers such as foreign technological behemoths gain traction.

If the European Central Bank does adopt a virtual currency, it will most certainly follow China's lead, where experiments have already begun in numerous places. Grenada and St. Kitts and Nevis, two Eastern Caribbean islands that share a central bank, have already established their own versions. The Federal Reserve of the United States and the Bank of England are both looking into the potential for their respective economies.

The characteristics of a digital euro are already taking shape, with studies and public statements describing a payment system that is quick, simple, and safe. It would also provide an alternative to Bitcoin and its contemporaries, which is important for Lagarde, who has criticised private crypto-assets.

“It's been nine months since we published our study on a digital euro. In that time, we've undertaken additional study, solicited advice from residents and professionals, and conducted various trials, all of which have shown positive results,” Lagarde said in a statement. “As a result of all of this, we've decided to kick it up a notch and start working on the digital euro project.”

Cash but not quite

A digital euro, according to the ECB's website, would be "like banknotes but digital." In actuality, replicating a crucial feature of notes and coins — the capacity to make payments that are both anonymous and offline — will be difficult.

To avoid counterfeiting and compromise anonymity, digital currencies will need to be validated by a distant ledger, according to a paper released this year by Sweden's Riksbank.

The European Central Bank(ECB) stated in a report last year that “The Eurosystem would be better placed to win European citizens' trust in an offline payment tool,” and that “anonymity may have to be ruled out.”

However, it saw room for a “selective” approach to privacy. Certain types of transactions could be processed without the payer and payee's identities being recorded in the system.

Greener and cleaner

The European Central Bank said on Wednesday that preliminary tests show that a digital euro core infrastructure would be environmentally friendly, consuming “negligible” power compared to crypto-assets like Bitcoin, which, according to Executive Board member Fabio Panetta, consumes more electricity than Greece & Portugal put together.

Bitcoin has been chastised for consuming a lot of energy to power the machines that conduct the intricate calculations that keep the network running.

Traditional money, on the other hand, necessitates the use of resources such as copper and tin for coins, fossil fuels for transportation, and energy for ATMs. The energy used to permit a typical purchase with notes and coins, according to a 2018 study by the Dutch central bank, could light an 8-watt lamp for two hours. When using a debit card, the time is reduced to 90 minutes.

Anxiety about banking

Commercial banks are concerned about the impact of innovation on their businesses. One risk scenario is customers moving their deposits to the ECB in a crisis, thereby causing a digital bank run.

Panetta has proposed a cap of around 3,000 digital euros ($3,550) for any individual to possess, or deeply negative interest rates above that level to discourage huge ownership, to mitigate that risk.

Banks, on the other hand, will have plenty to do. While the ECB would be in control of the technological infrastructure and supervision, it has indicated a preference for having intermediaries provide access to the digital euro.

Alternative to Blockchain

The rise of crypto-assets has inspired central bank digital currencies, however they do not have to use the same technology. The European Central Bank is concerned that so-called distributed ledger technologies, such as Bitcoin's blockchain, rely on a decentralised verification procedure that could endanger oversight.

The central bank already has a system called TARGET Instant Payment Settlement, or TIPS, that was implemented in 2018 and may be more appropriate. It might also think about a hybrid system that combines TIPS and DLT.

The European Central Bank said Wednesday that tests showed both systems could be scaled up to manage the roughly 300 billion retail transactions carried out in the euro region each year.

Monetary Policy

The ECB's web page on the digital euro says little about monetary policy, but a paper from last year suggested that it might be a "potent tool" with a future function "may materialise."

It could remove some of the hurdles to further lowering interest rates below zero in order to stimulate the economy because digital euros are difficult to store, they can't be easily hoarded.

It would also make helicopter money, which involves delivering cash directly to consumers in order to increase consumption, more feasible. That last-resort policy, according to Lagarde and her predecessor Mario Draghi, should be decided by governments rather than central banks.