Towards digital dollarization?

A weak digital euro risks Europe's monetary control

(I gave on Monday the 5th of May the keynote talk on the implementation of the Draghi report reform recommendations at a European University Institute conference. Here are the slides.)

Throughout history, currencies have evolved from physical objects issued by governments to more abstract forms of value based on promises and debts.

Initially, money came in the form of coins stamped by a king or government (‘state money’). But physical coins were often scarce. The change came when banks figured out how to turn promises and debts into something that could be used like money (‘bank money’). As described in Paolo Zannoni's ‘Money & Promises’, banks in Renaissance Italy did this by keeping ledgers. If someone owed you money, instead of paying you in coins, the bank could just mark down that credit in your name, and you could then use that recorded credit to pay someone else. This ‘bank money’ helped trade flourish where physical currency was hard to find.

Of course, this system relied heavily on trust in honest book-keeping by the banks. When banks failed, as many did in Venice, governments stepped in with regulations, demanding banks hold more actual coins to back up their promises. Later, governments got more directly involved. The Bank of England, for example, was set up partly to turn government debts (like taxes owed) into a form of widely accepted bank money, effectively creating a national currency backed by government promises.

This was the central axis of the clash over America’s financial system in the late 18th century: Alexander Hamilton favoured a strong national bank and currency (more central control), while Thomas Jefferson preferred state-level banks and currencies (more decentralized). For a long time, much of the US economy ran on money created by numerous state-chartered banks.

This is the tension that will soon be relitigated across the Atlantic, between official digital money (CBDCs) and private digital money (stablecoins).

Stablecoins are cryptocurrencies designed to maintain stable value by pegging to established currencies like the US dollar or euro. There are over $210 billion worth currently in circulation globally and monthly transaction volumes reaching hundreds of billions, stablecoins provide a digital alternative to traditional currencies—though they still remain much smaller than established payment networks like Visa.

Unlike actual dollars or euros, stablecoins function like the ledgers of Renaissance banks: they represent claims on value rather than the value itself. This structure introduces credit risk, as private issuers might fail to maintain adequate reserves backing their coins. Central Bank Digital Currencies (CBDCs), like Europe's proposed digital euro, offer a public alternative—electronic versions of official currency issued directly by central banks.

The US and EU are placing fundamentally different bets: the US backs private money with low regulation, while the EU pursues a twin-track approach of launching a new form of public money while building high walls around the private market.

How will it play?

Widespread adoption of dollar stablecoins within Europe would constitute a form of "digital dollarization" with serious macroeconomic implications. It would weaken the European Central Bank's ability to manage the euro area economy, as a significant portion of transactions would bypass the euro system, reducing the effectiveness of interest rate adjustments and other monetary policy tools.

This outcome also creates financial stability risks. European businesses and households earning euros but making payments in dollar stablecoins would face dangerous currency mismatches if the euro weakened. Additionally, the ECB cannot act as a lender of last resort for dollar-denominated instruments, limiting its capacity to manage crises involving these stablecoins.

Ultimately, the proliferation of foreign digital currencies would erode Europe's monetary sovereignty, reducing the ECB's control over its payment system and increasing dependence on US financial infrastructure.

At first glance, dollar-denominated stablecoins might seem unattractive to Europeans, who would incur currency risk by using them. But they offer three significant advantages that could enable them to gain traction in Europe.

First, coins denominated in dollars enjoy overwhelming market dominance. Euro-denominated stablecoins represent a minuscule fraction of the market – the top ten have a combined capitalization of only €600 million, less than 0.24% share of the total stablecoin market. This limited liquidity makes euro stablecoins less practical, creating higher transaction costs through wider bid-ask spreads.

Source: CoinMarketCap, CoinGecko. Accessed May 6, 2025. Rest of the world combined $0.067 billion (GBP, JPY, CNY, SGD, TRY, IDR, KRW)

Second, regulatory approaches differ significantly between regions. The EU's Markets in Crypto Assets (MiCA) regulation is trying to impose tight control, close loopholes for offshore issuers (any stablecoin issuer wanting to sell any type of stablecoin within the EU must register locally and follow MiCA's rules), and require strong consumer protection regarding both reserve requirements and orderly failure procedures – issuers must have sufficient, safe, segregated reserves and have credible plans for winding down operations smoothly if needed. The US has no comparable legislation yet, though pending bills (the STABLE and GENIUS Acts) appear more growth-oriented and allow for notable gaps – they don't cover offshore issuers like El Salvador-based Tether and lack comprehensive resolution mechanisms. While this creates higher systemic and consumer risks, it also allows for faster innovation and expansion.

Third, dollar stablecoins already dominate early use cases and benefit from network effects. The cryptocurrency trading ecosystem and decentralized finance (DeFi) platforms primarily use USD stablecoins. Each agent wants to pay in whatever way others will accept, so once a unit of account gets locked in, it is hard to change it (see the dollar’s position in global trade, for an example). Businesses with international operations priced in dollars may find efficiency gains in using these instruments for cross-border payments and hedging, particularly where there are capital controls or currencies are unstable. For instance, according to the FT:

“Elon Musk’s SpaceX uses them to repatriate funds from selling Starlink satellites in Argentina and Nigeria, while ScaleAI offers its large workforce of overseas contractors the option of being paid in digital tokens.”

For most other European users and businesses whose economic lives revolve around the euro, it would appear the downsides –especially the currency risk and the hurdles imposed by MiCA on foreign stablecoins – make it unlikely they will be attracted to foreign stablecoins. And yet the immense power of network effects, which caused widespread alarm in banking circles during Facebook's Libra project, can trigger rapid adoption once a critical mass is reached. If these stablecoins offer compelling advantages like interest payments or usability advantages, in contrast to the unremunerated, sticky traditional bank deposit accounts, a significant outflow of funds from the banking system becomes a credible threat.

The digital euro as an alternative

Given this risk of losing control of the currency, the European Central Bank views the ‘digital euro’ as essential for preserving monetary autonomy. If digital money must come, let it be digital money it controls.

But the project faces strong opposition from traditional banks concerned about losing deposits to central bank accounts. Their lobbying has resulted in the current proposal making their way through the Council and the European Parliament imposing severe limitations on the digital euro's functionality – including low holding caps, zero interest payments, and mandatory links to bank accounts (see my November post “Do we need banks?”).

These compromises risk making the digital euro unattractive compared to private alternatives. Even if it successfully navigates the complex EU legislative process, a heavily restricted digital euro might struggle to compete with private euro stablecoins and globally dominant dollar stablecoins. These private alternatives will offer advantages over the digital euro like remuneration, no holding caps, and freedom from bank account linking requirements. Features intended to protect the banking sector may ultimately undermine the digital euro's adoption.

Europe cannot have it both ways. It wants to protect its banks from competition while also defending the euro in the digital age. This won't work. By coddling banks, Europe may hand victory to dollar stablecoins. Unless Europe creates a truly useful digital euro, it could lose control of Europe's payment systems and weaken the euro itself as digital money spreads worldwide.

References:

Brunnermeier, Markus K., Harold James, and Jean-Pierre Landau. The digitalization of money. No. w26300. National Bureau of Economic Research, 2019.

Massad, Timothy, Howell E. Jackson, and Dan Awrey “Stablecoin regulation is pending in Congress. Here are six ways the proposals should be improved. New Atlanticist, April 18, 2025