He discussed the main effects a digital euro could have on banking intermediation, financial stability and the international financial system; and considered some key design options that could address the risks involved.

The ECB and the Bank of Japan conducted a joint research effort on how to balance confidentiality and auditability in a DLT environment. The collaboration marked the fourth phase of a joint project called Stella, which started in December 2016 and aims at exploring DLTs through conceptual studies and practical experimentation.

The fourth phase of the Stella project looks into the fundamental features of privacy-enhancing techniques (PETs) for ensuring confidentiality of transaction information. It takes different perspectives: accessibility of the necessary information, reliability of the obtained information and efficiency of the auditing process, to assess whether confidential transaction information could be audited effectively by an authorised entity in the DLT network.

The outcomes of this research can be used as a starting point for choosing PETs and designing auditing processes for transactions in a financial market infrastructure based on DLT.

The ECB explained that it first started to explore trends in cryptoassets in 2011 and published its first report on virtual currency schemes in 2012, followed by a second one in 2015.

It then goes on to discuss what cryptoassets are, what are their implications for monetary policy and financial stability, payments and market infrastructures.

In conclusion, it said that the risks from cryptoassets being used in financial market infrastructures are considered to be limited and manageable within the current EU regulatory and oversight frameworks. Further, depending on how regulation develops in the future, it may be easier for cryptoassets to be used in financial market infrastructures, leading to a deterioration in their risk profile.

The paper starts with a characterisation of cryptoassets, and then reviews recent developments in the market and how these are linked with financial markets and the economy.

It then assesses the potential impacts of cryptoassets on monetary policy, payments infrastructures, and financial stability.

The analysis shows that, at present, cryptoassets' implications for and/or risks to the financial stability of the eurozone are limited and/or manageable based on existing regulatory frameworks.

However, the report recommends that the ECB carry on monitoring the sector.

The report notes that the combined value of cryptoassets is small relative to the financial system, and their linkages with the financial sector are still limited.

In the current regulatory framework, it is hard for cryptoassets to enter the EU financial market infrastructures (FMI) and there is no indication that EU banks have systematically relevant holdings of cryptoassets.

"Cryptoassets do not fulfil the functions of money and, at the current stage, neither do they entail a tangible impact on the real economy nor have significant implications for monetary policy," the report said.

However, the report calls for "continuous careful monitoring" of the sector, taking into account the fact that cryptoassets are "dynamic" and the fact that linkages with the wider financial sector may increase in the future.

As the cryptoasset ecosystem develops, exposures may increase, and depending on how they will be regulated in the future, cryptoassets may more easily enter the FMI environment, and "deteriorate the FMI risk profile".

The report adds that, from a prudential view, cryptoassets should be deducted from CET1 as part of a conservative prudential treatment.

Further, independently of the stipulated prudential treatment, financial institutions that have exposures to cryptoassets are expected to put in place an appropriate risk management framework commensurate to the risks posed by these activities.

Future regulation

In terms of future regulation, the report notes that the legal status of cryptoassets varies among countries, absent a common taxonomy, and a shared understanding of how they should be treated from a regulatory perspective.

As things stand, cryptoassets do not appear to fit under any of the relevant EU legislation (particularly PSD2, MiFID and EMD2).

Disjointed regulatory initiatives at national level could trigger regulatory arbitrage and, in the end, adversely affect the resilience of the financial system to cryptoasset market-based shocks.

The paper recommends that a broader approach to regulation could be pursued "at the intersection with the financial system", where risks arise from unregulated "gatekeepers" that provide an entry point for retail investors and regulated entities (such as custody or exchange services).

The report added:

"Any regulation should also be balanced to avoid incentivising risky cryptoassets business."

To conclude the report said that the ECB should continue to monitor the cryptoassets "phenomenon", raise awareness and develop preparedness for any adverse scenarios, working with other authorities.

Central bank digital currency (CBDC) in the EU

In an annex, the report also explored the question of central banks issuing their own digital currencies, noting that this can be done outside the distributed ledger technology.

The report noted that CBDCs could bring benefits and costs, and have many implications, from their impact of financial stability to their interaction with the transmission of monetary policy and the operational efficiency of payment systems.

The report concluded that current conditions do not warrant the issuing of CBDCs.

There is not enough demand for them, and while non-cash payments continue to grow, the demand for euro banknotes has been sustained and cash is still popular.

Further, European citizens have a wide range of electronic payment instruments at their disposal beside cash.

However, this situation could change in the future, driven by changes in the needs of EU citizens, the decline of cash or another central bank issuing a CBDC available cross-border.

In any event, the ECB and the broader euro community will continue evaluating the case for making a digital version of the euro central bank available to the public based on evolving requirements and global developments.

He concluded that virtual currencies do not herald a new world of money, being are a misnomer in the first place. They are not money, nor will they become money in the foreseeable future. They lack the official recognition and backing of a public authority. Their market share is still small, the amount of money at risk in financial market infrastructures is insignificant and their ties to the real economy are still limited.

But this can change. Authorities should therefore pay close attention to mitigating the potential risks that could stem from a growing virtual currencies market.

Mersch said:

"We have to be mindful not to have the complex and interlinked financial system contaminated by immature technologies or shallow business models. Interfaces and gatekeepers require particular scrutiny.

"Likewise, we should not succumb to the temptation to sacrifice the achievement of a level playing field for innovative advances that are aimed at regulatory arbitrage.

"But I don’t want to sound too negative. It is not unknown for new innovations to bring about euphoria, which in turn fuels bubbles that eventually burst. Still, just because the initial euphoria subsequently fades, does not mean that the innovation itself is without virtue.

These virtual currencies are clearly not suitable for use as money, but the underlying technology may, in time, become useful and widespread. And although we at the ECB don’t intend to introduce a central bank digital currency for the foreseeable future, we are actively experimenting with the technologies. We will be able to cater for changing needs in trusted and stable central bank liabilities that are accessible to the citizens, if and when this becomes necessary."