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The European Central Bank (ECB) has moved a step closer to pursuing a digital euro, becoming the latest global central bank to seriously consider following China's lead in creating a digital currency.
China appears to be the clear leader in developing a sovereign digital currency, with pilot tests under way in several parts of the country.
But other central banks are starting to explore the idea, spurred on in part by the attention the Chinese project is getting and the nation's advanced system of electronic payments through mobile apps.
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The ECB outlined the potential benefits and pitfalls of a digital euro in a report released late last week, saying it must be designed to avoid "adverse effects on monetary policy and financial stability".
Key risks include the impact on monetary policy, financial stability, the safety and efficiency of retail payments, cross-border flows, cybersecurity and legal and privacy issues, the ECB said.
"The move to introduce a digital currency in which users hold deposits directly with the central bank is quite a radical one, and there isn't much research done on the effects on the economy, especially the banking sector," said Leonhard Weese, president of the Bitcoin Association of Hong Kong.
Financial stability could be undermined if banks' funding costs were affected by depositors changing their savings at commercial banks to a central bank-issued digital currency, the ECB said.
Banks might have to replace the lost deposits with borrowing from the central bank or directly from capital markets, which could mean the ECB would have to expand its role in the economy, potentially forcing banks to take on more risk to earn money.
"Were this demand to increase their funding costs, banks might have to deleverage and decrease the supply of credit, thus preventing an optimal level of aggregate investment and consumption," the report said, adding this could ultimately drive up the cost of borrowing, hampering economic activity.
"Moreover, if their traditional business model is compromised, banks may decide to take on greater risks in an attempt to earn higher (nominal) returns and to offset the reduction in profitability."
During a crisis, when savers have less confidence in banks, they might opt for the digital currency and so increase the likelihood and severity of bank runs, risking overall financial stability, the report said.