Today, the head of the European Central Bank (ECB), Fabio Panetta, gave a presentation on the digital euro in which he outlined the current state of progress of the central bank digital currency (CBDC), including the “principles of a model of compensation to encourage distribution. He was speaking at a European Banking Federation event.

The clearing principles of the digital euro are:

• Free for consumers to meet their basic payment needs
• Network effects that generate economic incentives for acquirers and merchants
• Comparable economic incentives for issuers
• The Eurosystem bears its own costs, in terms of the production and issuance of banknotes

The presentation didn’t say much more on the subject, so the rest is our analysis.

Compensation is one of the four items on the agenda of the digital euro work program for the current quarter. And it is a fundamental challenge.

Reversal of roles: cards vs digital currency

There are parallels between the players in card payments and a digital euro, with the network operator role of the card company being replaced by central banks. That being said, Visa and Mastercard are likely to continue to play roles. For example, they have developed digital currency AML and wallet technology that banks can license. And there will be a need for debit cards that store digital euros for those who don’t use smartphones.

Payment systems are all about network effects, but you need to incentivize four groups of participants, each of which needs to be addressed on one of the principles: the consumer, the merchant, the merchant wallet provider (acquirer) and the issuing bank of the CBDC.

For conventional cards, the acquirer is the bank that records debit card payments on behalf of the retailer. In a digital currency scenario, the acquiring bank will provide the business wallet that records all transactions. Wallet providers will probably not be limited to banks.

Because the digital euro is intermediated, there are also issuing banks where the consumer has a hosted wallet. So it is similar to a consumer getting a bank card but instead having a digital euro wallet from a bank.

In card payments, Visa, Mastercard or Amex operate the network. But in this CBDC system, it is operated by the Eurosystem of central banks.

Now that we’ve established the players, who gets paid?

Traders should be the biggest winners

In the absence of additional details, it appears that retailers could earn more. With card payments, a significant portion of the fees paid by merchants goes to interchange payments.

When a consumer makes a card payment, the consumer’s bank (issuer) pays the money to the merchant’s bank (acquirer), which delivers it to the retailer. And the acquiring bank pays the issuing bank the interchange fee. The issuing bank keeps some of the fees, but a large portion goes to Visa or Mastercard.

Central banks do not plan to charge anything to operate the CBDC, so the exchange fees should be very small, which would cause the acquirer to charge lower fees to the merchants. However, Europe already has interchange fee caps of 0.2% on debit cards. So even if there were no interchange fees, is 0.2% a great incentive for merchants?

The question is whether the interchange fees will continue to exist. On the one hand, it seems necessary to encourage issuing banks. But it seems like excess of a legacy system being incorporated into a new, more efficient system. The reference to ‘comparable incentives’ is a clue.

One argument is that traders do not need incentives because the digital euro will be legal tender, which means they must accept it. Another argument is that with lower fees, merchants could be incentivized to favor CBDC over other forms of payment. That includes cash because in many countries, depositing cash carries steep fees that can be as high as 1%.

But is 0.2% enough to incentivize merchants to push CBDC?

Consumers could be indifferent to CBDC. Keeping merchants happy is critical to generating the necessary network effects.

How to incentivize issuing banks

Note the reference in the presentation to consumers who do free essential payments That likely means that if you do a simple p2p payment, an ecommerce payment, or a retail payment, it will be free. But there is plenty of room for additional features with additional charges.

While the central bank-issued digital euro will not be “programmable”, that is only in the strict sense. For example, the central bank will not restrict digital euros to being food stamps that can only be spent on food. But it will be possible for intermediaries to add a programmable layer, including conditional payments, recurring payments, or much more complex logic, where the user could be charged transaction costs. It is no coincidence that one of the other items on the work program for this quarter is value-added services.

A key remaining question is whether issuing banks will receive interchange fees.