Europe should stop banning interest on digital money

Banknotes cannot pay interest. As a note passes from hand to hand, no one records how long each holder keeps it. But the daily use of ready cash in transactions is declining and electronic money is different. There is no technical constraint on e-money, stablecoins or a future digital euro earning interest. Whether they do is a regulatory choice.

The European Union has made this choice unevenly. Banks may remunerate sight deposits, but e-money, e-money tokens or cryptocurrencies may not be remunerated. In 2023, the European Commission proposed a legal framework for the digital euro under which it will earn no interest and will also be subject to individual holding limits. Instruments that households use for payments are thus treated differently, depending on who issues them.

There is an ample economic literature on the interest rate spread between money and neighbouring financial assets. None of the various approaches implies that money should earn nothing, whether market rates stand at zero, 3% or 10%. A spread equal to the full market rate is the product of regulation, not of any equilibrium.

Bans on remuneration for some forms of money act as a tax on money holders that rises with nominal interest rates and accrues to issuers. This tax is regressive. Wealthier households move surplus balances into high-interest accounts, money market funds or securities. Less-wealthy households hold more of their wealth in payment balances and have fewer alternatives. Under current and proposed EU rules – the digital euro framework is still to be agreed – this ‘inflation tax’ on cash is thus extended to electronic money.

Meanwhile, remuneration bans are in any case slipping. ‘Internal’ circumvention is already visible. Some EU e-money institutions pay monthly ‘cashback’ that is interest in all but name. United States crypto platforms offer returns on stablecoin holdings, despite the US currently prohibiting remuneration by issuers.

‘External’ circumvention means flight into easily accessible alternative assets. Instant payments, open banking, tokenisation and artificial-intelligence-based liquidity management now push switching costs towards zero. Funds will flow in and out of constrained instruments, such as stablecoins, over the interest-rate cycle for no reason other than the remuneration ban. This poses risks to financial stability: if the central bank needs to increase short-term interest rates for monetary-policy reasons, it could as a side-effect trigger liquidity outflows from stablecoins, pushing stablecoin issuers to rapidly liquidate their reserves.

There are arguments in favour of the remuneration bans, but they are inconsistent. The first is that competition for deposits induces reckless risk-taking by banks. Capital and liquidity requirements are the proper answers to that. The second is the claim that bank intermediation has positive economic externalities for society. If so, targeted subsidies are more transparent and effective than an implicit subsidy that fluctuates with interest rates. The third argument is that banks deserve compensation for working within heavy regulation; this contradicts the principle of ‘one function, one risk, one regulation’.

By banning remuneration for some forms of money, the EU is also out of step with some other jurisdictions. In Brazil, fintech accounts linked to the Pix instant payment system are remunerated at the interbank rate. In India and Mauritius, savings accounts paying close to market rates serve for everyday payments. These countries have not seen the instability that the franchise argument predicts.

A genuine second-best case exists only for stablecoins circulating on pseudonymous public blockchains. Remuneration could add to their appeal for illicit use, although non-remuneration does little to deter such use, except for the store-of-value function in countries subject to capital controls.

For the EU, this suggests three implications as work on the digital euro continues and rules on other electronic money forms are reviewed. First, the digital euro could replace the combination of zero remuneration and holding limits with tiered remuneration, with a less favourable rate on larger balances. This would address fears that the digital euro could replace bank deposits to some extent. It would also avoid making central bank money the only widely available money subject to quantity limits, which inverts the normal hierarchy of money.

Second, the current block on interest for payment stablecoins need not be lifted overnight, but could be made subject to review, tied to effective enforcement of anti-money-laundering rules on public blockchains. Third, the prohibition on remunerating e-money should be abolished.

None of this requires the EU to impose remuneration. It only requires the EU to stop prohibiting it, and to let issuers of all forms of electronic money compete on the terms they offer to those who hold it.

Read the Working Paper, 'Remunerating means of payment', by Ulrich Bindseil.