Notes and coins play little part in the daily lives of most Swedes, whose enthusiastic adoption of digital payments has created one of the world's most cashless economies. The tapping of phones, cards, and keyboards is convenient for consumers but could become a headache for the Riksbank, Sweden's central bank, which has seen its ability to control and stabilize its monetary system diminish.

The Riksbank may be about to react, and establish itself as a digital pioneer. S&P Global Ratings believes that Sweden's plans to launch a state-backed digital currency, dubbed the e-krona, will position the country at the forefront of a central bank digital currency (CBDC) roll out across Europe. The hope is that a CBDC will empower the Riksbank, and other central banks, to better deliver on their mandates to maintain a stable value for their currencies and deliver secure and efficient payment systems. Digitalization of transactions has undermined those goals by funnelling an ever-greater share of payments onto the systems of private actors (including Visa, Mastercard, Swish, Paypal, ApplePay, GooglePay, and Klarna), resulting in concentration that could create instability and which risks excluding certain parts of the population.

A state-controlled alternative to private payment platforms could reintroduce competition and provide consumers with a (theoretically) more secure and digital store of wealth. That, in turn, should help the Riksbank to maintain confidence in the Swedish monetary system, further bolstering the standing of a country whose reputation for stability is already a major contributor to its robust credit quality (AAA/Stable/A-1+).

Sweden Is A Natural European CBDC Leader

It is little surprise to find a Nordic country taking a CBDC lead. Digital payments may have become the norm in many countries over the past three years, in a large part due to the fallout from COVID-19, yet Europe's North was already well down that path before lockdowns swept the world. Sweden, in particular, has been steadily developing the infrastructure and habits that underpin cashless transactions for decades--payment by check was effectively abandoned about 20 years ago.

By 2021, less than 9% of Swedish transactions involved cash, while withdrawals from automatic teller machines (ATMs) had tumbled, and almost everyone used some form of mobile payment technology. Those trends were replicated across the Nordic region (see charts 1 and 2).

Chart 1

Chart 2

Having retreated during the pandemic, cash is unlikely to make a return. About two-thirds of Swedish consumers believe they don't need physical money, while just as many use cards for most payments under SEK100 (about €9.10), according to a recent Riksbank survey. Retailers appear to share that dim view of physical money, with about two-thirds claiming they will no longer accept cash by 2030, according to a survey cited in by Swedish newspaper SvD in 2017.

E-Krona's Objectives And Development

Sweden launched the e-krona project in 2017, making it one of the first countries to consider the merits of a CBDC (see chart 3). The recent completion of a second pilot phase has seen it maintain that pioneering position, placing it alongside China, Canada, and India, all of which are running live CBDC pilots. The e-krona is likely to be Europe's first CBDC, though Sweden will follow a handful of countries, including Nigeria and the Bahamas.

Chart 3

The development of the Riksbank's CBDC project observes three key principals outlined by the Bank for International Settlements (BIS) in 2020. They are:

• It should not threaten monetary or financial stability in Sweden;
• It needs to coexist with and complement existing forms of money-- meaning it should be exchangeable for cash, or general fiat money, on a one-for-one basis;
• It should serve to promote financial innovation and efficiency.

If those goals can be achieved, we believe the e-krona can benefit Sweden's financial system, for example by facilitating a reduction in transaction costs, while also improving the speed of cross-border transactions.

The Riksbank argues that an e-krona will also make the financial system more resilient and facilitate public access to the Swedish payment system. We agree that a CBDC could reinforce Sweden's payment infrastructure by creating a state-backed alternative that could be based on distributed ledger technology (DLT). That system would provide a form of insurance against potential disruptions to bank and card company payment infrastructure, while also reducing dependence on credit card and payment service providers. The new payment option also has the potential to foster financial inclusion and lower financial transaction costs for households.

There will however be downsides to the new CBDC. If the e-krona uses blockchain-enabled payment solutions, or similar technology, there will be new risks, including potential vulnerability to cybercriminals, opportunities for IT system glitches, and unforeseen issues associated with smart contracts (if they play a role). We believe central banks and lawmakers, including those in Sweden, are aware of these dangers and are factoring them into the CBDC's testing.

The Riksbank has said its overarching target for the CBDC is to maintain a role for public money in an increasingly digitalized society. For this to be achieved, we consider that the e-krona will have to contribute to public policy objectives by improving access, efficiency, resiliency, and competition (see table 1).

Table 1

E-Krona Will Preserve Established Financial Institutions' Roles

The launch of the e-krona promises change, but for many of Sweden's financial players it will likely prove more evolution than revolution. Under current proposals, established financial institutions and payment service providers will retain their central role in providing payment and transaction services.

Those plans recognize that Sweden's payments infrastructure is already technologically advanced, meaning it makes sense for the Riksbank to explore a CBDC model that can be integrated into and complement existing systems and infrastructure. It should also add optionality to the system by enabling payment service providers and other financial institutions to connect to the e-krona's network and supply their services through it.

We understand that the latest e-krona architecture tested by the Riksbank mirrors current electronic payment systems' usability. In practice, that should mean that it offers similar functionality to existing systems for retailers, for e-commerce transactions, and for peer-to-peer transactions between individuals (such as those currently conducted through Swish, Sweden's biggest provider of such services).

The Riskbank's plans, as we understand them, enables the creation of e-krona at the central bank's node in the network. Once created, the digital currency would then be distributed to participating financial institutions' nodes in the network. These participants will be responsible for managing the downstream operations involving end-users' tokens, and notably the provision of retail customers' wallets,which will provide identification and e-krona custody. That should create a new field of competition for banks and payment providers, in which success or failure could have an impact on creditworthiness over the long term. That playing field should, theoretically, be relatively level, providing opportunities for new entrants--though established brands with their large IT budgets could prove to have an advantage.

We expect further and more thorough testing of technology options ahead of a final decision on the system that will be used for the e-krona. The Riksbank will also want to evaluate data gathered from the public and market participants on how the proposed e-krona model is perceived and how it could best be delivered.

Heading Toward A Hybrid?

The extent to which the central bank that issues a CBDC is involved in the on-boarding and management of retail accounts can be used to broadly categorize the resulting system under one of three structures:

• A disintermediated model, where the issuing central bank authorizes users to open accounts which it manages directly
• An intermediated model, where banks or other financial intermediaries open and manage accounts
• A hybrid model, where accounts are opened with the central bank, but are managed by banks or other financial intermediaries

Under current plans, e-kronas will be held on the Riksbank's balance sheet, though end users' digital wallets will be managed by banks or financial service providers that are part of the e-krona network. While that is suggestive of a hybrid-type model, we note that the e-krona is still in a testing phase, meaning that many aspects of the future architecture are yet to be developed, tested, and decided upon. For that reason we consider it too early to definitively characterize the e-krona model according to the commonly used framework.

Chart 4

The Riksbank's final decisions on the model it will adopt for the e-krona will also be determined by lessons learned from the launch of CBDCs in other jurisdictions and from collaborative research, mainly within the BIS. While the development of state-backed digital currencies remains nascent the volume of that information is growing rapidly, supported by a handful of groups and initiatives.

Project "Icebreaker" for example, is a recently announced collaboration between the Riksbank, Bank of Israel, Norges Bank, and the Bank for International Settlements' BIS Innovation Hub Nordic Center. The project provides a platform to which participating central banks can connect their national CBDCs in order test interactions and develop systems. More specifically, the project will scrutinize the robustness of the different CBDC-systems' key functions and the technical feasibility of connecting the systems. We expect the result of this project will be published in early 2023.

Data Protection And Privacy Concerns

E-krona will have to comply with the security norms that are inherent to the payment landscape, such as Know Your Customer (KYC) and Anti-Money Laundering (AML) compliance practices. To meet these standards the Riksbank has been testing e-krona user identification systems that perform an authenticity check by transferring transaction history to the recipient of a token.

That has, however, raised questions about compliance with banking secrecy regulations, which dictate the extent to which personal customer data must be protected. The Riksbank's most recent formal update, published in the second quarter of 2022, suggests it remains unclear how information sharing using distributed ledgers and blockchain technology fits within financial confidentiality and data protection legislation. Investigations are ongoing, but we believe that it is likely that the data in the e-krona's transaction history will be considered personal and subject to financial secrecy.

Beyond that question of confidentiality, the system likely to be put in place to manage the e-krona raises a handful of other issues relating to data protection and privacy. They include:

• The effects of the Riskbank's arms-length relations with end users, whose contractual agreements will be with the network participants that oversee transaction flows, namely banks or payment providers, rather than the central bank.
• The inability of the Riksbank to control what transactions are conducted on the network due to the contractual intermediation of network participants. This means, for example, that the state is unlikely to be able to directly disable transactions for politically motivated reasons.
• The likelihood that e-krona transactions won't be entirely anonymous. We expect that the need to confirm with traceability requirements stipulated in the Swedish Money Laundering Directive, will mean that all but the smallest transactions will have to remain traceable.
• The impact of the EU's amendments to the Transfer of Funds (TRF) regulation in 2022. While that amendment was not directly targeted at CBDCs, it does cover crypto assets and updated the rules for so-called un-hosted wallets linked to regulated entities. More specifically, that seems to indicate that any transaction above €1,000 will need to be traceable back to a wallet holder.

Potential Impact On Swedish banks

The impact on Swedish banks of the e-krona, and the system under which it operates, will remain uncertain until the structure is settled. Even then, further potential effects are likely to become apparent due to the Riksbank's continued testing, and possibly only once the system enters real-world operations.

We do, however, expect Nordic banks will remain at the forefront of digitalization and offer more cost-efficient digital services relative to their European peers. That existing digitalization should enable the banks to participate in the e-krona network without having to significantly alter either their strategic positioning or operational effectiveness.

Existing infrastructure should also limit costs directly related to the adoption of e-krona, though spending on IT, anti-money-laundering systems, and cyber risk mitigation will remain significant. This tends to weigh less on larger Swedish banks, where economies of scale have historically translated into lower IT costs as a percentage of operating expenses (see chart 5), and resulted in a digital advantage over smaller rivals. We expect this lead will be maintained as larger banks establish themselves as the first nodes on the e-krona network. The resulting competitive advantage would be magnified in the event of strong demand for, and fast adoption of the e-krona. However, we expect the Riksbank will act to protect smaller players against crowding out by bigger banks, at least during a potential implementation phase of the e-krona.

Chart 5

Banks will likely have to change some business strategies to account for the launch of the new digital currency. This will particularly relevant to banks that are active in payment infrastructure or that offer retail payment solutions, where the risk of choosing not to join the CBDC network could be significant. We believe that Swedes could quickly adopt the CBDC if it demonstrates clear benefits, such as lower fees, greater perceived security (due to its central bank backing), and faster settlement. If that happens, take-up could be rapid, as is evident from the rise of Swish--an instant payments solution launched in 2012 and now used by about 95% of Swedish adults.

The launch of a CBDC is likely to leave bank's facing a small reduction in liquidity and minor deterioration in funding due to the replacement of cash with the digital currency, according to modelling by the BIS. Those calculations suggest that as some customers switch retail deposit balances to a CBDC on a permanent basis, the volume of deposit funding available to banks could decline. We consider it to be too early to assess the potential impact of the e-krona on banks' funding profiles, notably because we are unable to make definitive assumptions based on elements such as the level and stability of retail deposits.

There are also variations to the digital currency that could considerably alter is effect on banks. The impact of an interest bearing CBDC, for example, would be significantly different to the interest-free version, which is the Riksbank's current proposal. An interest-free CBDC should enable banks to offer savings rates just above zero in order to minimize the new currencies effects on deposits, their cost base, and their profits. An interest-bearing CBDC, which we consider unlikely and which is not foreseen in the latest e-krona testing, would leave banks competing with the central bank through deposit pricing, potentially increasing their cost of funding.

The widespread adoption of e-krona by the Swedish population could weigh heaviest on larger banks which have a relatively high share of transactional accounts and a greater share of deposits in the funding base, compared to smaller and mid-sized lenders (see chart 6).

Chart 6

The launch of e-krona also threatens significant disruption among payment service providers. In particular, we see risks for companies that are unable to revise their payment solutions in a timely manner to differentiate them from the CBDC, or which are unable to justify higher fees through additional value adding services to merchants and consumers.

E-Krona's Future Is Political

Because a central bank-issued digital krona will have important consequences and impacts on the banking industry and Swedish society, responsibility for oversight of its launch inevitably extends beyond financial regulators. The project has many questions to answer before it gets a greenlight. That takes time, and we believe that more time will be needed before policymakers are comfortable giving the Riksbank a mandate to issue a CBDC.

The process is currently at an inquiry stage at the Ministry of Finance, which is assessing the benefits of, and most beneficial model for, a state role in the payments market. The inquiry includes an analysis of the need for a CBDC, suggesting that the very idea of an e-krona remains under consideration.

The government-led study, called the "Role Of The State In The Payment Market" is due to present its findings during the first half of 2023. Its recommendations will then form the basis for political debates and, ultimately, a decision on whether-or-not to award the Riksbank a mandate to create the CBDC.

If the mandate is given, we will be a step closer to learning the final details of the system that will be constructed and details of the e-krona itself. And it is only then that we will be in a position to deliver our view on its likely impact on banks and their credit quality.

Related Research

• Stablecoins: Common Promises, Diverging Outcomes, June 15, 2022
• The Future Of Banking: Central Bank Digital Currencies In Asia-Pacific--Pathways Are Plenty, Destination Is Uncertain, Oct. 05, 2021
• Digitalization Of Markets: Framing The Emerging Ecosystem, Sept.16, 2021
• The Future Of Banking: Digital Wallets Will Replace Cash In Pockets, Jun 14, 2021
• The Future Of Banking: Central Bank Digital Currency May Replace Cash, Not Banks, Dec.02, 2020

External research

• Press Release: The Riksbank tests cross-border payments with the e-krona, Sept.28,2022
• Riksbank: E-krona Pilot Phase 2, April 2022
• BIS Annual Economic Report: CBDCs: an opportunity for the monetary system, June 21, 2021
• Riksbank: E-krona Pilot Phase 1, April 2021
• The Riksbank's e-krona Project, Report 2, Oct. 2018
• Riksbank Economic Review: When central bank digital currency meets private money: effects of an e-krona on banks, April 2018
• The Riksbank's e-krona Project, Report 1, Sept. 2017