e-HKD: The Future of Money in Hong Kong

The unrelenting winds of digitalisation are blowing in the direction of virtual money. Although their widespread circulation is still nascent, Central Bank Digital Currencies (“CBDCs”) are gaining more and more currency. Spurred on by ground-breaking technological advances and the overall drop in cash usage, central banks around the world increasingly regard the introduction of CBDCs as the logical next step in the evolution of monetary interactions. At present, approximately 100 countries are exploring the use of CBDCs at varying stages, including researching, testing, and distributing CBDCs to the wider public, according to the International Monetary Fund. For example, the Bahamas’ Sand Dollar was launched more than a year ago and has helped to widen financial inclusion. In mainland China, the People’s Bank of China (“PBOC”) has been pilot testing the e-CNY in a number of cities for the past few years, including at selected venues of the Beijing 2022 Olympic Winter Games. As of December 2021, there were 260 million individual users of the e-CNY – nearly twice the number of users in October 2021.

The winds of change have also reached Hong Kong’s shores: the Hong Kong Monetary Authority (“HKMA”) embarked on its CBDC journey back in 2017 and has recently announced that it will be trialling the e-HKD starting from the fourth quarter this year, alongside laying the requisite technical and legal groundwork for its implementation. These exciting developments dovetail with the HKMA’s “Fintech 2025” strategy unveiled in June 2021, the aim of which is to encourage organisations in the financial sector to adopt technology comprehensively by 2025, and to promote the provision of fair and efficient financial services. One of the strategy’s five main areas is “future-proofing Hong Kong for CBDCs”. As well as stepping up its efforts on launching wholesale CBDCs (“wCBDC”) in the near future, the HKMA is planning to run a series of pilot schemes to test the e-HKD’s feasibility, so as to boost Hong Kong’s readiness in both wholesale and retail trade. It is almost a given that the e-HKD will be a disruptor to the existing financial ecosystem, bringing along with it a unique set of benefits and challenges. Let us delve deeper into the e-HKD’s journey and the various aspects that need to be taken into account for its possible adoption.

What are CBDCs?

In a nutshell, a CBDC is a digital payment token issued by a central bank and is pegged to the value of a fiat currency, i.e., a country’s currency that is not pegged to the value of a commodity, such as gold or silver. Since it is issued and backed by a central bank, it is considered legal tender and can, therefore, be used in the exchange of goods and services and to settle any debt, tax, or charge. Conventionally, there are two types of money issued by a central bank: physical and tangible money in the form of banknotes, which is familiar to the average member of the public, and central bank reserves – electronic money used to facilitate payment between financial institutions holding clearing accounts at central banks. CBDCs, in contrast, are both electronic and available to the wider public. Furthermore, they are amenable to programming and design, which means that specific functions and features can be embedded into the token itself, subject to technical viability.

CBDCs differ from cryptocurrencies in that the latter are decentralised and unregulated. As they are privately issued and lack the backing of a central bank, cryptocurrencies are highly responsive to the whims of investors, moving up and down in value very quickly. Investing in crypto-assets can be a risk-laden and speculative enterprise. Hence, its volatile nature renders them an unsuitable candidate for holders of stable value or a method of financial exchange. On a separate note, commercial bank deposits are also considered electronic money; however, the crucial difference between CBDCs and bank deposits is that the former fall under the purview of central banks and are not subject to credit risk. The liability in respect of bank deposits, on the other hand, rests squarely with depository institutions, which in the event of insolvency may mean exposure to high credit risk.

Charting Hong Kong’s exploration into CBDCs

The HKMA initially embarked on its CBDC journey in 2017. Given the wealth of retail payment solutions already available on the market, the HKMA prioritised research work on wCBDCs and investigated its application in high-value payments and delivery-versus-payment settlements under Project LionRock. In collaboration with the Bank of Thailand, the HKMA commenced a research endeavour called Project Inthanon-LionRock, focusing on the use of wCBDCs in international payments. The project was subsequently given a new name, Project mBridge, in 2021 to reflect the additional participation of the Digital Currency Institute of the PBOC, the Central Bank of the United Arab Emirates, and the Bank for International Settlements Innovation Hub (“BISIH”) Hong Kong Centre. Joining hands with the BISIH Hong Kong Centre, the HKMA launched Project Aurum to conduct research into the design and technical architecture of retail CBDCs (“rCBDC”). In 2021, drawing on the know-how and experience accrued from previous projects, the HKMA announced the start of the rCBDC-focused Project e-HKD as part of the “Fintech 2025” strategy.

Potential advantages of e-HKD introduction

Promoting financial inclusion

One of the main drivers that has prompted central banks worldwide to explore CBDCs is widening access to financial services. In the case of the Bahamas as mentioned in the introduction, due to the island’s distinct topography, access to financial services is often strained and expensive, leaving many households underbanked or unbanked. In such communities, the difficulties associated with the lack of a bank account – a prerequisite for using digital banking and payment services – can be mitigated by introducing an rCBDC, which would provide these tools at minimal cost to consumers. In addition, as ordinary households do not have accounts at central banks, their access to central bank money is confined to its most rudimentary form of banknotes. Introducing central bank money in virtual form would boost its accessibility and user-friendliness, especially in economies tending towards declining cash circulation.

According to a discussion paper entitled “e-HKD: A policy and design perspective” (“Policy and Design Paper”) published by the HKMA in April 2022, however, the potential benefit described above does not offer a “compelling rationale” to launch the e-HKD, given that cash still plays a significant role in the city’s day-to-day monetary activities and the size of its unbanked community is small. That notwithstanding, the tightening of regulatory requirements in the banking industry arguably puts a damper on financial inclusion by rendering it difficult to open a bank account. Generally speaking, commercial bank deposits are deemed to be of very low credit risk thanks to Hong Kong’s robust banking system, which qualifies the argument of the e-HKD as a risk-free form of money. Nevertheless, introducing the e-HKD could help bolster the HKMA’s function as a central banking institution to provide legal tender, as well as ensure continued availability and circulation of the Hong Kong dollar.

Enhancing the operational resilience of the extended payment network

While major disruptions are rare in Hong Kong – thanks to its robust and sound technical infrastructure – an rCBDC could provide a reliable “backup” in the event of an outage taking other electronic payment platforms out of action. In addition, it could help promote healthy competition among market incumbents, propelling other electronic payment platforms to innovate and improve their offerings.  

Catering to the needs of a rapidly digitalising economy

In light of the accelerating digitalisation affecting all spheres of life with traditionally offline activities shifting online, the introduction of an rCBDC could enable near-instantaneous, low-cost, and peer-to-peer payments, as well as help meet consumers’ ever-evolving payment needs. While the rCBDC’s amenability to programming is at the discretion of issuing bodies, particular attributes and features embedded into the token can open up opportunities for innovative application, such as the use of smart contracts. These are contracts where all the terms between both parties are encoded, and upon the fulfilment of certain conditions, they execute themselves automatically, for example in the case of insurance policies. When there is a flight cancellation or delay, passengers can be paid compensation automatically, providing that certain predetermined conditions are met. Another potential application of an rCBDC identified by the HKMA in the aforementioned paper is acting as a channel for the provision and disbursement of fiscal subsidies to the general public, although users would still be subject to similar identity verification checks to safeguard against fraud.

Considerations prior to e-HKD adoption

Potentially destabilising effect on commercial banks

Since the introduction of an rCBDC is likely to cause a major shift in the financial ecosystem, its rippling impact on the stability of other financial entities must be carefully assessed. The HKMA has voiced concern over the uncertain effect that the e-HKD may have on the balance sheets of commercial banks, resulting in their disintermediation. Consumers may decide to withdraw their funds from their usual bank accounts. This would be particularly salient in the event of a financial crisis – if consumers were to flock to their banks to convert their savings into e-HKD that is sheltered from credit risk. Such a concern was also echoed by the European Central Bank in a policy paper: “By potentially providing an alternative to some types of bank deposit, CBDC could induce its holders to withdraw a substantial amount of liquidity from the banking system, thereby influencing its ability to finance economic activity in normal times.” Having said that, the HKMA offers reassurance that the risk of a bank run is very low in Hong Kong, given the various safeguarding mechanisms in place to protect consumers.

Interoperability with other payment systems

The HKMA has emphatically stated that the objective of introducing the e-HKD is not to replace other electronic payment systems. Therefore, the e-HKD should be developed such that it is compatible with other systems so as to avoid the creation of “a closed-loop payment system”, which would hinder seamless transactions between consumers using e-HKD and those on other payment platforms. Indeed, the desire for interoperability has also been expressed by respondents to a whitepaper entitled “e-HKD: A technical perspective” (“Technical Whitepaper”) published by the HKMA in October 2021. Interoperability is deemed “a crucial element of CBDC, which should be pursued at both the domestic and international levels”; in particular, interoperability with the e-CNY should be explored. Similarly, most respondents to the Policy and Design Paper advocated the idea of “an open system design” based on a common set of rules and protocols to facilitate better integration of the e-HKD into existing payment systems.

Privacy and data protection

An important design consideration is whether to opt for a token-based or an account-based approach. A token-based approach would allow for more anonymity in transactions between parties, but the onus would be on the payee to authenticate the payment object. Furthermore, the anonymity that this approach affords may be susceptible to abuse in furtherance of illicit activities. On the other hand, an account-based approach would mirror the operation of commercial banks, which entails the logging of transactions and balances of e-HKD holders. The focus on verifying the account holder’s identity can help promote compliance with Anti-Money Laundering and Counter-Financing of Terrorism regulations. Regardless of which approach is implemented, the HKMA concedes that “full anonymity is not plausible as a design option”, given that a ledger would need to be used in either case. The task is then to determine which parties have access to the data and to what kind of data specifically. Alternatively, a middle-ground way would be to adopt a “tiered wallet approach” with full anonymity for low-value transactions and traceability for high-value ones.

Design and implementation

Two-layered system

According to the Technical Whitepaper, one possible design that is currently under consideration is a two-layer structure. The first layer is called the “interbank layer” or “wholesale system” whose function is the issuance and redemption of CBDC at wholesale level.  Access to this layer is restricted to the central bank and intermediaries or licensed participants, such as commercial banks and payment service providers, which include those that are allowed to issue CBDC-supported electronic money. In contrast to rCBDC, which falls under the direct purview of the central bank, this type of money is considered “private money” and designated “indirect and synthetic CBDC” and is the liability of the issuing body. These intermediaries act as facilitators of communication and synchronisation between the two layers.

The second layer is called the “wallet layer” or “retail system” whose function is to distribute and circulate rCBDC or CBDC-supported electronic money. With minimal intervention by the central bank, this system is operated by intermediaries and accessible to members of the general public using appropriate digital wallet applications. It is proposed that the central bank would initially issue CBDC to intermediaries, who would in turn distribute and circulate it among the general public. The authority to generate and destruct CBDC resides with the central bank alone. The role of intermediaries is to act mainly as a “gateway”, passing on transactions and messages between the wholesale and retail layers, and to serve a security function by protecting the issuance mechanism from falling prey to cyberattacks originating from the retail tier.

The rationale behind a two-layer structure or what the HKMA terms the “decoupling of wholesale and retail layers” is that the overlapping or intertwining of both tiers would make the system more vulnerable to cyberattacks, given that the retail tier is open to the wider public. The intermediaries, therefore, act as an indispensable “buffer” between the two systems, shielding the core interbank network from cyber threats.

“Three-rail” approach to e-HKD implementation

In its most recently published position paper “e-HKD: Charting the Next Steps”, the HKMA likens the three-stage approach to three railway tracks – with the first two “tracks” eventually merging into one, to be precise.

• Rail 1: The technological and legal groundwork necessary for rolling out the e-HKD in the future will be laid. In particular, the development of the wholesale layer as delineated in the above section is to take centre stage. The process will comprise the formulation of a system development plan, which is expected to take nine months, and the construction of a wholesale layer of production grade, which would take, at a minimum, two to three years. In cooperation with the Hong Kong Government, the HKMA will need to identify and address the “gaps” in existing legislation so as to legally accommodate the issuance of a digital currency with legal tender status.
• Rail 2: To be run in tandem with Rail 1, in-depth exploration and research will be conducted into matters relating to use cases, application, design, and implementation of the e-HKD. In addition, pilot tests will be carried out together with stakeholders so that insights into the possible designs of the retail layer can be garnered, and the approach to implementation can be fine-tuned.
• Rail 3: Its focus is on rolling out the e-HKD, which will draw on and build upon the successes of the previous “rails”. At this stage, it is difficult to ascertain the exact time frame for the launch as it is contingent on a range of factors, including the findings and outcomes from Rail 1 and 2, as well as developments in the national and international arena.

Is a cashless future imminent in Hong Kong?

CBDCs have often been touted as a disrupter to the existing financial landscape, having the potential to revolutionise the payments infrastructure and effect a paradigm shift in how we think about money. Rather than blindly joining the digital bandwagon, however, central banks have called for a measured approach to assess the far-reaching implications for the wider financial ecosystem prior to adoption. It is noteworthy that the HKMA has explicitly remarked that the e-HKD “might not have an imminent role to play in the current retail payment market”, unless the general public can “see very tangible benefits”. It appears that there is still a long road ahead until cash loses its currency.