Central bank digital currency (CBDC) is a form of digital currency that leverages the advantages of blockchain technology, such as instant cross-border transactions, traceability and programmability, providing efficiency and transparency in financial transactions.
The exploration of CBDC dates back to 2017, when the Hong Kong Monetary Authority (HKMA) launched Project Lion Rock to look into the application of wholesale CBDC to large-value payments. In 2021, stemming from the research outcome of the wholesale CBDC projects and as part of the “Fintech 2025 strategy”, the HKMA launched Project e-HKD to expand its scope into the technicalities and commercial viability of launching a retail CBDC, also known as the e-HKD. Contrary to the wholesale CBDC which targets large-scale interbank payments, retail CBDC targets daily usage by the general public and to be circulated as a digital representation of the traditional Hong Kong dollar with legal tender status.
On 30 October 2023, the HKMA published the “e-HKD Pilot Programme Phase 1 Report”1 (the Report), shedding light on the potential use case of e-HKD and marking a significant step forward in Hong Kong’s commitment to financial innovation. In particular, the Report discusses six potential use cases of e-HKD, which include the following:
By bypassing intermediaries that are typically involved in an electronic payment flow, e-HKD serves as a full-fledged payment alternative, allowing consumers to benefit from negligible transaction costs and instantaneous settlement finality.
Currently, merchants may not receive payments in real-time due to a lengthy payment chain and the use of net settlement for card networks, such as settling once a day at the end of a day. For the same reason, merchants are also exposed to greater risks of reconciliation errors in the event of erroneous transactions.
With the use of a private blockchain network to transact e-HKD between consumers and merchants, the need for frequent liquidity management payments for settlement purposes can be removed, allowing instant and final settlement at a transaction level. As such, both consumers and merchants can enjoy a more efficient settlement process and lower transaction costs.
The mechanism of programmable payments is to impose conditions to govern when and how payment should be initiated. The pain points with our existing payments include the following: (i) only simple and unidirectional payments are supported which are triggered regardless of whether the underlying goods or services have been provided; (ii) there are no restrictions as to how the money can be spent, which may compromise the integrity of payment in some situations; and (iii) consumers are exposed to the risks of losing funds and/or not receiving the promised goods or services in the event of merchant bankruptcy.
E-HKD aims to solve the above issues by (i) allowing multidirectional exchange of information on whether the imposed conditions have been fulfilled; (ii) allowing parties to impose pre-defined conditions to restrict how the money can be spent; and (iii) offering greater consumer protection by allowing phased payments for goods or services.
An example of utilising such programmable payments is seen in retail escrow. When consumers prepay their funds which are held in escrow, such funds will be disbursed automatically to the merchants only when certain agreed conditions have been satisfied. This is largely similar to the current escrow mechanism we use today, the only difference being that no agent is required to manually perform the validation and prepayment release process, which in turn saves manpower and costs. This also incentivises merchants to maintain a good level of service throughout the process as they may risk not receiving the full amount of funds until all goods or services have been provided to a satisfactory level.
Currently, in-person transactions that are settled via electronic payments in real time require network connectivity, in particular, to support real-time validation. Despite Hong Kong being one of the cities that enjoy extensive cellular network coverage, the possibility of intermittent or lack of network connectivity that would prevent the usage of e-payments should not be completely ruled out.
By using secure elements, e-HKD will be stored within smartphone wallets and physical smart cards. The transaction can be conducted offline via proximity-based technologies, namely near-field communications (NFC). Safeguards against double-spending would also be in place. Each digital wallet owner will be assigned a unique digital signature, which is designed in an intricate manner where replication by malicious actors is arduous, if not impossible. Each transaction requires digital signature and validation before it will be posted onto an e-HKD digital wallet or network.
In contrast with other payment schemes where transactions are reconciled on a daily basis and netted for settlement at a later time, offline payments allow transactions to be settled with finality and funds can be used immediately in subsequent offline transactions. Such offline payments can be synchronised online in a seamless manner once connectivity is restored.
Existing payment schemes often pose the issue of lengthy execution process in the case of a business transaction. Transacting parties are typically required to manually track and complete costly reconciliations, and incorporate additional processes to manage liquidity, reconcile flows based on different data sources and prepare their onward payment instructions for processing.
The proposed e-HKD mechanism allows interbank transfer in a more efficient manner. As an illustration, please refer to the example below:
Merchant A has an account in Bank A; while Merchant B has an account in Bank B. Now, Merchant A intends to make a transfer to Merchant B. Upon Merchant A’s request, Bank A will conduct the transfer using wholesale CBDC to Bank B on the HKMA’s ledger account. The tokenised deposits at Bank A will be destroyed while the tokenised deposits at Bank B will be created simultaneously.
The above example illustrates the flexibility of e-HKD, allowing transactions to be settled around the clock and reducing the number of dependencies imposed by intermediaries in further processing the transactions. Parties can also benefit from the high-level transparency and check on the transaction status in real time.
Web3 symbolises the next generation of internet, where decentralised networks and blockchain technology are at the forefront. Contrary to traditional web platforms (i.e. Web2), Web3 allows peer-to-peer interactions, enhanced security with greater control over personal data and the use of decentralised application and smart contracts. With the emergence of Web3, we have seen more new types of transactions that involve decentralised applications and digital assets, such as NFT.
Depending on the type of marketplace or exchange, certain platforms exclusively accept cryptocurrencies and stablecoins, which may not be easily accessible to the general public. In this case, e-HKD plays a crucial role as an intermediary, connecting the traditional fiat economy with the emerging Web3 economy, facilitating the adoption of Web3. To this end, the attributes of e-HKD enable it to directly integrate with decentralised applications and blockchain networks, facilitating effortless funding into and withdrawal out of the Web3 ecosystem.
The proposed mechanism requires the consumer to first convert the token for use on another blockchain (i.e. the process of wrapping). Then, the consumer will deposit tokens into the consumer token wallet while the merchant will upload the digital assets to the merchant token wallet simultaneously. Once this is completed, a smart contract will be created between the consumer and the merchant. Via the tokenised asset network, the consumer receives their digital assets while the merchant receives funds. Merchants have the option of converting the tokens received into e-HKD.
Currently, it is difficult for an individual borrower to obtain a syndicated loan given the lack of funds. Similarly, it is difficult for lenders to control how the loan proceeds are spent after disbursement, with a greater risk of default when proceeds are misspent.
E-HKD comes into play in the case of a mortgage loan, where the lending bank first loads tokenised property and funds into the vault. Then, the vault disburses funds into the borrower’s e-HKD wallet as per the bank’s instructions. Similar to a typical loan situation, the borrower is required to repay in accordance with the contractual terms except, in this case, payments are made into the vault. Both the tokens and the funds will be released back to the bank upon full repayment.
This mechanism allows borrowers to have more lending options, since they can now borrow from multiple lenders at different interest rates, which is akin to the effect of having a syndicated loan. On the other hand, lenders also benefit from such mechanism. With the enforcement of smart contracts, lenders can ringfence and gauge the risks of the loan proceeds being used for prohibited purposes, encouraging lenders to offer competitive interest rates for loans that are using e-HKD.
Having discussed all the potential use cases of e-HKD above, we should also highlight the potential legal challenges faced by e-HKD.
First, from the anti-money laundering perspective, there is a delicate balance to strike between privacy and traceability. Some propose that full anonymity should be allowed for low-value transactions and traceability should be enforced for high-value transactions. Others argue that the line to draw between low and high value is blurry.
Second, the questionable legal status of e-HKD. Even if the Hong Kong government were to accord full legal status to e-HKD, it is difficult to envisage its worldwide acceptability. In particular, for commercial transactions, where parties have the flexibility and freedom to determine for themselves the terms upon which they will transact, this includes the means of payment that they accept. In other words, even if there is legislation to regulate e-HKD, such laws are unlikely to compel contracting parties to accept e-HKD as payment or prohibit a party from contractually refusing e-HKD. Generally, currency that is legally issued in a jurisdiction (including e-HKD in this case) should be recognised as a legal currency in other jurisdictions. However, the data protection laws and governing law may differ markedly between jurisdictions and, as such, it is difficult to ascertain the interoperability of e-HKD across the globe.
Apart from the legal challenges discussed above, it boils down to the question of necessity. In other words, does the launch of e-HKD help to fill the void in our current retail payment ecosystem? Based on the current findings from the Report, the HKMA acknowledges that we are still at a premature stage and would refrain from jumping into any policy decision on whether or when to launch e-HKD. Going forward, to achieve greater clarity on this issue, the HKMA will continue its retail CBDC journey by kick starting phase 2 of Project e-HKD.
This article is co-authored by one of the trainees of Dentons Hong Kong, Charmaine Chan.
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