Last Thursday (May 18), the Hong Kong Monetary Authority (HKMA) announced the commencement of a first round e-HKD pilot initiative that will investigate the use cases, implementation and design issues associated with the potential introduction of a central bank digital currency (CBDC) – the e-HKD – in the special administrative region (SAR).
The regulator announced a list of 16 firms from the financial, payment and technology sectors that have been selected to participate in the scheme and will explore potential use cases across six key categories: fully-fledged payments; programmable payments; offline payments; tokenised deposits; settlement of Web3 transactions; and settlement of tokenised assets.
The results from the pilot will be presented in public during Hong Kong FinTech Week 2023, which is scheduled to take place from October 30 – November 5.
The launch of the pilot initiates the second of the regulator’s “three-railed approach” to investigating CBDC viability, which was outlined in a white paper published in September 2022, titled “e-HKD: Charting the Next Steps”.
The first rail – which runs concurrently with the newly announced pilot – aims to lay the technological and legal foundations to support implementation; while the third will commence once results of the first two schemes have been consolidated and reviewed. This final stage will involve full analysis of progress to date, as well as more thorough planning around any proposed implementation and launch of a digital currency.
The pilot launches amid a global decline in cash – one that was significantly accelerated by the coronavirus pandemic – as well as acknowledgement that the development of the digital asset space requires close regulatory oversight, in a manner that protects participants but does not stifle innovation.
Speaking to FinanceAsia, David Chan, managing director and partner at Boston Consulting Group, one of the participating firms in the settlement strand of the project, offered some colour around what the pilot will contribute to ongoing discourse around digital assets.
“We believe the findings from a public-private pilot such as this will support assessment and provide insight into real value creation for society. Cross-industry perspectives are important to ensure the assessment is client-centric and actionable for the industry, and which is why we are working with innovators across industry verticals for this assessment.”
“One crucial factor is identification of the benefits for end-users,” he said.
Wholesale versus retail application
Hong Kong’s exploration of the e-HKD follows the success of China’s trial of a retail e-CNY during last year’s Beijing Winter Olympics; the Reserve Bank of Australia’s foray into digital assets through fintech partnerships; a recently announced tie-up between BNP Paribas and Bank of China (BoC) to launch treasury services using e-CNY; and Project mBridge, an investigation into the capacity for CBDCs to support cross-border financial flows; among other regional endeavours.
According to data published by US-based think tank, the Atlantic Council, there are CBDC projects underway in 114 markets, representing over 95% of global GDP. Another report by the Official Monetary and Financial Institutions Forum (OMFIF) expects nearly a quarter of these to issue functioning, live CBDCs, within the next two years.
There are two – not entirely discrete – approaches to the development of CBDCs: one being the development of a retail currency, which would have the same traits as fiat currency – issuance by a central authority, distribution to the general public; and a wholesale CBDC, which would be used by financial institutions that maintain reserve deposits with a central bank, and could be used for efficient payment and securities settlement.
Regardless of end application, both forms of CBDC would be issued by the governing monetary regulator and would rely on distributed ledger technology (DLT) to ensure rapid processing, security, transparency and traceability.
Concerning wholesale development, managing director and partner at Boston Consulting Group, Kunal Jhanji, shared, “Our use case selected for the pilot is to examine the potential value and challenges of offering an innovative secured lending solution. As an example, our pilot will explore the feasibility of onboarding an additional set of collaterals for secured lending to unlock trapped liquidity, and introduction of additional parameters for credit risk assessment and management.”
“The benefits are expected to be delivered by leveraging potential features of CBDC, such as programmability and instant settlement, which traditional fiat currencies cannot provide efficiently,” he explained, highlighting the potential for application across the capital markets.
On the retail side, while general use by consumers would not be unlike that of fiat currency, by using a CBCD, payments could be made offline.
“CBDC systems, like all digital payment systems, must work for everyone in society, whenever and wherever individuals and businesses need them. The ability to pay when offline could ensure this is achieved by providing a layer of resilience, as well as supporting inclusion, accessibility and privacy objectives,” said Beju Shah, head of the BIS Innovation Hub Nordic Centre, in a statement around the firm’s Polaris project, which explores offline CBDC use.
Arta TechFin is one of the 16 participants exploring programmable payments. The firm's CEO, Eddie Lau, shared with FA, "Our innovation stream focusses on smart contract-based cash management. It incorporates open and portable digital identity and credential systems, streamlining customer onboarding and using privacy-preserving interactions to protect customer identities."
Also focussed on the payments side of CBDC capability is HSBC. The bank is participating in the scheme alongside the Hong Kong University of Science and Technology (HKUST), with whom it forged a strategic partnership last year, to develop an e-HKD payment ecosystem for use on campus.
“HSBC will develop a prototype of e-HKD and a corresponding wallet to allow hundreds of students and staff members of HKUST to make real-life purchases from merchants at the campus with the digital currency,” a spokesperson for the bank told FA.
“Three hypotheses have been set out for testing, including using e-HKD to lower transaction cost for merchants, enhance fraud prevention, and provide targeted spending offers and discounts. The first phase will be conducted at HKUST campus in September, with other round of pilots to follow,” the contact said.
Addressing key concerns
However, a number of key issues arise surrounding the proposed implementation of CBDCs.
In February, protestors took to the streets of Amsterdam to march against the European Central Bank’s (ECB) proposal to explore CBDC adoption, citing fears that the government would control the population’s spending habits, given that their transparent nature would enable government entities to monitor purchases made by the public.
Meanwhile, questions are posed around whether cross-border application would threaten monetary sovereignty, as consumers based in different jurisdictions would theoretically be able to access different CBDCs on a borderless basis.
“CBDCs are the same as existing central bank issued fiat currency but just in a different form, so this doesn't seem like a realistic concern,” Paul McSheaffrey, senior banking partner at KPMG China, told FA.
“The relevant central banks would need to control the ability to mint (issue) and burn (recall) the CBDC tokens in the same way they regulate the money supply.”
A spokesperson for the HKMA told FA, “Generally speaking, monetary sovereignty issues are more relevant in a cross-border context, in which foreign CBDCs or other digital currencies are widely used in a domestic market. Since Project e-HKD focuses on the application of retail CBDC in a domestic context, we do not see it posing any monetary sovereignty issues to others.”
On the back of the recent banking crisis, which was fuelled by mass withdrawal of deposits from regional lenders, there are fears around whether wide-scale CBDC implementation could propel more bank runs in future. For example, in an instance of threat to market stability, it might make sense for depositors to transfer their funds from commercial banks into these digital, centrally maintained digital currencies, given that central banks would have overarching authority of them, yet would be unlikely to fail even in economic crisis.
“Regarding the risk of bank run, mitigation measures such as holding caps could be implemented to minimise the risk,” the HKMA spokesperson told FA.
McSheaffrey agreed that Hong Kong – like most developed economies – has some form of deposit insurance, which would mean that there would be “arguably little difference between keeping your money in a commercial bank with deposit insurance and moving it to a CBDC”.
“There would be some benefit to those whose deposits are not covered by insurance, but these are typically a small portion of depositors – in Hong Kong 90% of deposits in retail banks are covered by deposit insurance – and so this would be unlikely to cause a bank run,” he explained.
Threat or opportunity?
However, McSheaffrey admitted that the ability to hold entire savings in CBDC wallets could challenge the traditional banking model.
“My view is that developments such as CBDC offer the potential for customers to disintermediate banks, but the reality is that most consumers will still look to banks and other financial institutions to help them with their banking and investment needs as it is easier and more convenient,” he said.
Last month, the ECB proposed that any digital euro would need to be “free for basic use”. However, the central bank would expect commercial banks to manage day-to-day processing of CBDCs on behalf of consumers, including know-your-customer (KYC) and anti-money laundering checks.
“Banks need to stay competitive by leveraging the benefits of CBDC operations through improved operations and value-add solutions for clients,” Chan said.
“Banks today already have established capabilities for money processing under existing regulatory regime and their individual risk management policies…They will have opportunities to leverage potential features of CBDCs to optimise their operations,” he noted.
The HKMA spokesperson told FA, “The HKMA is studying the distribution of work between the HKMA and banks or payment services providers, if e-HKD is to be launched in the future.”
“Generally speaking, the HKMA believes that a two-tier approach emphasising public-private collaboration will be conducive to the potential implementation of a retail CBDC. More specifically, central banks and the private sector should each do what they are best at, i.e., central banks to provide the hard and soft infrastructure; while commercial banks conduct customer-facing activities such as day-to-day processing and KYC checks.”
The contact emphasised that the insights gained from the pilot scheme will help to inform decisions around potential design choices and opportunities for collaboration across the financial markets.
In addition to the pilot project, the HKMA announcement laid out plans to establish a CBDC Expert Group comprising leading academics from local universities who will advise on the policy and technical issues surrounding CBDC implementation, such as the issues of interoperability, cybersecurity and privacy protection.
While the regulator has not made a firm decision around whether e-HKD will be introduced to the market, the pilot is considered to serve “a tremendous opportunity for the HKMA to collaborate with the industry in exploring innovative use cases and maximising readiness for a potential e-HKD,” said HKMA chief executive, Eddie Yue, in the release.