Hong Kong has excelled as a world center of finance, trade and professional services. An excellence that was degraded by the brain drain in the years of social unrest, followed by the Covid-19 pandemic and negative perceptions about what Hong Kong has become. Advancements in digitalization and tokenization technologies present an opportunity for Hong Kong to regain its position as a beacon of free trade and stability, making the territory a unique testbed for new financial technologies. There is no reason for Hong Kong not to become the financial leader of the Greater Bay Area, which has a GDP of nearly US$2 trillion.
Helping lead the charge is Hong Kong Monetary Authority (HKMA), the territory’s de facto central bank that is spearheading two important digital currency projects highlighted during Hong Kong FinTech Week, which just wrapped up yesterday. Let’s delve into these two initiatives, Project Sela and the e-HKD, and evaluate their roles as payment rails, the significance of their value adds, and whether they can bring Hong Kong to the forefront of the global digital money race.
The results of Project Sela, which explored the feasibility of a retail central bank digital currency based on account-based permissioned distributed ledger technology (DLT), were officially introduced in September 2023. The project focus is on being an “exposure-less,” two-tiered digital currency, while intermediaries “don’t touch the money.” Traders interact directly with the central bank through a real-time gross settlement (RTGS) system. This simplicity and the capability to easily integrate to RTGS seem to be the main advantage of this project. However, it requires that every trader has an account at the central bank.
Can Project Sela really utilize the advantages of tokenization? Not really. Actually, it does not add anything significant for the user experience that is beyond what WeChatPay or Alipay can do. The Sela project incorporates DLT, which does not make the payments or transactions faster, more private nor more secure. They evaluated the security aspects of the CBDC and tradeoffs, ignoring quantum computing threats.
The results of the second project, which explored the commercial viability of and potential use cases for e-HKD, were published last month. The e-HKD is still a work in progress, but if the second phase of this project progresses in accordance with the recommendations I present here, it has the potential to become not only Hong Kong’s flagship project for digital money but also an example for the world.
As an expert on digital currencies who has worked directly with the People’s Bank of China when its Digital Currency Institute was developing China’s digital yuan, also known as the e-CNY, I would like to share some concerns about the e-HKD project that I have not seen much discussed.
The proposed DLT-based online settlement protocol of Hong Kong’s digital currency seem to have a high energy burden, compared to what could be achieved if different settlement protocols that are not DLT-based had been implemented. The e-HKD’s current protocol seems to burn the server and require a lot of energy for cooling, which means a large carbon footprint and high costs to the environment. On top of that, it relies on a single algorithm and represents a “one point of failure,” rather than utilizing a mutating or changing algorithm, which can be more nimble in being ahead of potential cyber criminals and attackers.
With so much money at stake, online settlement protocols must minimize its environmental footprint, prevent double spending without intermediaries, maximize privacy and security, and plan for the future, to ensure they are resistant to massive hacks by quantum computers.
The e-HKD’s offline protocol is also troubling to me. The technology is based on cryptographic dialogues aimed at convincing an offline payee the authenticity and security of transactions. However, any such dialogue that convinces a payee, in the current system, can also be emulated by a resourceful counterfeiter. Furthermore, a viable payment system must make sure that the offline value operates like paper money or coins — the money can be either in the payee’s wallet or in the payer’s wallet, and there is no option or possibility that value left the payer’s wallet, but the payee’s device did not receive it. The reported solutions do not seem to be able to mitigate these risks in offline-to-offline transactions.
From a functionality and use cases point of view, the e-HKD seems to be lacking in performance and does not bring added value compared to other similar projects conducted around the globe. For example, a digital token, whether in the form of e-HKD or a stablecoin or a loyalty token or for asset tokenization, should have a unique value and identity that enable splitting the coin to any desired resolution by a trader or device without a network connection, as well as allow for machine-to-machine payment and continuous payments per time or service.
A red flag that is related to both projects, Sela and e-HKD, was raised by researchers affiliated with Wuhan University, who published in September 2023 an article describing the impending fusion of artificial intelligence and quantum computing as posing “a catastrophic threat to modern cryptography” — the technology that undergirds private cryptocurrencies like Bitcoin as well as government-backed efforts like Hong Kong’s e-HKD.
The Wuhan article concludes, in essence, that the technology behind both the e-HKD and Project Sela is vulnerable to AI cryptanalysis and hacking by quantum computers. This means that if the cryptography that underlies a CBDC is breached, all the digital money can disappear. The Wuhan researchers advocate a family of solutions to mitigate this threat, that HKMA should study carefully.
Security for any financial system is paramount, and it is an unaddressed and unsolved concern in the current design and transaction protocol of e-HKD. HKMA should be taking more stringent measures to enhance e-HKD creation and circulation security assurance capabilities, bolstering most advanced security technical means, and improving threat handling mechanisms, emphasizing the importance of independent and controllable solutions.
Despite the above concerns, there is no doubt that in the first phase of the e-HKD project, serious and professional work was carried out by HKMA and all partners. That said, it would be prudent for the HKMA to reconsider whether a digital currency on a private blockchain secured by classic cryptography is the right way forward. Ideally, the e-HKD would have a settlement protocol that is not based on a cumbersome consensus mechanism but rather a public ledger and a settlement protocol that is not based on a single vulnerable algorithm. The digital currency also must allow the payer to validate the genuineness of tokens and prevent double spending, without requiring the intervention of intermediaries or validators, at no risk to the payee or issuer while protecting privacy without being an enabler of illicit financial activities.
We stand before a historic opportunity to redefine the very nature of money. Hong Kong, as a territory of China in the unique position of still being open economically to the rest of the world, can learn from China’s vast experiences with the digital yuan, a development that I witnessed and participated in firsthand, and to explore features for the e-HKD that would not only be relevant to Hong Kong but also the rest of the world. It is now up to Hong Kong to decide the future of its digital currency.
To paraphrase a famous Alan Turing quote from 1949, digital currency should be a prelude to things in the future, not a shadow of things in the future.
HKMA should think long and hard about how to fashion the e-HKD so that this switch to a new form of currency will benefit the fundamental aims of money as the blood vessels of society while mitigating systemic risks.