Even official money is quasi-private in Hong Kong, with people interchangeably using the IOUs of its three note-issuing banks. But as central banks around the world plan to take cash digital, can this arrangement hold up? Or will the city’s 7.5 million residents have to deal in a brand new currency, a direct liability of the Hong Kong Monetary Authority?

The answer may be of global interest as governments everywhere are under pressure to adapt to the new technology.

Stablecoins, pegged 1:1 to the dollar or the euro, are emerging as a haven of value for those who trade volatile cryptocurrencies. Synthetic private cash might go mainstream when social-media giants put the power of their networks behind stablecoins. For instance, Meta Platforms Inc. (formerly Facebook Inc.) is backing Diem, a yet-to-be-launched token that can be sent instantaneously to anyone, anywhere with an entry-level smartphone and a data connection.

To preempt the risk to financial stability from too-big-to-fail stablecoins, central banks are contemplating their own versions of official digital cash. But they’re hesitant to open their ledgers to the entire population and track in real time whether anyone is trying to spend the same money twice. Regulatory authorities that have historically only worked with a limited number of banks simply aren’t equipped to take on the extra work that comes from being consumer-facing institutions.

How Hong Kong navigates the world of digital cash could offer useful pointers.

Three years after it officially became a British colony in 1843, bills issued by designated commercial lenders started to circulate as the medium of exchange in Hong Kong’s local transactions. The tradition has continued. Shortly before the city’s 1997 handover to the People’s Republic, the Bank of China (Hong Kong) Ltd. joined the two U.K.-based institutions, HSBC Holdings PLC and Standard Chartered PLC, as the island’s third money-printer. Since all their pieces of paper are fully backed by assets deposited at the Hong Kong Monetary Authority (HKMA), nobody except first-time tourists even notices the name of the issuer of banknotes.

Can a similar public-private partnership work with a retail electronic Hong Kong dollar (e-HKD)?

The city’s monetary authority is currently only studying the feasibility of retail digital cash, but one of the design options laid out in a technical white paper looks promising. The proposal is to create two blockchain-based layers: wholesale and retail. The central bank will operate only in the wholesale domain, and here, too, will only issue new currency or redeem it. Banking intermediaries will decide by consensus if one of them is entitled to receive wholesale digital cash from the HKMA based on whether it’s surrendering 1:1 value in backing assets.

The central bank will have no presence in the retail layer. Intermediaries will convert their wholesale digital cash into e-HKD and hand them over to customers in single-use envelopes, known in the crypto world as unspent transaction output, or UTXO. When a customer spends, she’ll tear open one or more envelopes and store any change in a new one. By tracing these cryptographically marked packets, transactions could be followed all the way back to the original source: the wholesale money that entered the retail system.

The advantage of this traceability feature is that if an intermediary in the retail layer goes bankrupt, payment disputes don’t need to head to court. Code can settle them, with the blockchain forging a consensus on which stuck e-HKD holder has a bona fide claim on backing assets parked with the central bank.

On the flip side, the anonymity of physical cash will be lost forever. The public key in a blockchain-based payment system is like a postbox address. People can use new ones to avoid their identities being unmasked by intruders. But banks, which will have to run know-your-customer checks as a safeguard against money-laundering, must register all the public keys of their clients. They’ll know.

However, for transactions where absolute anonymity is not crucial and a payer would voluntarily use a debit card — or a digital wallet — instead of having to shell out cash, e-money will be a welcome addition as a convenient, smartphone-based payment option. Such a version of digital cash will nominally be a private-sector liability, but because of ironclad backing, it will be indistinguishable from state-printed currency.

Separating out the wholesale and retail layers will reduce the “attack surface” for hackers. So it’s conceivable that even Hong Kong’s new-age virtual banks — such as Mox Bank Ltd. and ZA Bank Ltd. — may also be allowed to issue e-HKD alongside the established trinity of the note-printing institutions, making the financial system more competitive.

No large country can emulate Hong Kong’s currency-board system of a fixed exchange rate. But when it comes to tokenization of money, the Asian financial center may have a valuable message for the rest of the world: Rather than going head-to-head against the private sector, the public sector should try to coopt it as much as possible. It may be a less cumbersome route to digital cash than taking on every individual depositor as the central bank’s customer.

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