The virtual disk did not originate in iCloud, but is synchronised by iCloud because I ticked the 'desktop' option. But be clear, it is the .dmg file, not the Photos libray, that is on the desktop precisely because I know iCloud can break packages, so that is not the problem.
You double click the .dmg file to mount the disk, type in the decryption key and then it appears as an external 1Gb drive. Where is it safe... does not mention this specifically, but I assume the same rules as an external drive apply? The solution has the added benefit that the drive itself (i.e. the .dmg file) is mirrored to my other computers. I know it always syncs the whole .dmg file because after any change to it, iCloud reports that it is uploading 1Gb, the size of the virtual disk.
Where is it safe... says 'Do not format the external drive for the Photos Library as case-sensitive, if the internal drive is not case-sensitive'. The .dmg file is formatted as Mac OS Extended (Case-sensitive, Journaled) and the internal drive is formatted APFS, which is case sensitive, so this should be OK?
It is not read-only
It is not used for Time Machine.
This solution has been working for many years until the recent import problem. The existing pictures and folders seem OK.