On June 18, 2019, Facebook unveiled its highly anticipated cryptocurrency — Libra. It is absolutely a good thing for the whole crypto community because Facebook will educate millions of non-crypto consumers and increase the size of the crypto community significantly in a short period of time. Consumer education is very expensive and Facebook is one of the few companies that have the brand, resources and user base to succeed in doing that.
Of the three main components of Libra, two of them, Libra Blockchain and Libra Reserve, are relatively proven in the market. For example, Stella exists as a BFT-based blockchain, and USDC operates as a fiat-backed stablecoin. The third component, the Libra Association, acts as the governance body and unfortunately there is no proven governance model yet as of today. Will governance become the Achilles heel of Libra? I hope not but I have found at least one potential issue — the funding of the governance body.
By analyzing Libra’s public documents, I have found a weakness in the current design which could allow destabilization of Libra by organizations who choose to suppress the long-term funding of the Libra Association. I am sharing a hypothetical attack I have come up with, intended only to start the discussion and hopefully help the Libra team to refine its design.
Stablecoin Attacks
Libra is designed as a stablecoin, a topic that I have a strong personal interest because stablecoin is a key component to drive the success of Commerce 3.0, the next new era of commerce. For a stablecoin to become the “holy grail” of crypto, it not only needs to maintain its stability but also needs to survive all kinds of attacks including speculative attacks (Soros attacks) and price war attacks.
When evaluating a stablecoin, the majority of people focus on its stability method and few people analyze other important issues — the stability of the organization behind the stablecoin, the funding source for the project, and the incentive and return for investors who back the project. Will a stablecoin be long-term stable and useful if the organization behind the stablecoin is shut down due to lack of funding? I don’t think so.
This is also true for fiat currency. To maintain its “independence within the government”, the US Federal Reserve does not receive funding that is subject to approval by either the congress or the president. Its income, protected by laws, comes primarily from the interest on government securities that it holds and in 2016, the interest was about $111.1B while the operating expense was about $4.0B.
Interestingly, according to the Libra Reserve document, the Libra Association is funded in the long term by the interest generated from the Libra Reserve. (Even though it is not clearly described, I suspect that short term funding of Libra Association is either from Facebook or from the founding members’ $10M entry fee or both.)
“… The revenue from this interest will first go to support the operating expenses of the association — to fund investments in the growth and development of the ecosystem, grants to nonprofit and multilateral organizations, engineering research, etc. …”
However, the interest from the reserve and the funding for Libra Association can be suppressed in the current design, which can destabilize the whole Libra global currency.
Arbitrage Attack on the Libra Reserve
Ultimately, the majority of money for the reserve will come from users of Libra instead of investors in the Libra Investment Token. However, in the current design, users of Libra do not receive a return from the reserve.
“Users of Libra do not receive a return from the reserve.”
To increase users’ confidence, Libra will enable liquidity and make it easy for users to buy and sell Libra at any time at or close to the value of the reserve. The combination of “no return” and “easy liquidity” gives no reason for users to hold Libra. This opens up an attack to suppress the reserve held by Libra Association and, as a result, the interest generated from the reserve.
Such an attack is profitable and legit, and it will be very likely carried out by competitors. Let’s use the traditional banking giant JP Morgan as the example here. To execute the attack, JP Morgan can add a Libra wallet function into its existing consumer banking mobile or online apps. It needs to offer some return to users so they will store Libra using JP Morgan apps/wallets. Once it receives Libra from users, JP Morgan can immediately sell Libra back to the Libra Association for cash and earn interest with same risk by buying the same basket of assets that the Libra Reserve is choosing. When users need to use Libra, JP Morgan can buy it from the market immediately. As long as the interest earned from the reserve is larger than the interest paid to users, it is profitable for JP Morgan.
Basically, JP Morgan uses arbitrage to earn additional money while, at the same time, attacks its competitor Libra by suppressing its reserve and interest. Besides traditional consumer banks, other organizations such as crypto wallets could earn money by doing this type of arbitrage. (It is unlikely but Facebook’s own Calibra wallet is in a position to do it as well.)
How to Defend?
There were no traditional banks on the list of the initial 27 founding members of the Libra. Why? I don’t know. Is Facebook competing with traditional banks? You bet. Will those banks fight back? Very likely. If the above hypothetical attack is being carried out, how should Libra defend? It is a very tough question.
Limiting liquidity does not seem to be a good idea since it can cause users to lose confidence in Libra. Providing return to users for holding Libra will add complexity for Libra, as its long term goal is to be decentralized. Hence these designs should not be changed.
New funding sources for the Libra Association should be designed into the system in case the interest earned from the reserve is not enough to cover the expenses. There are some existing models such as membership fee in SWIFT. It is still not an easy task to manage an association of big corporations. But I am confident that Libra and its founding members will resolve the long-term funding issue.
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