Let’s assume Libra works as a technology and people love it. Libra Reserve would qualify either as a systemic risk or as a market participant with unfair advantages, likely both.
I formulated a harsh critique of Libra’s tech as is, but hey it is software, it will evolve, and with enough persistence and enough funding it could at some point become technically usable.
Let’s assume people love it, as it is easy to use and delivers on the promise of a quite stable value if measured in traditional currencies. How big could its Libra Reserve grow?
There are many ways to estimate its magnitude, some examples:
- If people use it as pocket change, maybe as a single digit fraction of the cash they currently carry, then the value of all Libras could become about 700 billion USD (ca. 10% of global M0).
- If Libra is at least as popular to hold as Bitcoin, then it must have a total value above 150 billion USD
Above estimates are pretty conservative, if Libra works and people love it, it can easily acquire value 10 times of them.
So what, you say? We have seen a few companies surpassing the market value of 1 trillion USD recently and facebook is also worth about half of that.
There is problem with the promise that Libra’s purchasing power will be stable at those magnitudes. To understand why, let’s review how alternatives work.
The only guaranteed value of paper cash is that the government accepts it as a method of paying taxes. The central bank, as the issuer of paper cash, promises to exchange paper cash against a digital representation of the same, so it can be deposited into a bank account and withdrawn again from there as paper cash. That is it. Anyone else accepting paper cash and giving some value in exchange is doing so voluntarily. The ubiquitous willingness of people to accept paper cash gives stability to its purchasing power.
Bitcoin as cash
Bitcoin does not have any representation outside its ledger. Bitcoins are created on its ledger following a predetermined schedule. The number of Bitcoins in existence does only depend on the time passed since the network started. It does not matter how much energy was spent in mining or how many people find Bitcoin useful. Bitcoins value is supported by voluntary exchange only.
Since only a small subset of people is currently willing to accept Bitcoin, and its quantity does not adjust to demand, but follows time, Bitcoin’s purchasing power is fluctuating wildly.
Libra as cash
The quantity of Libras will follow demand. People will buy and sell Libra for their traditional currencies. The net of those transactions will create marginal demand or supply for Libra, which will force Libra Reserve to create or redeem Libras.
Libra Reserve will sell newly created Libra’s to those facilitating the exchange and invest the proceeds into hight quality liquid assets. Similarly it will sell the liquid assets to buy back and potentially destroy Libras in case supply exceeds demand at exchanges.
The standing offer of Libra Reserve to buy or sell Libras should keep its purchasing power stable.
The problem with scale
Above scheme of stabilizing value works, until it does not. It breaks down with scale as the magnitude of the assets backing the scheme reaches a level where eligible assets became scarce or transactions triggered by demand changes have market moving size.
It is very hard to collect and trade liquid assets in quantities of hundreds of billions or even trillions. Such pool of money has market corrupting effects only comparable to the market operations (known as QE) of central banks.
There are ways Libra Reserve could deal with scale:
- Avoid frequent trading of collateral assets by also holding Libra. This actually means running fractional reserve.
- Holding cash. This is inconvenient in paper form in quantities required. Bank accounts are also not suitable for these sums as insurances would not cover losses if the bank would fail. One would rather want to have a deposit at the central bank. Access to central bank digital cash is until now restricted to big banks. Means that Libra Reserve would have to either get a banking license with all its consequences or an exception. Later would be an act that would be seen un unfair advantage by many corporations that would love to access the central bank ledger without becoming a bank.
- Free float Libra. Means widening the bid — ask spread of Libra Reserve’s offer or even suspend it. This could be attempted as willingness to accept Libra becomes ubiquitous, so it stabilizes. But what if its value drops e.g. through a vulnerability of its most popular wallet? Even if its unwarranted, panic sellers of Libra could drive the price down quickly without a standing order of Libra Reserve. Who will pick up the bill for the lost wealth in supposedly stable currency?
The giant pool of liquid assets at Libra Reserve would qualify it either as a systemic risk or as an exceptional market participant with unfair advantages, likely both.
The preferred alternative by the incumbents is that things just stay as they are. There is little chance for this outcome.
Libra might accelerate central bank’s consideration of issuing their own digital currency adding to the strong reason I wrote about earlier.
Given that Bitcoin is bootstrapping a global currency without introducing the problems that Libra implies, we might see some surprising converts to Bitcoin maximalism.