In case you missed it, Facebook announced its much-rumored cryptocurrency, Libra, along with an accompanying consortium for essentially governing the currency’s blockchain. From Techcrunch:
Facebook has finally revealed the details of its cryptocurrency, Libra, which will let you buy things or send money to people with nearly zero fees. You’ll pseudonymously buy or cash out your Libra online or at local exchange points like grocery stores, and spend it using interoperable third-party wallet apps or Facebook’s own Calibra wallet that will be built into WhatsApp, Messenger [Instagram, Marketplace,] and its own app. [They forecast] a public launch in the first half of 2020.
Facebook won’t fully control Libra, but instead get just a single vote in its governance like other founding members of the Libra Association, including Visa, Uber and Andreessen Horowitz, which have invested at least $10 million each into the project’s operations. The association will promote the open-sourced Libra Blockchain and developer platform with its own Move programming language, [get the ability to operate a validator node,] plus sign up businesses to accept Libra for payment and even give customers discounts or rewards.
In other words, Libra is a bit of a hybrid, blending crypto’s libertarian financial systems with digital peer-to-peer networks (P2P). It’s not fully trustless like Bitcoin or fully permissioned like PayPal, but relies on a handful of (theoretically) trusted 3rd parties to serve as judge, jury, and intermediary. It’s also not fully decentralized like Bitcoin or fully centralized like traditional P2P, but relies on that same handful of (relatively) distributed consortium members. Finally, it’s not capacity-constrained like Bitcoin or scalable like P2P, but promises to add validators in almost a step-function when more throughput warrants more support.
In the founding consortium’s mind, that hybridity strikes a sweet spot in the middle of the payments spectrum. Libra’s white paper explains why:
The challenge is that as of today we do not believe that there is a proven solution that can deliver the scale, stability, and security needed to support billions of people and transactions across the globe through a permissionless network. One of the association’s directives will be to work with the community to research and implement this transition, which will begin within five years of the public launch of the Libra Blockchain and ecosystem.
The Libra team’s insight is that the Utopian version of a cryptocurrency isn’t fundamentally practicable yet, so they’re going to start with a half-measure to establish a beachhead, then iterate from there. Naturally, it won’t be that easy…
The Endogenous Transaction Loophole and maximalism
That all said, I need to inject a bit of important nuance here. “Know Your Customer” (KYC) and “Anti Money Laundering” (AML) are two key regulatory policies in the bedrock of financial services compliance. However, KYC and AML would require that Libra’s overlords monitor and report activity for only the on-ramps and off-ramps into and out of Libra exchanges. As for the Libra-denominated transactions that occur endogenously among holders — a closed loop within Libra’s blockchain — the activities of pseudonymous counterparties therein would be really difficult to track. (Goes without saying that there will always be blockchain audit services, like Chainalysis, who can try and bootstrap transaction data to ascribe identity, but more on that later.) Let’s call this the “Endogenous Transaction Loophole”, which adds to the sweetness of the sweet spot Libra’s trying to occupy.
This gets at one of the moonshot visions for strong-form Bitcoin maximalists. It’s also why the scale of the Libra market is important. If there were enough adoption and liquidity within Libra that it were to capture a significant swath of transaction use cases — in addition to mere throughput/volume — then there would be a real pot-of-gold here. When I refer to “use cases”, don’t just think of P2P, ecommerce, and ad buying; but also think of online bill pay, offline retail point-of-sale (PoS), and business-to-business (B2B) transactions. Not just me buying a latte a la Square or splitting a dinner bill with my buddies a la Venmo; but also me paying my household’s landscaper and settling-up with my business’ office supply vendor. Such breadth would allow users to live, work, and play within a Libra ecosystem without having to evacuate back into the terra firma of the traditional banking system and all of its associated regulatory burdens.
As such, a maximalist Libra ecosystem would afford network effects and economies of scale for everyone involved. And, if anyone ever had a shot at crossing that chasm, it’d be Facebook and this consortium, as I’ll discuss at length below.
Fantastic! Except, to begin, there’s another pretty big hurdle between here and there: the problem of incentives…
Libra’s incentive problem and tax solution
One of the bigger challenges standing between Libra and its maximalist vision is the opportunity cost for individuals/entities to keep cash denominated in Libra over the long term, without repatriating back to their local currencies.
For example, the Libra currency economically cannot offer competitive interest-bearing deposit accounts, so hodling Libra risks erosion of purchasing power for any individual or entity whose liabilities are denominated in another currency, like the US Dollar. More on all of this in a moment, but, for now, let’s just say that this form of asset/liability mismatch is a big enough risk that it may trump most of the value propositions being trotted out there today — especially for users like the “unbanked”, a cohort of 1.7 billion people worldwide who are deprived of access to any banking system and whom Libra is explicitly addressing with its marketing push.
This is one of many chicken-or-the-egg problems. Indeed, the consortium can (and will) try to layer-on non-cash incentives like coupons, discounts, and rewards to compensate users for the lack of interest-bearing deposits (and related asset/liability mismatch), but it’s hard to imagine that alone being sufficient and sustainable, given how thin margins already are for all of those involved.
There is another incentive that’s big enough to displace this shortcoming without an out-of-pocket cost: tax avoidance. Because Libra’s endogenous transactions will occur between two pseudonymous users, investigating said activities would be a resource-intensive endeavor, as I already mentioned. A regulator doing a deep dive a la Chainalysis would only be economical for sizable Libra transactions by sizable Libra pseudonyms. (e.g. For good reason, US regulators currently tend to draw-the-line for investigations at $10k in flows.)
On the notion of tax avoidance, the upside for Libra’s closed-loop transactions is that these logistics let a lot of individuals and merchants run the digital equivalent of your drycleaner’s “cash business”: When you pay your drycleaner in analog greenbacks or digital Libra, the money changing hands under-the-table is imperceptible to the IRS, so your drycleaner gives you a 10% discount to thank you for saving him ~20% on taxes. (To be honest, this actually borders more on tax evasion 😬)
Were tax avoidance part of the value equation, then discounts/rebates on purchases would be more feasible incentives — not to mention far more alluring, sticky, and capital-lite than interest rates.
As such, either wittingly or unwittingly, Libra has both carrot and stick at its disposal. While the maximalist end-state may be an idealistic aspiration, the Endogenous Transaction Loophole offers real incentives to drive participation among SMBs and individuals. With tax minimization as its transmission mechanism, the Loophole gives your participating neighborhood drycleaner a cost or price advantage over dissenting rivals. That leverages FOMO to threaten non-conformists with punitive competitive disadvantage — a bit of a prisoner’s dilemma (but more on that later). At the same time, the on-ramp/off-ramp reporting requirement is enough to satisfy KYC, AML, and, frankly, the IRS, per the letter-of-the law as it stands today.
In that vein, it will be interesting to hear from Facebook’s lead on Project Libra, David Marcus, who is scheduled to testify in front of Congress on July 17. I’ll discuss some other concerns about this system’s unintended consequences momentarily, but Congress must probe the scope of Libra participants’ opportunity to exploit the Endogenous Transaction Loophole. As one example, federal lawmakers should use upcoming hearings to identify and close any loopholes that these new technologies could exploit for otherwise legal tax avoidance. This is also their chance to nip any collusion or antitrust potential in the bud. While the latter strikes me as more alarmist than realist, the nature of crypto maximalism means that the power such blockchains can accrue could become somewhat irrevocable, giving rise to a new kind of shadow banking system that regulators would struggle to put-back-into-the-bottle. cc Maxine Waters, Patrick McHenry, Senator Sherrod Brown
Incumbents and the status quo
Inertia is another challenge. The credit card infrastructure throughout much of the developed world is ubiquitous, familiar, and, frankly, good enough. This presents a problem known as “leapfrogging”: A new technology has to overcome the challenge of changing both consumer habits and supply chain infrastructure.
That’s one of the reasons why digital payments adoption has been slow in the developed world: Apple Pay’s incremental improvements to the user experience relative to the preexisting standards were so marginal as to be insufficient to disrupt the status quo. By the time you ask the clerk at your grocer’s cash register whether or not he/she accepts Apple Pay, you could have already had your credit card out and swiped. If you have to ask in the first place, it just isn’t worth it.
In contrast, the ubiquitous digital payment apps that have succeeded internationally — like WeChat, Alipay, M-pesa, and Dwolla — were launched into emerging markets where physical payments infrastructure had never existed to such an extent. There have also been a handful of domestic players who have managed to pick-off narrower use cases, as did PayPal, having launched at the advent of the consumer internet and grown with internet usage as the web’s (almost) natively integrated payment method. This is the very playbook dictated by “The Monty Hall Path”:
In sum, during the rise of mobile, power initially accrued to the default services that new users discovered when they first arrived in the new surface area; but, now that mobile has matured, power accrues to the biggest aggregators in their respective verticals, including [PayPal for e-payments]. Instead of framing this as The Monty Hall Dilemma — a binary choice between Door 1 and Door 2 — it’s more like The Monty Hall Path — a linear path to the Promised Land that first led [PayPal] through Door 1(The Power of Defaults), then eventually wound its way through Door 2 (Aggregation Theory).
These giants became payment defaults in a new surface area, filling a void in the power vacuum created by the web/mobile/social. (That’s part of why Apple Pay’s new deal with New York’s MTA is such a brilliant strategy to build momentum — to boldly go where no credit card has gone before by making contactless digital payments available to all of those public transportation riders who frequent the subway/train/bus.) While The Monty Hall Path is a mere strategy — which glosses-over a lot of the research, development, innovation, and hustling it took for these mainstays to compete and survive, per the cautionary tale of the now defunct Facebook Credits — the point is that Facebook is consciously trying to fill a similar void in the power vacuum that could eventually be created by blockchain.
That puts this aforementioned excerpt from Libra’s white paper in new light:
The challenge is that as of today we do not believe that there is a proven solution that can deliver the scale, stability, and security needed to support billions of people and transactions across the globe through a permissionless network. One of the association’s directives will be to work with the community to research and implement this transition…
I’m not convinced that Facebook or anyone else knows exactly how Libra will benefit them, but I’m pretty sure that they’re all making the bet that they’d rather be involved with blockchain technology than not. (By now, The Innovator’s Dilemma, Disruption Theory, and Aggregation Theory are all well-read and well-understood by business strategists!) Like PayPal and many others before it, the Libra gang is racing to become a default in the new surface area — trying to launch at the advent of blockchain deployment and grow with blockchain usage as its natively integrated payment method.
Bear-hugging disruptive innovations
To wit, back in 2018, Ben Thompson published a succinct analysis of blockchain’s implications for tech’s super aggregators:
[A]long with all of their other moats, Google and Facebook are free. It’s not like a competitor can be cheaper — except, if it is making you money… the fact there is money to be made in cryptonetworks is critical…
I am often asked why we don’t hear much about cryptonetwork work from Google or Facebook, and the answer is obvious: their entire business model is predicated on centralization, which means both are heavily incentivized to ignore [or obstruct crypto development]… That, though, is a reminder of just how far cryptonetworks will need to go: gaining users and overcoming obstruction will require being fundamentally better…
[W]hen cryptonetworks have their moment (beyond speculation), it will likely be in an application that is completely new, not an imitation with an inherently worse user experience.
There are three major strategic takeaways that I emboldened therein, summarized as follows…
- The profit motive:
The fact that cryptonetworks make money for users is a competitive advantage for upstarts vs incumbents, who are merely free;
- The Innovator’s Dilemma:
Incumbents fundamentally don’t want to decentralize, as their business models require centralization;
- Superior user experience:
Cryptonetworks still need to “10x” the user experience in order to overcome incumbents, who already have maximum economies of scale/network effects
So, in addition to the profit motive from extrinsically rewarding early adopters (#1), blockchain’s effectiveness as a disruptive force also requires both the threat of self-cannibalization to prevent incumbents from competing a la The Innovator’s Dilemma (#2) and the old school means of new entrants winning by simply being much much better than the status quo (#3). Without the second two criteria, a new cryptonetwork won’t be able to sustain upon reaching its terminal rate. For example, sure, early adopters of a disruptive blockchain dapp or protocol would profit handsomely, but the investment of time and money demanded of a user to adopt a new network would become less of an investment and more of a cost for later-adopters, who would arrive on scene well after the network’s velocity has started decelerating/reversing — and, by extension, its token appreciation. After growth and its promise for profit have come to pass, such cryptonetworks would be left to compete on the utility of their user experiences — for which the 2.4 billion Facebook users and their network effects are high hurdles. (This echos of Eugene Wei’s Status-as-a-Service; his Utility vs Capital axes; and the concept of “evaporative cooling”.)
Were you to view Libra through the one-dimensional lens of ‘real blockchain protocols have a profit motive’, then you’d miss the potential strategic angle Facebook is approaching this from — one in which FB has hope that it may obstruct its own disruption at the hands of a properly decentralized blockchain.
Do not assume that Facebook is naive for rolling-out a half-baked blockchain. Do not assume that Facebook is ignorant of blockchain’s existential threat. Per Ben Thompson above, all three of the ingredients I listed can conspire to create the conditions of a truly disruptive innovation — as opposed to a mere sustaining innovation. The Libra Association is attempting to ladder-up from the status quo and nestle right on up under the shade of blockchain Utopia, getting just close enough to Bitcoin maximalism that any breakthrough therein will feel more like a sustaining innovation (relative to Libra) than a disruptive one. This is what I call a “bear-hug” strategy. Without all three ingredients, you’d miss what’s so fascinating about the Libra gambit and the balancing act Facebook’s performing:
- By forgoing the profit motive (#1 above), Libra is relying on the vulnerability of true cryptonetworks to the profit motive’s evaporative cooling effect;
- By launching as a distributed network, Libra is relying on the vulnerability of true cryptonetworks to radical decentralization’s bureaucratic inefficiencies — a half-measure that side-steps Facebook’s Innovator’s Dilemma (#2);
- By virtue of its combined scale and efficiency, Libra will not only achieve a great user experience for itself, but also foreclose on rivals achieving a 10x improvement over-and-above Libra (#3)
To borrow another term from Ben Thompson above, Libra could also be seen as “obstructing” blockchain development if you squint just right: Aside from diverting resources away from blockchain R&D, including qualified developers, Facebook seems to have engineered Libra such that it’s “good enough” to make potential disruption from proper blockchain innovations too incremental — whether money (Bitcoin), programs (Ethereum), or data (Filecoin) — without fully decentralizing in such a way that would disrupt the supply chain for its Data Factory.
The Prisoner’s Dilemma Wedge
For Facebook, at worst, Libra’s bear-hug strategy promises to increase both the efficiency of their ads business and possibly the depth of their user engagement. While Libra isn’t fully decentralized/trustless/incentivized in such a way that crypto purists had envisioned, it does promise to be a compelling successor to today’s P2P platforms, in particular. That’s key, as discussed in “The Prisoner’s Dilemma Wedge”:
Here’s the framework… which anyone can apply via the following canvas…
1. What do you want from upstream suppliers in your industry that will cost these suppliers nothing?
2. Who are the commoditized upstream suppliers in your industry?
3. What’s something you can offer them in exchange for what you want?
4. Who are the end-users in your industry?
5. What is your unique solution?
6. Who are the subset of niche end-users that would pay a premium for your unique solution?
7. What is your value proposition for that subset?
8. Who is the direct competitor in your own horizontal who makes your value proposition look strongest in a head-to-head comparison?
While conscious of the future rivalry, Libra is not positioning itself as a competitor to cryptocurrencies or traditional banking. Instead, it is marketing itself as a direct competitor in the horizontal occupied by P2P payments incumbents, per the above framework’s eighth and final step…
Question: “Who is the direct competitor in your own horizontal who makes your value proposition look strongest in a head-to-head comparison?”
In juxtaposition to the PayPals of the world, who are still scrapping to add more merchants and more consumers to their platforms, Facebook has already added everyone on both sides of the two-sided marketplace. Today’s fintech paragons have great businesses here in the US, with a lot of growth still ahead, but they’re also the incumbents most vulnerable to Libra proliferation.
While there are levers that a target like PayPal could pull to turn this in their favor, PayPal has, at worst, a (dilutive) stake in its own demise, since it happens to have preliminarily joined the Libra consortium. That’s better than no stake at all. In such a way, PayPal could be to Facebook’s Libra what Starz was to Netflix’s streaming upstart. This analog was also discussed in “The Prisoner’s Dilemma Wedge”:
[E]ven in 2008 Starz had a number of on demand offerings of its own, and although every one of them had its own foibles, inertia would’ve likely allowed traditional distributors’ video on demand (VOD) services to squelch Netflix’s offering. But, part of Netflix’s marketing genius was to comp itself not against its own suppliers’ VOD offerings, but rather against Blockbuster and other dinosaur movie rental chains, relative to whom its value proposition was strongest. By serving a different niche than its suppliers, Netflix might have even been viewed favorably by the integrated providers, since it was growing-the-pie for the entire entertainment industry.
Again, Facebook has been careful to not pit Libra against Bitcoin or PayPal explicitly — the latter being a bit channel conflict. Instead, it’s implicitly pitted Libra against the dinosaurs in remittances, like TransferWise. Facebook has used this playbook before too, with the spread of Facebook Core amidst MySpace’s dominance!
The zero marginal cost flow state
So, Facebook is well-endowed to gatecrash this competitive landscape. But, that said, Facebook’s large, captive audience does not guarantee Libra adoption. In fact, its mass could actively work against it. From “The Killer App and the App Killer”:
Facebook Core was originally unassailable for entertainment such as social networking, but given their marketshare of attention, they almost inertially expanded to subsume other verticals like news… Zuckerberg never planned on Facebook assuming its current role as a social supermarket. He always wanted (and still wants?) Facebook to be a social network instead of social media — to connect people, not inform them. Competitive dynamics and, frankly, users’ needs led Facebook to integrate so much functionality that it grew into the Swiss Army Knife of a social hub that it is today.
In addition to the well-documented difficulties of managing a massive platform like Facebook, being a social supermarket predicates inherent bloat that buries new features among legacy ones. So, just because there’s a shiny new “Libra” button front-and-center doesn’t mean users will even notice it — or suffer the brain-damage required to onboard.
Regardless, the importance of the Endogenous Transaction Loophole is that it’s the one locus wherein Libra could enjoy zero marginal costs. Given that one condition, the strategic playbook almost writes itself. From “The Missing Incentives for Cryptonetworks”:
Big Tech’s markets all trend toward monopoly, because they operate multi-sided networks with zero barriers-to-entry. Thus, network liquidity is the basis of competition for many of them: Who has the most buyers and sellers; the most producers and consumers; the most supply and demand; etc. That liquidity sets-off the virtuous cycle of network effects, wherein scale improves user experience improves scale and so on. If you add software’s zero marginal costs to that virtuous cycle, you get Aggregation Theory…
Never mind its partners, Facebook alone “has the most buyers and sellers; the most producers and consumers; the most supply and demand”. That puts low-hanging fruit like remittances, micropayments, tipping, and peer-to-peer transfers all in-play, since Libra could theoretically disinflate the cost of such money transfer activity by virtue of its lower CAC and larger economies of scale. For example, were we to entirely discount the consortium’s firepower and the blockchain’s value-added, Libra would still be launching to 2.4 billion Facebook users worldwide. That scale provides a structural competitive advantage over incumbents like TransferWise, who represents the nouveau-riche among modern remittance incumbents, with a user base at 4 million sending $4B of FX per month that translates into an $8M annual profit. That’s a low hurdle for Facebook, given its firepower.
That scale is also an antidote to the challenges of Facebook’s preexisting bloat. The only questions is: Why should they care? Why should Facebook & Co want to inherit-the-earth via Libra and Calibra?
Stablecoin tradeoffs and false narratives
Honestly, other than having a seat at the table, it doesn’t look like there’s a whole lot in it for Libra’s members.
I know what you’re thinking about the incentive quandary: ‘But Libra is invested in an underlying basket of currencies and assets, including interest-bearing sovereign notes and bonds that should spin-off cash flow’. Therein lay a popular misconception, plus a few theoretical problems endemic to stablecoin architecture on a global scale…
First and foremost, currencies themselves don’t bear interest. Simple as that. If, for some reason, Libra itself were to become an interest-bearing asset for hodlers, then it would likely subject itself to full regulation by SEC/OCC/OFAC/etc, lest its sponsors in the consortium face sanctions by the US government, among others. More on this later, but Libra simply will not go down the path of registering a security here — a la a money market fund (MMF), money market mutual fund (MMMF), exchange traded fund (ETF), or exchange traded note (ETN).
More importantly, the white paper already ruled out the possibility of Libra itself bearing interest for the benefit of users:
Interest on the reserve assets will be used to cover the costs of the system, ensure low transaction fees, pay dividends to investors who provided capital to jumpstart the ecosystem… and support further growth and adoption. The rules for allocating interest on the reserve will be set in advance and will be overseen by the Libra Association. Users of Libra do not receive a return from the reserve.
More precisely, Libra will bear interest, but that interest is for the benefit of consortium members, not users. The “carry” on reserves is a part of the consortium’s revenue model. (And, for the record, there’s nothing wrong with that; after all, that’s central to PayPal’s business model too.) But, the more profitable the more volatile, so don’t expect this to be a cash cow for them. The risk-reward ratio is simply an immutable tradeoff. FX is surprisingly volatile, even in the developed market currencies Libra has thus far nominated for its managed basket. It’s also hard to diversify into sovereign debt markets and generate meaningful cash flow when Japanese and German paper remains at negative yields. (e.g. 3 month JGBs yield -0.13% and 3 month German Bunds yield -0.56%!) It’d be a bonus were the cash flow from reserves able to cover the blockchain’s overhead alone.
Second, the way Libra’s white paper describes it, its approach to reserves gives the consortium some discretion as to the composition of Libra’s underlying basket of currencies (e.g. USD/EUR/JPY/GBP) and assets (Tbills/Bunds/JGBs/Gilts). While that enables dynamic diversification in an effort to theoretically dampen Libra’s volatility, it also means that Libra is not redeemable at par:
It is important to highlight that this means one Libra will not always be able to convert into the same amount of a given local currency (i.e., Libra is not a “peg” to a single currency). Rather, as the value of the underlying assets moves, the value of one Libra in any local currency may fluctuate.
So, if I have $1 worth of Libra, there’s no assurance that I can sell my Libra and receive a full $1 back in exchange. Some really prominent thought leaders are broadcasting/speculating/misunderstanding this very point, and it’s contributing to a dangerous popular narrative. In reality, Libra has no FX peg, no NAV peg, etc.
Third, the whole theoretical notion of “low volatility” depends on the end-user’s reference currency. For example, if your base currency is South African Rand ($ZAR), then your local liabilities could wildly increase or decrease relative to a “stable” Libra. Our intuition is to think that most currencies are volatile to the downside. But, foreign exchange (FX) is a zero-sum game. Sure, over the long term, a lot of emerging markets currencies have historically trended toward devaluation, but that’s not a free lunch or a one-way trade. Not only are the costs to buy and sell those currencies material (e.g. “spread”), but the rips up in those currencies can be vicious, like the +24% rally in the MSCI EM Currency Index across 2016–17. Such a surge would’ve made it very hard for someone in the 3rd world to pay his/her bills, which would have effectively inflated 24% in domestic terms relative to the cash he/she had stored in stable Libra throughout that 2016–17 episode. In other words, Libra’s low volatility — whatever that means — does you no good if your local currency is still in flux.
There’s another side of that coin too: Were Libra to become a pseudo-global currency, the aggregation of savings, investment, trade, and consumption into a single, monolithic medium of exchange would neuter the abilities of sovereign nations to manage their own idiosyncratic economies. True, that would likely have the greatest impact in the emerging markets where Libra offers a promise to supplant corrupt, repressive, and/or incompetent central governments. But, economists have conducted a lot of empirical studies about outsourcing monetary policy — from currency pegs to gold standards to monetary unions — and there are always unintended consequences to such unnatural synchronization of asynchronous systems. This is another grey swan that warrants Congressional inquiry. cc Maxine Waters, Patrick McHenry, Senator Sherrod Brown
The business of Libra wallets
That’s all about Libra itself — the currency and its consortium. Separately, there are questions about how Libra wallets will monetize for themselves and how they’ll compete for new users. So, let’s talk about wallets for a moment…
To start, could wallets like Facebook’s own Calibra offer interest on deposits? The short answer is “yes”, wallets could theoretically bear interest, however that’s highly unlikely for a number of reasons, including the structural mechanics of how these wallets have to monetize.
Calibra’s VP of Product, Kevin Weil, discussed the wallet’s monetization plans in a recent interview:
The [direct benefit for Facebook] is the more pure Calibra part: if we are successful at providing a wallet that allows people to store money securely and send to anyone anywhere in the world, then over time we think there will be an opportunity to provide more financial services for people — you can imagine things like credit.
At least as it stands today, Calibra’s product roadmap includes forays into some pretty traditional financial services, like credit. Crucially, these wallets will not be engaged in “fractional reserve banking” when they actually extend that credit. More on this below, but Libra deposits and credit will be two independent accounting items — as opposed to traditional savings and loan (S&L) banks in which deposits are but one form of bank capital that goes in one side as customer deposits (bank liabilities) and out the other as loans (bank assets). This is called fractional reserve because, simplistically, banks are only required to reserve against a fraction of their deposit liabilities, and they can literally extend the rest as credit. Hence, when a run-on-the-bank occurs and depositors all try and pull all of their money, banks generally cannot honor all of those withdrawals all at once. (Technically, “reserves” themselves are bank assets that somewhat mirror — but aren’t the same as — deposit liabilities; plus reserves aren’t lent out to customers, which is confusing, but you get the point.)
It’s important to understand that plumbing from at least a high level, because the deposit side of Libra wallets’ businesses should not have an impact on the credit side in the traditional sense of a bank balance sheet. For example, Calibra will not take my deposit in one side and lend it to you out the other side. To wit, Calibra will have to make money from you on the credit side — at least they hope — but I cannot fathom what their financial incentive would be for having me on the deposit side.
More precisely, the benefits of Calibra deposits would accrue disproportionately to the Libra blockchain and Facebook’s diluted share therein — as opposed to Calibra itself as Facebook’s wholly-owned subsidiary. I understand the intrinsic motivations of having a non-revenue generating or loss-leading depositor, considering the size of the tangible addressable market (TAM) and its adoption curve. But, more specifically, I’m skeptical that the lifetime value (LTV) of a depositor would prove sufficiently large to warrant high customer acquisition costs (CAC) for most Libra wallets — especially those not named Calibra — even accounting for cross-selling opportunities that could augment LTVs.
Here, again, Congress must probe the market dynamics to determine whether competition can be sustained at the wallet layer or power will accrue disproportionately to a structurally advantaged, aspiring aggregator like Calibra. cc Maxine Waters, Patrick McHenry, Senator Sherrod Brown
Sure, Calibra is the Facebook owned-and-operated wallet, so I’d expect to see it integrated across all FB properties. In that sense, FB wants users to have funded wallets so they can, well, use them in any and all transactions. Here, there are a few final points to be made…
First, while deposits wouldn’t be creating loans in Calibra’s system, as discussed above, loans would be creating deposits. If credit were to become the money-maker for Calibra, then they should offer the cheapest credit possible to attract more borrowers. Were they to needlessly pay interest on deposits, that would hurt their ability to lower interest rates on loans — not to mention that deposit rates are a marketing vehicle that attracts high churn customers. (Generally speaking, the bigger the bank the lower its deposit rates and, to a lesser extent, the lower its loan rates, which is only to say that the long term consumer surplus portion of banks’ scale advantages tend to accrue on the lending side, not the deposit side.)
Furthermore, logistically, were a borrower to draw on his/her credit, Calibra would then drop the loan proceeds into the borrower’s Calibra deposit account. When the borrower then spends that Libra by transferring it to a counterparty, the downstream effect is to fund a bunch of wallets, bootstrapping adoption.
In such a way, credit creation sparks an inevitable flywheel (credit > deposit > transaction liquidity) that doesn’t necessarily spin were the process started by deposits instead (deposit ≠ credit ≠ transactions). Thus, there’s far less of an economic incentive for wallets to compete for deposits, eliminating the need for promotional interest rates.
It’s also important to note that net interest margins (NIMs) at US banks have averaged 3.4% this decade — a really skinny margin-for-error that not only excludes all of the extraneous costs of running deposits and lending, but also includes the benefits of lending with fractional reserves (i.e. lending with leverage is a considerably more profitable model than the fully-reserved one Calibra will have to employ). As alluded to above, these wallets won’t engage in fractional reserve banking because Libra itself is not only supposed to be pseudo-decentralized (i.e. distributed), but also a fully-reserved currency (i.e. backed by the basket of currencies and sovereign notes that the Libra consortium manages).
Credit creation is fascinating technology, but it really requires controls and centralization, such as those provided by central banks and various regulators — lest money supply run amok and the currency fail, absent a lender-of-last-resort. Thus, were Libra wallets to extend credit to users, that capital would have to be funded by preexisting Libra or other fiat that the wallet operator already holds on his own balance sheet. In other words, Facebook will take USD-denominated cash on its own balance sheet, create new Libra backed by those USDs, then drop that newly minted Libra currency into your wallet as a loan — fully-reserved as opposed to the fractionally-reserved method of taking my Libra deposits and lending them to you to create fiat ex nihilo.
Since Libra wallets will be operating on something less than a 3.4% net profit margin (base case NIM), I cannot envision a high-enough LTV opportunity to justify Calibra paying interest on deposits — or I can at least envision more efficient means of Calibra arriving at the same LTV opportunities. (Best of luck to the rest of y’all wallets.) This all amounts to deposits not being a very important KPI.
Left in its own silo as such, the credit business will have to thread-a-needle too. Take credit cards as a working example, since they’re a good benchmark for the kind of unsecured credit in which Libra will have to traffic...
By and large, APR covers the risk of the consumer defaulting on his/her credit balance. Some accounts carry balances and others pay-off their balances monthly, but APR isn’t assessed until a consumer carries a debit balance beyond his/her monthly payment date.
Separately, chargebacks and fraud are additional costs of doing business. These risks are covered by merchants, who pay small interchange fees levied on every customer transaction. Another way of viewing the interchange fee is as an expression of the expected value of fraud in any given transaction. Credit card issuers (banks like Citi) and networks (sponsors like Visa) are a lot like insurance companies: They’re very good at estimating risk events like the propensity for fraud and chargebacks. The bigger they are, the better they get at forecasting; and the bigger they get, the more their user bases resemble the risk pools of the broad populations that their estimates model. (i.e. The Law of Large Numbers, not to be confused with my pet peeve, The Logistic Principle 😂)
APRs (and other revenue streams in the credit card supply chain) are as high as they are because servicing unsecured credit is a costly, risky business for creditors. Of course, there are exceptions, but the suitability of APRs is something reaffirmed by academic and empirical studies of the credit card industry. There have even been studies about alternative forms of unsecured credit extension, like microfinancing, which are often less regulated, less capital-intensive, and less bureaucratic, but most of those studies still conclude that a risk-based interest rate between 15–30% is advisable — varying due to factors like the market, available data a la credit scores, etc.
Judging by the commentariat’s Libra hot-takes, the popular perception is that banking is a wildly profitable enterprise, replete with fat margins and gratuitous bonuses. (Yes, there are divisions within investment banks that operate at fat margins with big bonuses, but they are inherently risky businesses with lumpy performance. Nevertheless, a full undressing of iBanking is beyond the scope of this article.) In reality, the net margins for traditional banking business lines are razor thin — and thinning due to compliance costs associated with post-9/11 and post-crisis regulations. While not at all a comment on the integrity of those regulations, compliance is the biggest growth business in finance!
The point is that basic banking (i.e. certainly retail and, to a lesser extent, commercial) is a highly commoditized operation; capital intensive; heavily regulated; bureaucratic; etc. There’s no alchemy here: At least one stakeholder would have to accept a tradeoff were a new product/service/system to try and break that mold.
Unfortunately, the unbanked users that Libra is targeting are an expensive proposition for wallets — whether the vehicle is credit lines or vanilla money transfer business. The smaller presence a user has in the regulated system, the higher risks and compliance costs he/she will impose on Libra’s end-points.
There is money to be made in lending for some, like Calibra, but the real question is: “how much?”
Beyond that, wallets do have a legitimate opportunity to compete for FX business against non-traditional fintech. Like a TransferWise at super-scale, Calibra would be able to provide services for users who are looking to redeem Libra in exchange for their domestic currencies. Yet again, interest-bearing deposits have little to do with building this business, because these wallets won’t extract fees from stock (i.e. deposits), but rather from flow (i.e. currency conversion).
The “Libra Day” airdrop op
Albeit a higher-ROI/higher-LTV proposition than paying interest on deposits, due to retention rates, airdropping a lump sum into FB users’ wallets is a viable option to seed adoption — a la the early days of PayPal.
The public proclamations made by Libra’s leaders would make execution difficult: Not only is there not enough seed capital to go around (currently targeting a $1B raise vs 2.4B Facebook users), but there’s also not enough user data to optimize the distribution of airdropped Libra were they to partially allocate to only a handful of users, rather than the whole population.
From the white paper:
Facebook created Calibra, a regulated subsidiary, to ensure separation between social and financial data and to build and operate services on its behalf on top of the Libra network.
And from Calibra’s leadership:
I want to make one point really clear, which is the data that you have inside Calibra, the transaction data, the financial data, will stay separate from Facebook’s data, in particular your Calibra transaction and financial data will not be used to target ads on Facebook. I say that because I was talking about those two things back to back, but they are very separate, and the data does not get joined and that was one of the initial key principles that we made as we started this project.
They’ve pledged to start from a clean-slate and not draw-on Facebook data. (After Marcus’ aforementioned Congressional testimony comes to pass, this pledge will soon be punishable by perjury too — over and above the normal rules of corporate engagement — so I don’t want to hear the ‘Facebook’s word is not its bond’ rebukes.) So, the Libra Association would have no way of knowing whom to award a few dollars worth of Libra and whom not to. Therefore, they’re left with the option of allocating an even $0.46 to everyone.
(N.B. This assumes that the whole consortium is willing to neglect their own users and limit an airdrop to Facebook’s, which is reasonable given the aforementioned limitations on data commingling that will hamstring their ability to isolate unique users among their platforms. FB could, of course, contribute its own capital to a Calibra account in its own name, then conduct a supplemental airdrop unto its own users from there.)
That $0.46 doesn’t sound like much of an incentive to get people transacting in Libra; linking-up their traditional bank accounts; and scaling up the learning curve. But, then again, the consortium could get clever with something like a mashup of Amazon’s Prime Day and WeChat’s red envelopes. They could declare a global holiday, “Libra Day”, in which users would have a chance to log-in to Calibra (or the consortium-sponsored Libra wallet of their choice) and send up to $0.46 worth of Libra to any of their friends. If a user hasn’t logged-on and gifted all of his/her original $0.46 quota, then his/her remaining balance expires at the end of the day. By design, only a fraction of the consortium’s $1B nut would get drawn-down — maybe they can raffle off the rest as a guerrilla marketing ploy — but Libra Day would at least start spinning the flywheel.
That would work. Yet again, you have to ask, after having spent almost $1B to promote initial liquidity, how long will it take for Libra Association members to get a return on their invested capital (ROIC)?
The Fat Wallets/Protocols/Dapps Trilemma
Assuming this all works, nobody really knows where the most value will accrue. Will the key choke-point be the Libra currency, the Calibra wallet, or the apps built atop both of them?
That question segues nicely into this missive from “Fat Protocols, Fat Dapps, and Fat Wallets”:
[T]he crypto ecosystem already has hundreds of different protocols [like Bitcoin and Ethereum], with many more coming. If the ecosystem is not interoperable, this creates a ton of complexity. We’re already seeing technology move towards enabling cross-chain transactions, for instance between [cryptocurrencies]. Cross chain interop would mean low switching costs between different protocols. Would this limit the amount of value any single protocol will capture in the long run? [The Fat Protocol Thesis says] a small number of protocols emerge to dominate specific, high-value parts of the total base stack [like] transactions, data storage, computing, and messaging to name a few…
All the value accretion in protocols is based on the assumption that these blockchains will ultimately end up being useful for more than just speculation. [Dapps] offer the potential to codify incentive structures that drive usage, and they reward those who contribute to their creation and development. This is the Fat Dapp Thesis…
If crypto is to really hit the mainstream, users will want generalized access to ‘the network’ with products that make using both protocols and Dapps accessible, simple, and safe… Great wallets hold keys to dapps and protocols… like AOL and Netscape in the early days of the internet [or] Google and Tencent today… Users are unlikely to want to use many different wallets, just as they don’t want to use many different music stores or browsers… This is the Fat Wallet Thesis…
Such a centralized outcome may seem at odds with the decentralized ethos of the crypto world. But success of [any layer in this stack] rests on the success of the others.
To summarize that, the maximalist thesis for each layer of the blockchain stack requires limited competition at each layer, as follows…
- Protocols (e.g. Libra, Bitcoin, Ethereum, Filecoin):
A platform winner for each foundational base-layer — like DNS, storage, computation, messaging, and payments — providing decentralized, open, interoperable, modular building-blocks that developers can use as the plumbing for user-facing tools.
- Dapps (e.g. Cryptokitties):
An aggregator for each major use case, which users subscribe to based upon each dapp’s scalable governance model (kind of like Mastodon instances but not as innumerable).
- Wallets (e.g. Calibra, Coinbase):
A trusted clearing house for user data — like keys, passwords, currency, tokens, reputation, social graphs, and interest graphs — which is not only an aggregator allowing users to control their own privacy and port their own data, but also a platform letting developers tap into a wealth of user-permissioned data.
Similar to how Facebook hopes to forgo the profit motive, cheat The Innovator’s Dilemma, and win on user experience — as discussed above — Facebook is also trying to have-its-cake-and-eat-it-too by sweeping this Fat Wallets/Protocols/Dapps Trilemma. It’s going to crowdsource the Libra protocol (#1), launch the Calibra wallet (#3), then hope that’s enough to bear-hug the true dapps (#2) that result. Libra alone is trying to take the whole stack by storm and ward-off the existential threat decentralized blockchains pose to Facebook proper.
In sum, this all whittles down the laundry list of Libra’s professed value propositions until it’s reduced to a mere sustaining innovation — an incremental improvement in remittances and micropayments. Yet, Libra may also gives rise to some unintended consequences, like tax avoidance, that could predicate more of a disruptive innovation. The only real known-known here is that Facebook & Co are trying to bear-hug disruption. Beyond that, as with most innovations and disruptions, whether or not Libra is desirable really depends on who you are 😉
A working example of mutually-assured incentives
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