The long-awaited cryptocurrency from the social media and advertisement giant, Facebook, was unveiled on 18th of June 2019 after months of rumour and speculation. Project Libra, as it is officially called, is expected to introduce its Libra cryptocurrency to the world in the first half of 2020 and likely to become the first cryptocurrency from a large, global entity. For better or worse, Libra will become subject of regulatory and media scrutiny for months and years to come. A controversy of its own due to its sheer size and potentially disrupting effects for the financial industry and beyond.
Facebook has created and published on libra.org much interesting information about Project Libra and has been vocal to welcome community feedback with regards. However, noting and warning that many details are yet to be clarified and some of these details are key to the content below, this article aims to provide a review of the monetary side of Project Libra. In other words, this review focus on governance and monetary regime proposed in the latest release documents and not on the technical aspects such as the Libra blockchain and protocols.
This review draws its comments from mainly three documents release on libra.org, these are Libra White Paper (henceforth as LWP), Libra Reserve (henceforth as LR) and Libra Association (henceforth as LA).
The Libra Reserve
Project Libra proposes the creation of the Libra cryptocurrency which, unlike many others cryptocurrencies today, will be backed, fully, by stable and liquid assets denominated in major fiat currencies (e.g. USD, EUR, etc.) with the primary aims of:
supporting stability and value preservation. [LR pp. 1]
In other words, Libra will be effectively a “stablecoin”, a cryptocurrency pegged to an existing government-issued fiat currency such as the dollar (e.g. 1 Libra equals to 1 USD), therefore, potentially limiting its downside devaluation relative to the pegged fiat currency. The only difference being that Libra will be pegged to the value of a basket of weighted currencies rather than just one currency.
The mentioned stability and value preservation (and peg) are envisioned to be achieved by the establishment of a foreign exchange reserve fund to hold the backing assets called Libra Reserve. The fund of the Libra Reserve will come from an, while not explicitly called as such but sort of, initial coin offering (ICO) [LR pp. 1] and subsequent creating of any Libra [LR pp. 2]. Project Libra explicitly states that:
On both the investor and user side, there is only one way to create more Libra — by purchasing more Libra for fiat and growing the reserve. [LR pp.2]
The above seems to be a firm commitment to rule out “money printing”, similar to actions often undertaken by fiat central banks, to create more Libra out of thin air. The Libra Reserve seems to also have a dua “asset classes”, that is normal Libras hold by users do not receive a return from the reserve, but, to compensate early backers, early investors will be paid dividends [LR pp. 2] (via a second asset class called Libra Investment Token) from the interests earn, part and if any, from holding the fiat reserve. In other words, as an early backer, to compensate for your initial contribution of let’s say USD1 million, 1 million Libra will be created to be distributed and to be used as a medium of exchange, and in addition, you receive 1 million Libra Investment Token representing your investment and receive potential dividends. More on the above characteristics later.
Another difference between normal users of Libra and, potentially, the early backers is that:
Users will not directly interface with the reserve. Rather, to support higher efficiency, there will be authorized resellers who will be the only entities authorized by the association to transact large amounts of fiat and Libra in and out of the reserve. [LR pp. 2]
This arrangement largely resemble the post-WWII Bretton Woods System (to recap, where allied central banks around the worlds pegged their respective currencies to the US dollar and US dollar itself remains pegged to gold, additionally, only central banks can redeem dollar to gold but not individuals), with Project Libra fiat currencies are the new gold and “authorized resellers” are the new allied central banks.
Project Libra reinforces the commitment to not set monetary policy (i.e. in this case “money printing”) and affirm that:
Because the reserve will not be actively managed, any appreciation or depreciation in the value of the Libra will come solely as a result of FX market movements. [LR pp. 2]
We’ll see later that this latest statement is extremely naïve to the point of delusion, but for now, simply by observing the speculative forces behind all cryptocurrencies (e.g. Bitcoin) and fiat currencies (e.g. Swiss Franc), however well pegged and backed, it is highly unlikely that Libra will be priced always at or narrowly around its intended valued and changes attributed sorely to underlying FX changes.
Project Libra not only introduced the novelty of a fully backed cryptocurrency but also arguably the only one truly believable due to the sheer size of its backer and potential investors. However, the idea of a foreign exchange reserve is nothing novel, in fact, it is a centuries-old idea. Nonetheless, the Libra Reserve, while it will remain dependent on its final size, will unequivocally introduce a degree of stability and certainty to Libra, and unlike other cryptocurrencies, potentially making it day to day usable.
Project Libra made the explicit comparison of Libra with Hong Kong, o rather Hong Kong dollar. In fact instead of Hong Kong, Libra is more closely comparable to Singapore and Singapore dollar, as both are or will be pegged to a basket of currencies instead of just one like the Hong Kong dollar. However, for simplicity, we can stick with Hong Kong as an example and as suggested [LR pp. 3]. Hong Kong Dollar (HK$) is fixed within a band of HD$7.85 = USD1 (lower bound) to HK$7.75 = USD1 (upper bound) and backed by one of the world largest foreign exchange reserves (in absolute term and certainly relative to its economy size), more than USD430 billion, several times the entire money supply in circulation. The Hong Kong Monetary Authority (HKMA), its effective central bank, maintains the band by, among other mechanisms, intervening in the open foreign exchange market to buy HK$ when it approaches HD$7.85 (lower bound) to the USD and to sell when it approaches HK$7.75 (upper bound). It could be argued that the reason behind the huge foreign exchange reserve is the result of HKMA purposely maintaining HK$ low or undervalued via selling HK$ when it is worth more and use only parts of this “profit” to soar up the rate during rainy days when it challenges the lower bound. Central banks are rather profitable business (if the economy performs that is), at least on paper, however, the issue is that it should neither be a business nor pursue profitability.
The Hong Kong example tells us that even a well-defined and explicitly pegged currency with a behemoth size reserve to defend the peg and using all the tools of a central bank, there will still be large speculative forces that aim to test the boundaries, this will not be any different for Libra. Any thoughts believing that simply because there is an existing explicit peg level, Libra will always oscillate at or around the defined level is unrealistic. In fact, this idea seems to be straight out of a theoretical blackboard that would only function in a perfect world of rationality without speculations and emotions. A fantasy world indeed.
Libra as a fully-backed cryptocurrency it is designed to mitigate the likelihood and severity of these volatilities, particularly in the negative direction. However, let’s remember that volatility is not just about defending the lower bound. For Libra to work, it will have to hold steady both above and below the peg level relative to the underlying basket of currencies and ultimately to real-life goods in the respective countries or economic zones. For example, let’s imagine that Libra is initiated with the explicit peg of 1 Libra = USD1, volatility is not just from USD1 to USD0.5 (lower than the initial peg), but also from USD2 to USD1.5 (higher than the initial peg). Libra will certainly gain an implicit dimension of its own and, therefore, its own “value” regardless of the underlying asset. It is clear from the existing information that Project Libra wants to use the arbitrage effect to defend the lower bound, that is if 1 Libra drop below USD1 in the market, a user can always, somehow, exchange the 1 Libra against the reserve for exactly USD1 pocketing the positive difference. Therefore, there will be a strong incentive for 1 Libra to not trade below USD1. However, what remains unclear is the course of actions when Libra trade above its peg level, e.g. 1 Libra = USD1.2. Will the Libra Association (its effective central bank) sell Libra to restore the balance? If so (it seems to be the only solution but it is not explained from the currently available documents), and in such scenario, the Libra Reserve will certainly grow over time (similar to the Hong Kong example) creating a situation where there is reserve in excess of the total Libras in circulation and reinforcing, even more, the appreciation of Libra in a “vicious cycle”.
While much information remains to be released, such as the final amount of the Libra Reserve (for reference any amount below several billion US dollar would be rather disappointing) and the exact mechanism to manage the peg and stability of Libra, we can undoubtfully say that Project Libra is an ambitious and potentially disrupting project.
My only critique of the Project Libra (subject to the information available) is the decision to pay dividends from the Libra Reserve to only the early investors, doing so could be insanely profitable for its founders, but a lot less appealing for normal users. Instead, to pay all users of Libra dividends (mimicking the interest paying effect of fiat currencies) will not only be more “fair” but will also positively enhance the usage and holding of Libra which would make it more stable and usable. Seems to be a lost opportunity in exchange for appeasing and attracting initial backers.
Some commitments and promises also seem to be contradictory or unrealistic, such as the belief that Libra will remain stable at or around the defined level and change only due to FX change without active management similar to the actions of a central bank. Similarly, the idea that the Libra Association will not engage in monetary policy seems also to be practically unviable due to the previous commitment (let’s remember that monetary policy is not only the action of printing money).
Next (in part 2), we will examine in closer details the Libra Association (Libra’s effective central bank, interesting to see that despite championing a decentralised and “different” system, Project Libra, so far, is proposing to adopt an arrangement extremely similar to how currently central banking with fiat currencies work) and potential regulatory scrutinies from regulators all around the world (e.g. taxation, compliance, etc.).
The author is an economist and founder at www.iyokus.com, this article reflects only the personal opinion and knowledge of the author and does not necessarily reflect the opinion of any associated parties.