Governance, Regulation and Macro-Economic Impact
Libra: A balanced view- I
Company scrip writ large
All media is agog with Libra news this week. Regulators who are normally cautious, have rushed into the fray as well. The entry of FaceBook and its partners (willing or otherwise) into the crypto-coin universe has created a breathless series of stories; boosting the concept or deriding it. This is to be expected, as the scale of the potential market is enormous. Two odd billion users of Facebook apps like Instagram, WhatsApp, FB Messenger, core Facebook plus customers of their partners are the potential network. This could be half the population of the planet.
This is not a new phenomenon, from the link in the sub-title it can be seen that private scrips were introduced for various purposes in America and elsewhere by corporations. It was to deal with geographic seclusion and the unavailability of cash. Company scrip also became a way to control and enslave employees and merchants. The fungibility of the scrip and its liquidity were the most vulnerable features of the older models. These concerns continue to be raised in the commentaries on Libra. Today, in addition, we have M-Pesa, Paytm, WeChat and Ant Financial payment systems that are comparable in scale and operable through edge devices like mobile phones.
Meta-data from all transactions, including financial transactions, frictionlessly gathered by digital systems has propelled the rise of ad-tech and surveillance fueled behemoths. These have also become vectors of covert influence by operators who have directly or indirectly weaponized these powerful platforms. A truly asymmetric infection of the human mind, that has leveraged democratic systems to inflict significant harm. These are the main concerns around Libra.
In this article, I focus on the money supply and governance as presented in the Libra documents; as well as some moves by regulators and legislators. In later articles I will cover some of the technological aspects. I have no special insight into Libra other than what I read in the public material on the Libra site. These articles should not be construed as investment advice.
The design of the Libra money supply is to further the main stated aims of Libra: namely, frictionless, global, small transactions even for people who do not have bank accounts; interacting mostly through edge devices like mobile phones. Stability of value is paramount. The global payments space is north of $500 Billion.
Let us begin at the beginning. There is no independent money supply. Libra does not get generated out of thin air. The only way to create Libra is by depositing fiat currency into the Libra Reserve. Initially, invited investors charge the Reserve; they get a special Investment Token as well Libra distributed as incentives; so that they can sell or distribute these to their users: merchants, developers and clients. Ordinary users can buy Libra with fiat currencies. Libra is always linked to fiat in the Libra Reserve. The Reserve will grow as users purchase Libra and demand grows. In other words this functions similar to a currency association with strict controls on issuance, exercised in tight association with foreign exchange reserves. These foreign exchange reserves correspond to the basket of fiat currencies in the Libra Reserve. The Libra documents refer to Hong Kong’s system as an example. The money supply and cross-currency fluctuations are outsourced to the Central Banks of the fiat currency basket.
Ordinary users do not directly interact with the reserve. This is where authorized resellers come in. These resellers function as exchanges, collecting fiat from the users and selling them Libra or exchanging Libra for fiat. They charge “a small spread” similar to how an FX transaction works, you buy USD for EUR at a higher rate than you can sell. The resellers will probably have access to “local reserves” to satisfy immediate demand, where they have pre-minted Libra based on their own deposits of fiat, waiting in the wings. This is not stated anywhere, but will depend on how much friction is associated with reserve transactions. Resellers in conjunction with the Libra Association mints and or burns Libra with corresponding changes in the Libra Reserve, for big movements. I discuss the Libra Association in the governance section below. Resellers also need to do customer due diligence in the areas that they operate in since they will become VASPs (Virtual Asset Service Providers) subject to AML/KYC CDD requirements.
This is a lot of fiat currency to keep around and manage and the pile would get bigger when and if adoption kicks in. The reserve would be invested in low volatility instruments: stable government bonds, deposits etc. This would be spread around, in terms of investment grade custodians, geography and jurisdictions to reduce counter-party risk that could arise due to a variety of macro economic and micro-economic factors. To repeat, a money management challenge, that could get very complicated very fast. We also saw what happened to “investment grade” during the last downturn. Will there be big enough bazookas to handle a sustained run, especially if a significant portion is held in unstable fiats or “safe” securities by unstable firms. Diversification and decentralization should rule here. Systemic risk should attract significant regulation. Movements across currencies and low yield instruments could move markets if adoption is high.
The low yield from these low volatility instruments would be utilized to pay operating costs as well as other expenses. The spread between the yield and the expenses will be used to compensate the Investment Token holders. What if the yield is negative or expenses exceed yield? Presumably this will be compensated by eating the reserve and burning Libra, or the Investment Token holders only get cents on the dollar Libra as incentives or a combination of both these effects; leaving excess liquidity in the reserve to bootstrap Libra. On the happy path for the investors, the users flock to Libra boosting the cash reserve and yielding huge sums as excess spreads to expenses, yielding a bonanza for their Investment Token. For example a $1 billion total investment could end up being paid for the yield minus expenses from $100 billion worth of Libra.
It is clear that there are two kinds of tokens here “Investment Tokens” and Libra itself. Investment Tokens soak up the excess yield. This goes to compensate the big investors. Libra does not yield anything to the ordinary user, it is used to frictionlessly transact: buy and sell, globally. However, Libra to fiat conversion and vice-versa will entail paying a toll to the approved resellers. For ordinary users, then, it will cost to get in and out of Libra. So people may remain in Libra, especially if the bank interest rate is not much. This can cause destabilization of smaller currencies and loss of control of monetary policy for currencies under stress.
Governing the basket of currencies, interacting with and convincing regulators, authorizing resellers, discouraging bad actors whether they are resellers or custodians or ordinary users will be the Libra Association based in Switzerland. The main aim is to present a decentralized front, so that instead of just Facebook controlling it all, an Association composed of a “diverse” group of companies will oversee the governance. Let us see who the founding members are:
- Technology and marketplaces: Booking Holdings, eBay, Facebook/Calibra, Farfetch, Lyft, MercadoPago, Spotify AB, Uber Technologies, Inc.
- Payments: Mastercard, PayPal, PayU (Naspers’ fintech arm), Stripe, Visa
- Telecommunications: Iliad, Vodafone Group
- Blockchain: Anchorage, Bison Trails, Coinbase, Inc., Xapo Holdings Limited
- Venture Capital: Andreessen Horowitz, Breakthrough Initiatives, Ribbit Capital, Thrive Capital, Union Square Ventures
- Nonprofit and multilateral organizations, and academic institutions: Creative Destruction Lab, Kiva, Mercy Corps, Women’s World Banking
Mastercard, Visa, Stripe, Paypal, eBay, Uber, Lyft, Vodafone some of the largest and most well known companies want to operate a global network for the unbanked as a public good. Sounds too good to be true; except for the last group, these are not charity organizations. This is also the reason why many governments reacted negatively almost instantaneously to the Libra announcement.
The founding members are still working on the charter. But the current pitch is that even though Facebook is the leader in the formation phase, they will recede to the background with an equal vote as the other members. Calibra, “a regulated subsidiary” of Facebook was created to separate the social media and financial arms. This will be the focus of regulatory scrutiny as the privacy and correlation of users activity across the different spheres of our lives is of great concern. Calibra will also build services atop Libra.
How will Calibra keeps its independence? This raises questions about a powerful platform company controlling access to financial services and probably hosting merchants. What about anti-trust? The current arguments that transcend price based measurement of anti-trust will also kick in.
Public Permissioned versus Truly Public
The Libra blockchain will be open to the public to read, but closed for writes. The stated aim for Libra is to become truly public, for writes and reads; in the next years. There has been no transition yet from a permissioned network to a public(permissionless) network. It is highly doubtful that such a scheme can succeed.
The resellers have to collect identifying data from users under current FATF recommendation if the amounts being transferred exceed $1000. This data has to be managed and transmitted out of band from the blockchain. More higher quality data that can be misused unless controls with real teeth are put on its misuse. Real teeth means huge fines or other economic restrictions, since that is the language that these companies seem to understand.
Due to the availability of public data, there is bound to be great opportunity for companies like Chainalsys to unearth fraud and skulduggery; since they are already very familiar with uncovering actual identities based on pseudonymous public identities.
This is the greatest weapon in Libra’s arsenal. Even if we do a simple analysis of the scale of the founding members of the Libra Association we come up with staggering numbers. This includes sticky and a different sort of user from the users of social media. eBay, Paypal, Mastercard, Visa, Vodaphone, Stripe, Uber, Lyft, MercadoPago- you get the idea. There are huge numbers of highly valuable users (some might say raw material). The network effects that this could create will dwarf any currency network in existence.
- Facebook has 2.7 billion users worldwide, growing rapidly. 400 Million WhatsApp users in India alone.
- Visa + Mastercard covers 75% of credit cards issued in the world
- Naspers is worth one quarter of the Johannesburg Market because it owns 30% of Tencent the Chinese company and will be listed on Euronext next.
- MercadoPago is a big player in South America. Its parent MercadoLibre is the largest on line marketplace in South America and has operations in Argentina, Brazil, Chile, Colombia, Mexico and Venezuela. MercadoLibre has e-commerce operations, shop fronts, payment and credit arms.
- Demographically, 30 to 40 % of 24 to 35 year olds are active on Facebook.
- Geographic coverage, demographic coverage, integrated e-commerce, payment and credit operations, the Libra association founding members have all of these going for them.
- They even have the social good angle covered with Kiva, Mercy Corps and Women’s World banking. It is doubtful whether they took $10 Million from any of these organisations to be part of the Libra Founders Association.
- The only large region out of their direct influence is China. If they lure one or two large Chinese firms to the projected 100 founders; they will deal with this problem too. Maybe Visa and Mastercard already have many Chinese customers.
- Bison Trails is an infrastructure operations company for hosting Blockchain nodes and covers many mainnets, including the upcoming Algorand mainnet. Anchorage specializes in custody solutions. Xapo has a bitcoin wallet (about 7% of all bitcoin is held in Xapo wallets). These Blockchain partners are unlikely to have paid $10M was well and were brought in for their expertise.
Regulation & Legislation
aka “open mind but no open door”
The key principle here should be not closing the stable door after the horse has bolted. Mark Carney, the BoE governer said “Unlike social media, for which standards and regulations are being debated well after it has been adopted by billions of users, the terms of engagement for innovations such as Libra must be adopted in advance of any launch”. Let us develop this theme further.
For Libra and for any regulated financial enterprise there are three dials that can be turned. Financial Regulation, Data Privacy protection and competition or Anti-trust laws. The effects of specific instances of these controls can be expressed as in the image below from the BIS Annual report for 2019, which attempts to map specific laws into two dimensions. Further data on each of these can be found in the BIS report.
Public supra national organizations like the United Nations; the Bank of International Settlements, the IMF etc. are comparatively powerless; mostly through the drainage of their funding and power by nationalists and isolationists. This puts us all in graver danger, since public guardians are shorn of power and continue to be under attack. The loosely coordinated government agencies and legislators, are dashing off missives. Some central bank governors like Mark Carney seem more sympathetic. In his mansion house speech for 2019, Carney said the BoE would open its vaults to more players for overnight deposits. This could include the GBP Libra reserve, since he did allude to Libra in the speech. The Swiss are already sympathetic. This would work against commercial banks. If the Libra Reserve could be deposited directly with the central bank of each currency and earn overnight rates, they could cut out commercial bank custodians.
There was a letter from Maxine Waters (chair of the house banking committee) that Libra hold off developing the crypto-currency until they explain themselves. What if Libra does not do this? Can they force Libra development to be stopped? I doubt it. They should engage with them and if the architecture and governance are found wanting; suggest changes. They have to rely on experts instead of just grand-standing. In the measured presence of risks, legislate or regulate for the desired outcome. The strategy cannot be, stop development until we look at it. If that strategy were to be followed, almost no technical advances would happen. Let them develop the solution, guide them apolitically for the outcomes you desire; do not let them put these solutions into production until they prove that they have met the stated aims. Look for more emergent effects and then dial down the risk in conjunction with technical experts. Sounds hard, but this can be put into practice with measurable effects and counters.
The current president of the G7, France, has announced the formation of a stablecoin task force headed by a French central bank board member. Hopefully this will be more productive than the Paris agreement on Global Climate change. This can be so easily played as, “a bunch of know-nothing bureaucrats meddle in the Free Market”, unless they assemble a broad coalition (include poorer countries) as well as bring in some blockchain and crypto-currency experts into the mix.
“Move fast and break things” cannot be the slogan when the global financial system is at stake. When you are in the development and experimental phase of a system, this can be the right slogan. How do we ride both these horses, transitioning from one to the other; keeping intact the experimental side and ensuring production stability. This involves cutting back regulatory overreach, increasing the agility of regulators to come up with new rules based on emergent effects and other principles. However, regulators, especially global regulators are not setup to be nimble and reactive.
Regulation has to apply the same principles across all players for the same kind of activity. In the Libra whitepaper there are references to the Libra Association “shaping” regulation; we should agree to this as long as “shaping” cannot take away rights and privacy from ordinary users and shaping does not mean misapplication of laws like GDPR, India’s consent laws, CCPA, New York State’s new fiduciary law being developed. If gaps are found we should agitate and act to convince our lawmakers and regulators to close the gaps.
There are many questions, but the following about money supply and governance is a short list:
- Will the founding members or subsidiaries run resellers? The answer has to be yes, otherwise what is Coinbase doing there? How will the conflicts of interests between the founding members and resellers be resolved.
- Are there arbitrage opportunities for ordinary users? For resellers?
- Capital controls and capital flight, how will that be handled?
- Fractional banking implications as retail banks are written out of the picture; some of the custodians of the reserve are bound to be big banks with retail banking arms. Credit generation in general is a big question.
- Mark Carney raised the possibility that fintechs could deposit GBP overnight with the BoE. Will that mean that Calibra could have a Central Bank account?
- The users are pseudonymous, analogous to bitcoin. This will require more investigation and Privacy may have to be rebuilt using mixers and other techniques including ZKPs a la ZCash for public networks.
- Resellers or service companies will write wallets. As we know, these wallets are often the weakest points of a cryptocoin system. How controlled will the wallets written by “authorized resellers be” or will they use white-labelled versions of the Calibra wallet?
- Bugs and hacks and upgradeability? How does this work in the proposed system and in the future?
- Models predicting what percentage of global GDP will flow through this system will be interesting, as systemic risk will enter the picture as soon as we get massive adoption (even if it is 20–30% of the target population).
- How will Libra inter-operate with other payment systems? This is a biggie, needs some kind of settlement platform.
- The absence of big tech companies and platforms like Amazon, Apple, Google in the Libra Founding Members is also significant. Will they be welcomed as one of the 100 members?
- What is going to happen to existing stable coins? Even the ones inside walled gardens like JPM Coin.
- Are Investment Tokens fungible? What happens if a founding company becomes bankrupt or goes out of business? Can creditors get a hold of this asset.
- Is the Libra Association going to get into other financial activities like lending, insurance, savings and investment. Will they steer their users into the platforms of their members for these activities? This should face anti-competitive scrutiny.
Libra is a bold move by Facebook, especially in the context of calls for breakup of the company into separate entities. Libra, if adopted by a fraction of current users of Facebook and other large entities that makeup the Libra Association, will have a tremendous impact on the global transaction ecosystem. There are many reasons for adoption including the broken and expensive payments system in America and Europe and large numbers of unbanked in emerging markets and elsewhere. The lack of innovation and investment in this and other areas by banks have created an opportunity for these non-bank actors.
People forget that systems of this scale already exist in China (Ant Financial, Wechat and its ilk), which integrate merchants, payment platforms and social media in one. There are more than 25 eMoney systems in the world. The value of transactions on the eMoney network exceeded $18.7 trillion, more than all Visa and Mastercard transactions combined. However traditional banks are not written out of the picture as correspondent banking systems are still needed for global payments in these systems. Banks are also needed for bridging from payers to payees.
There are many currents against the success of such a move by big corporations. This includes regulatory push-back, and general sentiment against surveillance capitalism in developed economies. But according to me, the jury is still out. With determination, resources and the will to shape regulation, Libra could be a success; however, we need to remain vigilant against the draining of freedom and privacy. We need to influence governments and public opinion to bend the still nascent system into something that we can live with and come to adopt for our everyday needs. Enforceable regulation is the key.
The emergent effects of Facebook were not planned. The kidnapping of the US election, the massacre of the Rohingya, the live streaming of murders and mass shootings, murders by the cow guardians in India, were a result of asymmetric leveraging of the power of Facebook by third parties. These effects were abetted by Facebook culture, shot through with naivete, and arrogance. The desire to scale without boundaries using observed addictive visual and mental behavior contributed to these abuses. The snail’s pace of our regulators and legislators and the dictum that the platform is independent of the content, also contributed to its toxicity. This combination of technical innovation and social heft combined with cluelessness is what needs to be fixed if Libra is to be successful.
Libra could be a great leap in eMoney adoption; if the governance is spread-around even though it is technologically driven by Facebook. The the right amount of regulation should be judiciously applied. Instead of “don’t be evil” we need “can’t be evil”.
The next article will look at the technical underpinnings of Libra, the blockchain including the consensus algorithms, the smart contract language and the notion of assets and identities.
3. BROWN: Financial Watchdogs Must Scrutinize Facebook Cryptocurrency Closely | U.S. Senator for Ohio
WASHINGTON, D.C. - U.S. Sen. Sherrod Brown (D-OH) - ranking member of the U.S. Senate Committee on Banking, Housing…
4. Stablecoins, Central Bank Digital Currencies, and Cross-Border Payments: A New Look at the International Monetary System. Remarks by Tobias Adrian at the IMF-Swiss National Bank Conference, Zurich, May 2019
5. BIS Annual Economic Report Section III. Big Tech in Finance Opportunities and Risks, June 23 2019
Research & Analysis
6. (In)Stability for the Blockchain: Deleveraging Spirals and Stablecoin Attacks; by Ariah Klages-Mundt, Andreea Minca submitted June 5, 2019