Breaking Down Libra
This article was co-authored by David O’Shea
Facebook and its 27 partners published the Libra White Paper in June 2019. This article is an attempt to evaluate Libra’s unique value proposition, to examine its position vis-a-vis Bitcoin and other cryptocurrencies, and to review its potential and drawbacks as a permissioned global means of payment through practical use cases and applications.
David and I have spent all our careers in financial services. We have both traded foreign exchange (FX) and were heavily involved in payments, technology, and other financial market verticals. We were intrigued by Libra and its combination of crypto and FX wanted to further evaluate it, and break it down into real-life examples to see whether it would really work as marketed. Back in July, we were compelled to go down to DC and sit down at David Marcus hearing in front of the U.S. Senate Committee on Banking, Housing, and Urban Affairs (aka the Senate Banking Committee).
Picture #1: The Room Where It Happened
David’s approach, as a former professional FX trader and manager of a global payments book, is a bit skeptic in the application of Libra due to the many intricacies, complexities and heavy nuances of the FX and payments markets. Amir’s approach is a bit more supportive despite the above, mainly due to the potential user base size and tangible benefits it can bring to so many people around the world. We both agree the initiative comes at the right time of a true global digital demand and technology trace. We also agree that Libra rollout and adoption have to overcome many obstacles as laid out in the article below.
Is Libra a Currency, Security, Commodity, ETF, Means of Payment, Property or an Investment Vehicle?
How you define Libra is not central to our exercise. At this pre-launch stage, Libra should be evaluated on the basis of what it brings to the table of financial services. The Libra approach uses technology, which calls into question age-old issues of value transfer, practicality, and regulatory scrutiny. We leave this question of “definition” for lawmakers to decide because these arguments are very dynamic, and much remains to be seen with respect to the final iteration of Libra. We are of the opinion, however, that the Libra Project, which has the potential to be global in scale, will have to receive regulatory approvals in many or all jurisdictions it wants to operate in order for it to be acceptable to banks and governments, and thereby taken up by consumers. The House Financial Services Committee and members of the panel that attended the July 17th hearing are calling for Facebook and its partners to put a development moratorium on the project. In our opinion, there can still be on-going private and public sector dialogue, especially when it comes to such a project that can affect billions of people and the potential to rewrite the financial landscape.
According to David Marcus testimony in front of the U.S. Congress, Libra underlying fiat currencies will be U.S. dollar (USD), European euro (EUR), British pound (GBP) and Japanese yen (JPY). Marcus also said the share of the USD would be 50%. For the purpose of our analysis in this article, we assume the share of EUR, GBP and JPY will be 30%, 10%, and 10%, respectively (the full currency allocation composition has not been officially revealed yet). For the ease of writing this article and for consistency with Bitcoin, Ethereum and other cryptocurrencies, we will also refer to Libra as a cryptocurrency, even though it’s debatable whether Bitcoin and its peers are indeed true currencies and whether Libra is indeed a true crypto.
Centralized Versus Decentralized Blockchain
We acknowledge that the Libra coin and investment token will, at least initially, be managed by a centralized reserve that will be established by the Libra Association. In other words, it will be different than Bitcoin and almost all other 2,000+ outstanding cryptocurrencies today. That is the Libra network will, at least initially, be centralized or permissioned, and only its members will be able to validate transactions — versus the ability for anyone with the right tools to do so today, as in the Bitcoin Blockchain example.
While some supporters of Bitcoin and other decentralized cryptocurrencies are screaming “foul” and appear aghast, we are open to the Libra alternative, and believe it can provide valuable services to many people worldwide without necessarily infringing on their privacy rights under certain circumstances. Of course, proper governance of the Libra Association and security of the system are warranted, but that’s doable despite all complexities and challenges and has been done in the past during (or after) times of crises.
The fact that the Facebook footprint is so big, and scrutinized on a global scale, may prove fruitful in the end to the stated mission of Libra to increase market efficiency and to put cheap remittance in reach. Governments, agencies, central banks, and supra-national bodies could find it easier to deal with issues such as regulatory arbitrage, to advance an international regulatory harmonization, and to oversight a global crypto adoption with just one large organization. The alternative scenario is to instead deal with a very desegregated and seemingly disorganized ecosystem of thousands of cryptocurrencies and players. Facebook is stigmatized by past bad behavior in handling client data. While the U.S. and other regulators continue to (and rightly so) pursue Facebook over data privacy and protection deficiencies, they may run the risk of missing an opportunity to help model a new paradigm that Libra presents. Would the reaction to the Libra Project be different, if Amazon, IBM, J.P. Morgan, or another more trusted mega-corporation were the leading force behind it? Of course. Measures need to be taken to ensure the independence of the Libra Reserve and that of Facebook. Regulatory oversight and transparency need to be as efficient, accurate, and cheap to governments as the Libra proposition is to consumers.
“The intense interest in Facebook’s plans is a positive […] because it has forced governments and central banks to look more closely at whether laws and rules need to be updated […] It’s been an effective focal point for domestic and international regulators.”
These safety measures are not in existence as of now. The moratorium suggested by U.S. lawmakers can be seen as a poke in the eye to Facebook, but also as an opportunity to script proper oversight. Cooperation in full is promised by Facebook, but it is also applying pressure arguing that someone, somewhere, is already working on something similar, and now is the opportunity for U.S. Lawmakers’ input. The antagonist and protagonist drama continue to play out.
Remittance Payment Orders, Commercial Invoicing and Digital Wallets
Remittances are one of the areas where a global, stable, and accessible currency can have a real impact on people. However, this comes with some caveats. According to Facebook, an individual who lives in the U.S. will be able to easily buy Libra via the Calibra digital wallet and send it to their family in a different country, say Costa Rica. This is similar to how it’s possible today with Bitcoin and other cryptocurrencies through the use of digital wallets. It’s unknown whether Calibra will also support Bitcoin and other cryptocurrencies, and whether a user will be able to pay for Libra with a cryptocurrency and not with fiat currency. We can definitely see how wallets can be enabled with the addition of a private key unique to the family member in Costa Rica. The wallet can then facilitate the value transfer similar to how banks do it today. Both family members can either use a custodial digital wallet such as Calibra or Coinbase, or a non-custodial digital wallet such as ZenGo (the first digital wallet to support Libra in a test environment).
Wallets serve as on-and off-ramps and therefore have to be regulated by each jurisdiction. As such they may be subject to local reporting requirements, where transactions need to be presented to the Central Bank or other official agency. The total daily inflows and outflows generated through the exchange of Libra and local currency need to be accounted for, and regulated for the permissibility of any applicable exchange controls. Whether you are a resident of that jurisdiction or a foreign participant, the sovereign can dictate what type of transactions you are allowed to execute. This is the current case in some smaller and emerging economies. Locally licensed banks and exchange providers are tasked with these functions.
The family member in Costa Rica, or recipient of the remittance, would accept Libra only under the following conditions: 1) Libra can be used in their day-to-day life as a legal means of payment for goods and services, e.g., the local post office or supermarket accepts digital payments made with Libra. As such, it must be stable and not too volatile; 2) Libra can be easily and legally exchanged for the local currency (the Costa Rican colon in this example) and hopefully with no or very small markup or fee; and 3) Libra can be safely held in a digital wallet as a hedge in case where the family member believes the value of the colon is about to depreciate.
Chart #1: Bitcoin, Gold, Euro, and Libra 3-Month Actual/Historical Volatility in the Last 10 Years
When Libra is exchanged for colons through a legally-approved/authorized agents, exchanges or resellers, that agent will then either sell the Libra back to a different local buyer, keep it if they believe it can be sold later at a higher price, or sell the Libra back to the Libra Reserve right away. It’s possible the Libra Reserve will offer built-in conversion services and pay the agent with just one currency of choice, e.g., only USD (the Reserve will convert the EUR, GBP, and JPY to USD). Again, the agent will either hold the fiat or sell it in order to buy colons. In this example, foreign currency via Libra is entering Costa Rica.
Since using Libra involves the exchange of currencies, it makes sense for regulated financial services companies with existing foreign exchange (FX) capabilities, such as multinational banks or multi-asset brokerage companies, to serve as those agents. They could possibly even develop their own digital wallets as a consequence if they haven’t already. This can create a win-win situation for the regulators, which may be comfortable already dealing with those known entities and flows. Those entities may benefit because they will be able to leverage their existing electronic trading infrastructure and technology stack to generate more brokerage or fee-based revenues, as well as retain existing clients or add new ones. Individuals and end-users may benefit by keeping legacy relationships and maintaining trust with their banks and brokers, at least for their proven cyber-security capabilities and services.
Chart #2: Bitcoin price versus 3-month actual/historical volatility since 2016
Can Central Banks decide to buy Libra directly from those agents? Possibly. If the Central Bank wants to build and accumulate foreign currency reserves, it will be able to buy Libra from all agents and then sell it to the Libra Reserve (the Central Bank will provide the Libra Reserve with settlement instructions of its USD, EUR, GBP, and JPY custodians). Countries usually do not have any issues when legitimate foreign currency enters their money supply. FX inflows (aka “left-hand side”) expand the monetary base and size of the economy, which is very positive for many emerging markets economies. Many countries, however, have issues with the flow in the other direction (aka “right-hand side”) — when foreign currency (i.e., Libra) leaves the country.
As clients of Chase Bank and Citibank, we would feel more comfortable storing larger amounts of cryptocurrency on their digital wallets over other companies with fewer cyber-security capabilities (FDIC insurance would further support this notion). We are, however, in favor of innovation and encourage competition and interoperability in this space to provide fungible, legal and secure choices for everyone, including those with no bank relationship or no trust in traditional financial institutions. There can be a degree of comfort gained by clients and regulators if Libra and bank-sponsored wallets become an extension of routine retail banking. It may offer recourse through human interaction with their trusted banker. Banks may get more comfortable with the situation as well since it gives them an opportunity to increase interaction with their client base as well as an opportunity to capture biometrics or signatures for documentation purposes. This type of documentation may be a future regulatory requirement anyway.
Libra’s value proposition of reducing or completely eliminating the 7% on average money transfer fee (“the cheap”), shortening the transfer time from days to minutes (“the fast”), and providing a new, easy-to-use and reliable system (“the safe”) is indeed promising, since the majority of remittances flow from fully developed to lesser developed economies. However, as we examine in the next paragraph, many countries in the world have capital controls in place that will either heavily limit, or completely prohibit Libra to be used in their countries, unless they are eliminated or modified.
Another word on Calibra. In his testimony, David Marcus said Calibra would be the only bundled digital wallet in all Facebook apps (e.g., Facebook, Messenger, Instagram, and WhatsApp). Calibra, however, will be interoperable with other wallets, meaning Calibra users will be able to send and receive Libra to and from other wallets. We still do not know if such action will incur any fees, such as miner fees, and whether Calibra will support other cryptocurrencies. We assume the answer to both is yes. This reminds us of when Microsoft only allowed Internet Explorer web browser in its Windows operating system. It’s quite obvious now that one can choose between Chrome, Firefox, Safari, and even DuckDuckGo, Opera and Brave, but back in the days it wasn’t the case. At least not until the European Commission sued Microsoft in 2004 and then expressed concerns over its Internet Explorer bundling in 2009. The Commission said that “Microsoft’s tying of Internet Explorer to the Windows operating system harms competition between web browsers, undermines product innovation and ultimately reduces consumer choice” and by doing that it violated the union’s antitrust rules. Could this statement apply to Facebook and Calibra? “Facebook’s tying of Calibra to Facebook, Messenger, Instagram, and WhatsApp harms competition between digital wallets, undermines product innovation and ultimately reduces consumer choice.” It could very well be the case in the future where interoperability by itself does not satisfy antitrust regulation.
Capital Controls and the Un- and Under-Banked
Two-fifths of the 1.7 billion adults without bank accounts, or 680 million people, live in China, India, Indonesia, Pakistan, and Bangladesh. The regulation in the FX market in each of these countries is different and needs to be addressed in order for Libra to work. Similar to remittances, people who live in countries without capital controls will be able to use Libra for payments under similar conditions mentioned above. But in China, India and some African countries, where another large population without bank accounts reside, this will not be the case, because capital controls either restrict or prohibit buying foreign currency and sending it outside the country (on top of other crypto-specific restrictions such as the crypto ban in India).
In many sovereign money supplies, additional scrutiny is placed on foreign currency conversions by defining the individual transactions as retail or commercially reasoned for its purpose. Often, commercial transactions carry the additional burden of documentation requiring a copy of the invoice and registration by a locally licensed agent. The Chinese government limits the amount individuals can buy and sell foreign currency to $50,000 a year. You can apply for a higher quota, but this amount is not a bad starting point for buying online goods from Japan and paying with for them with Libra. However, China banned fiat-to-crypto trading in September 2017, and just recently hinted a digital version of its own currency, the yuan/renminbi, would become available soon. It’s hard to see how China will allow Libra to enter its economy, while it is still blocking Facebook on one hand and adopting a local digital stablecoin on the other.
In Nigeria, with a population of over 190 million people, the story is quite similar: its commercially licensed banks can have pre-negotiated waiting lists for critical corporations, who want to sell the local currency and buy USD, EUR, GBP, JPY, and other currencies, thus creating an FX outflow. It will be very difficult for Libra to be allowed to step in front by cutting the line. Preferential treatment is a fact and part of the process. If that’s indeed the case, Libra’s wide adoption outside of remittances in those countries may be very slow or will never happen. Therefore, governments may even limit, restrict or regulate the internal flow (“left-hand side”) of Libra, since they would want their residents to insert hard currency (FX) into their money supply, but if they keep Libra in their digital wallets, circumvent the banks, and leave Libra and its FX component outside of the money supply, that’s not really the expected result.
Flagging the slogan that “1.7 billion un- and under-banked people in the world will benefit from Libra,” therefore, needs to be taken with a grain of salt. In some countries, other processes would need to be developed to satisfy local requirements in order for Libra to work. Adoption may still be huge on a global scale, with a big concentration within developed countries, but can very much continue to be limited in many countries and for billions of people. It can certainly grow with time, once governments are convinced the new system works well, has real benefits, and doesn’t jeopardize the economy and the local financial system.
Libra is a basket of currencies that are digitized. Without any capital controls, anyone can essentially sell their local currency and buy USD, EUR, GBP, and JPY. Many people already do that either by buying the fiat currency directly and keeping it under the mattress or in a bank account or by buying a foreign asset or security (real estate, stock, bond, etc.). The underlying or embedded (e.g., dividends) foreign currency exposure can be hedged or not. Obviously, if buying one asset (Libra) is easier, cheaper, less volatile and more secure than buying other assets that serve the same purpose (whether it’s USD, EUR, GBP, JPY or Bitcoin), and in the end it provides the same or better user experience and value, then for the individual user it’s a no brainer. However, since Libra essentially involves buying and selling FX, there is a risk component that needs to be assessed.
As soon as Facebook published the Libra white paper and during and after the testimonies in the U.S. Congress, many have raised concerns that the Libra Project could destabilize the global financial system and create systemic risk we have never seen before. The term “run on the Libra” has also been widely used in the testimonies and in the media before and after the white paper was published. For example,
“There are also concerns about what would happen if the assets in the Libra’s reserve deteriorate; what is a safe asset one day may not be safe the next. For example, if one of the currencies in the Libra’s basket collapses, it could trigger a run on the Libra, necessitating a broad selloff of the Libra’s reserve assets. Depending on the size, such a selloff could trigger a significant financial crisis.”
What can such a run really mean? How does a run on one currency compared with a run on a basket of currencies? And if that basket is used globally, is it even possible to have a global run on that basket? We examine a few scenarios — some have already happened in the past while others have not — and conclude that a global run on Libra is quite unlikely to happen, however, cannot be ruled out completely.
We examined 13 historical stress scenarios by using the Bloomberg Professional Services Multi-Asset Risk System (MARS) and other Bloomberg analytics. In MARS, we created a synthetic Libra portfolio worth 100 million USD based on the underlying currency allocations mentioned above. We then ran the scenario analysis on each of Libra’s underlying currencies to examine what the biggest drawdown or loss in the portfolio value would be, if anyone of those 13 scenarios were to happen again. The portfolio did not lose more than 6% in any of those scenarios where the base currency was one of the Libra underlying currencies.
Picture #2: MARS Stress Scenario Analysis
We took a closer look at 4 out of those 13 scenarios:
- Russian Crisis and LTCM 1998
- Black Wednesday in 1991
- Lehman Default in 2008
- Greece Financial Crisis in 2010
Russian Financial Crisis and LTCM 1998
On August 17, 1998, the Russian government devalued the ruble (RUB), defaulted on domestic debt, and declared a moratorium on repayment of foreign debt. In less than a month, the RUB lost more value than what the GBP lost during the Black Wednesday period.
Based on data compiled by Bloomberg between 17 August 1998–8 September 1998, exchange rates moved as follows:
Pre-crisis, Russians would need 6.45 rubles to buy Libra. At the peak of the ruble devaluation (September 8, 1998) that rate would jump to 21.03 — an increase of 225%! Just like buying the individual currencies at the time was very expensive, buying the Libra would have been just as costly.
Theoretically, there can be one-way demand for Libra coming from any country whose currency is seriously devalued, like Russia in 1998 and Venezuela just recently, and where there are no restrictions on FX outflows (which was not/is not the case in either country). If a large country like Russia ever allowed its entire household population to buy Libra, and then all of the sudden decided through a new law or regulation that all Libra holdings must be liquidated, then a “run on the Libra” scenario could be possible. The question is whether such a doomsday scenario can impact other markets and economies or even the stability of the entire global financial system.
Let’s assume there were 52 million households in Russia in 1998 and all of them had bought Libra sometime prior to August 1998 as a hedge against the ruble devaluation, meaning they just bought Libra and held it. That’s a big assumption because there is no way each and every individual household would do that. Let’s also assume they would invest their entire annual average income of $6,500 (that’s in current terms) to buy Libra — which is again a very big assumption. That would equate to $338 billion worth of Libra the Libra Reserve would need to back with “low-volatility assets, including bank deposits and government securities in currencies from stable and reputable central banks….[those securities would be] short-dated securities issued by these governments, that are all traded in liquid markets that regularly accommodate daily trading volume in the tens or even hundreds of billions.” Let’s also assume all $338 billion would only be invested in short-term government securities at the same basket composition of 50% USD, 30% EUR, and 10% for GBP and JPY each, and that the other Libra activity outside Russia would net to zero (i.e., there would be no need for the Libra Reserve to further burn Libra or sell any other assets). This would put $169 billion into the U.S. short-term government securities market. Let’s further assume all that money would only be invested in U.S. Treasury Bills that have a maturity of up to 1 year and average daily trading volume of about $130 billion.
If all Russian households were to sell their Libra holdings on one single day, and therefore the Libra Reserve had to liquidate $169 billion of U.S. Treasury Bills on one single day, then yes that could be problematic. However, it’s likely the liquidation decree would be spread out through a longer time window, which will allow a more smooth operation in that market. Since multiplier or contagion effect exists in the financial markets, such liquidation scenario can be exacerbated and lead to unintended consequences — the exact unknown ones the regulators are afraid of and rightly so want to punctiliously examine and possibly monitor and have oversight of.
Black Wednesday 1992
Black Wednesday occurred in the United Kingdom on 16 September 1992, when John Major’s Conservative government was forced to withdraw the pound sterling from the European Exchange Rate Mechanism (ERM) after it was unable to keep the pound above its agreed lower limit in the ERM. In the months leading up to Black Wednesday, George Soros had been building a huge short position in pounds sterling that would become immensely profitable if the pound fell below the lower band of the ERM. Soros recognized the unfavorable position at which the United Kingdom joined the ERM, believing the rate at which the UK was brought into the Exchange Rate Mechanism was too high, their inflation was also much too high (triple the German rate), and British interest rates were hurting their asset prices. Between 4 September 1992 and 12 February 1993, the EUR and GBP were down against the USD by 18% and 29% respectively.
Chart #3: EUR, GBP, and Libra exchange rates and volatility — Black Wednesday until February 1993
Based on data compiled by Bloomberg between 4 September 1992–12 February 1993, exchange rates moved as followed:
Based on the above changes in global exchange rates, we see the following uneven changes in the value of Libra:
We also crunched the numbers for the Lehman Default 2008 and Greece Financial Crisis 2010 scenarios, but since the results were very similar and for the sake of space, we are not including them here.
The problem with all the above scenarios is that they are known and actually happened. It is possible another financial crisis like no other can blow in like a storm in the future, creating unpredictable results and outcomes. If Libra is indeed to be used solely as a means of payment and not as a store of value or an investment (after all the Libra coin itself won’t pay interest — unlike its underlying assets or the Libra investment token), there will be no incentive to hold it as a potentially appreciable asset like Bitcoin, and as such systemic risk won’t exist, since, at least in theory, the Libra Reserve will burn Libra coins at the same rate it issues them. However, since we are dealing with a new system that hasn’t been tested, we cannot be certain that’s the case and in practice, the size of the Libra Reserve can quickly balloon.
Further negative scenarios can arise from problems at the wallet level, or on a more systemic level. These are two very different points. As stated by David Marcus, wallet issues would depend on the integrity of wallet providers which can be a jurisdictional minefield. They are tasked to not allow bad actors into the Libra environment. These bad actors could introduce money laundering, fake transactions, and black market activity into an otherwise legitimate environment. The Libra Association will not accept responsibility for the actions and behavior of the wallet providers. It would be up to the jurisdictional regulators to police and regulate this activity. Regulators do not seem to be in a position to handle this responsibility at this time. Systemically, hackers could try to steal Libra from wallets, mint fake Libra, and induce price volatility by spreading false activity or price action. They may also seek to disrupt Libra Reserve activities in the government debt markets.
In his testimony, David Marcus suggested that Calibra would offer consumer protection against fraud just like any other wallet. It’s important to know if such protection will be explicit, contractual, and unlimited in value, or whether Facebook and/or the Libra Association will establish a cap and an insurance fund, similar to the FDIC that insures up to $250,000 in the U.S. While Facebook and many other companies were able to pay fines imposed on them by various regulatory bodies, a global heist on Calibra could have a much bigger magnitude than any of those fines, and could potentially dwarf the alleged $65 billion BP had to pay due to the 2010 Deepwater Horizon oil spill. If “only” a 1/3 of Facebook users used Calibra (that’s 792 million people assuming Facebook has 2.4 billion users), and kept $100 worth of Libra there that were stolen, would Facebook have to recoup $79 billion?
In this systemic topic, the Libra Association and Facebook’s Calibra do seem to be in a position to be a responsible actor that will put processes and procedures that offer recourse to participants. Consumer protections should be the goal to protect the integrity of Libra. This needs to exist in the form of codified law and contractual obligations by the Libra Reserve, which highlights the special situation presented to the consumer and Central Banks alike.
The Libra Association and international regulators could also agree to monitor and examine on a regular basis, and if necessary limit, the size of the Libra Reserve, and more specifically its asset allocation in order to reduce systemic risk. This is similar to how the Federal Reserve Bank conducts a stress test on 18 of the “too big to fail” financial institutions in the U.S. Any remedies would need the stated input and powers of a sovereign, codified as such, to limit the impact on its financial markets and money supplies.
Libra has a solid, unique value proposition and could become a legitimate, convenient and secure global means of payment. We appreciate, applaud and support the initiative and look forward to seeing it evolving and delivering its promises to help billions of people worldwide. Theoretically Libra can overcome its many roadblocks. That’s not the same thing as saying it “has” overcome them. A means of defining a transaction as a remittance, a commercial transaction, or buy and hold scenario should be contemplated. Libra Reserve activity needs to be defined for each of these scenarios, and processes need to be written in support. Regulatory oversight needs to be incorporated and adopted by sovereigns with respect to wallet providers and treasury hedging strategies in commoditized environments like G10 currencies, and more importantly in regions of significant exchange controls. Wallet providers appear to be taking on the role of Money Service Business (MSB) and locally licensed exchange providers, and as such should probably be subject to all related regulations and requirements.
We are sure Facebook and the Libra Association have already been fully engaged with respective regulators and other official parties to address all or most of the topics we discussed above, and we’d welcome further elaboration on those engagements. By providing more transparency on the evolution and progress of the project, Facebook and the Libra Association will gain more confidence and trust on a global scale. For the consumers, it should become crystal clear on how and where Libra will be de facto available.
Libra offers a significant opportunity for its constituency. While giving the benefit of the doubt as to its efficacy, we encourage your commentary. Will regulators match development step for step? Or will they squash the entire concept? Will the introduction of digital yuan/renminbi, or even digital dollar, take the wind out of the Libra sails and decrease its importance? Is Libra even needed? What do you think?
Amir Tal and David O’Shea