Facebook’s Libra will be a nonstarter

Facebook’s announcement last Tuesday that it planned to launch a new cryptocurrency called Libra has shaken not just the cryptocurrency world but the broader financial world and especially that world’s regulators and their political overseers.

Libra will be a nonstarter, for many reasons. The Libra Association, spawned by Facebook, stated in a white paper that “Libra is made up of three parts that will work together to create a more inclusive financial system:

  • It is built on a secure, scalable, and reliable blockchain;
  • It is backed by a reserve of assets designed to give it intrinsic value;
  • It is governed by the independent Libra Association tasked with evolving the ecosystem.”

In fact, Libra will be the functional equivalent of a bank, or more specifically an online, digital bank. While the Libra balance sheet will resemble a money market mutual fund, operationally it will be much more like a commercial bank because of an anticipated high level of transaction activity if, as intended, people use Libra coins primarily to make payments rather than as a short-term investment.

If Libra begins operating, its customers will use fiat currencies (e.g., dollars, pounds, euros, etc.) to purchase Libra coins from “authorized resellers.” Those resellers will then “transact large amounts of fiat and Libra in and out of the [Libra] reserve.” 

The Libra Association will invest the proceeds from the sale of its coins in a “collection of low-volatility assets, including bank deposits and short-term government securities … [that] will be administered with the objective of preserving the value of Libra over time.” 

Those assets will be denominated in a basket of “currencies from stable and reputable central banks.” Consequently, the value of a Libra coin in any one currency will fluctuate as the foreign-exchange value of those securities fluctuates, resulting in daily gains or losses to owners of Libra coins. 

Libra most definitely will not be a so-called “stablecoin” linked one-for-one with a fiat currency.

The paper also noted that the Libra Association “may occasionally change the composition of the basket [of currencies] in response to significant changes in market conditions,” such as in response “to an economic crisis,” but this would only occur under “exceptional circumstances.” 

Those basket changes, though, could result in a loss in market value to some Libra coin owners, which will be highly controversial.

The white paper is silent about an essential element of banking — capital, which is what protects a bank’s depositors and other creditors against losses, including losses from fraud, an all-to-frequent occurrence in the crypto world.

As we learned in September 2008 when the Reserve Fund “broke the buck,” investors in a money fund can lose money. 

The same could happen with Libra coins, specifically if the Libra Association suffers losses due to fraud, such as fraud committed by its resellers. Fraud could also occur within the association. I predict Congress and financial regulators will be critical of the lack of capital in Libra’s balance sheet to absorb any losses. Some may even demand bank-like capital regulation for Libra.

Although not too troubling during this time of low interest rates, Libra users will “not receive a return” on the Libra coins they own; i.e., these coins will be non-interest bearing. Libra’s interest income “will first go to support the operating expenses of the [Libra] Association” and to, among other purposes, fund “grants to nonprofit and multilateral organizations.”

The white paper is silent as to whether the resellers will charge transaction fees, but it did note that Libra coin “can be sold for fiat currency at a narrow spread above or below the value of the underlying reserve.” That spread would be equivalent to a transaction fee. 

Since the Libra resellers are likely to be cryptocurrency exchanges, which do charge transactions fees, resellers probably will charge fees to execute Libra transactions.

Transaction activity also means that Libra transactions will be subject to money laundering laws and state-level laws governing money transmitters. Those obvious legal requirements will trump a statement in the white paper that “the Libra Blockchain is pseudonymous and allows users to hold one or more addresses that are not linked to their real-world identity.” 

A more fundamental question though is how widespread will Libra usage be, for transacting in Libra, or in any cryptocurrency, entails converting back-and-forth between the cryptocurrency and the local currency used daily by individuals and businesses. 

That is a not-inexpensive hassle for most people and businesses, which will make Libra a nonstarter because of low transaction activity. 

Venezuela and Zimbabwe might be exceptions, but the business case for Libra cannot be based solely on transaction activity in highly troubled economies. Possibly, Libra will find some usage in countries with relatively primitive payments systems, but I doubt if that will make Libra a profitable venture globally.

Some central bankers as well as the Bank for International Settlements worry that Libra could “rapidly establish a dominant position in global finance and pose a potential threat to competition, financial stability and social welfare.”

Given Libra’s inherent shortcomings, central bankers do not have much to fear, but closely monitoring any launch of Libra would be wise.

Facebook’s ownership of Calibra, which will provide “a digital custodial wallet that enables storage and use of the Libra digital currency,” will provide a unique challenge to Libra in terms of protecting the privacy of the transaction data flowing through it. All Libra transactions, at least initially, will flow through Calibra. 

Facebook claims that Calibra “will not share account information or financial data with Facebook, Inc. or any third party without customer consent.”  Based on Facebook’s track record on privacy matters, that is not a credible commitment. This headline from a New York Times article captures the sentiment of many.

Libra is an intriguing concept, at least to some, but its economic feasibility is highly dubious. Don’t plan on setting up a Calibra wallet anytime soon.

Bert Ely is the principal of Ely & Company, Inc., where he monitors conditions in the banking industry, monetary policy, the payments system, and the growing federalization of credit risk. Prior articles by Ely on banking issues and cryptocurrencies can be found here.  Follow Bert on Twitter: @BertEly

Tags Cryptocurrencies Currency digital currency Facebook Fiat money

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