Why Libra must be treated like traditional banks and currency

Why Libra must be treated like traditional banks and currency
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If Libra is just another new cryptocurrency, why are governments so concerned? With more than 1,600 cryptocurrencies already trading, what is the harm in one more? In reality, Libra is more than a cryptocurrency. It is a new bank with global reach and is completely unregulated by any national authority. A bank similar to Libra once existed. It was chartered and run by a government, but the bank ultimately failed. The legacy of this bank can help inform the debate over this Facebook cryptocurrency.

If plans materialize, Libra will be accepted across the world as a new form of payment. Libra will be purchased from an authorized reseller, a Libra Association member, in a transaction similar to buying foreign currency. A consumer transfers local currency to a Libra reseller and receives Libra in return. It can then be used to pay bills or make purchases online without the services of a bank, credit card company, or money transfer agent.

Consumers benefit if using Libra is cheaper than using local currency and existing financial institutions. There will be costs to use it, but Facebook claims these costs will be lower than existing arrangements. Only time will tell if this claim proves true. Unlike most existing cryptocurrencies, Libra will have a stable value. It will be a transactional cryptocurrency, not a speculative one such as Bitcoin that attracts “get rich quick” investors.

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The Libra plan for reducing the costs of transacting in foreign currency is not new. One of the earliest and most successful approaches for reducing these costs was invented by the city of Amsterdam in the 17th century. It formed the Amsterdam Exchange Bank, which was authorized to operate much like Libra. By the late 1500s, Holland was a center of global trade, which required the exchange of goods for bullion or coins. Much of the circulating coins were foreign. Accepting coins was problematic because of the uncertainty regarding their precious metal content. Coins were “clipped” in circulation and debased by government decree. Merchants would only accept coins at discounts, which raised the costs of trade.

The official Dutch unit of account at the time was the florin, which was defined as a specific amount of gold or silver. The Amsterdam Exchange Bank was founded and run by city officials to accept specie and coins and certify their value in terms of florins. The bank accepted bullion and a wide variety of foreign coins, crediting a deposit account with specific amounts of coins set by government decree. In return for the deposit, the bank issued a deposit receipt in terms of florin. These receipts traded as bank money and could also be redeemed for florin coins at the bank.

Merchants paid for traded goods by transferring receipts among accounts at the bank or by using bank receipts to pay holders that did not hold accounts. The Amsterdam Exchange Bank receipts became bank money widely accepted across Northern Europe. The bank charged fees for these services, but its fees were smaller than the discounts applied to foreign coins. The parallels between Libra and the Amsterdam Exchange Bank are striking. One key difference is that the Amsterdam Exchange Bank was operated by the city, whereas Libra will be run by a private association.

The Amsterdam Exchange Bank ran successfully for almost 200 years. Its own success, however, created the seeds of its own downfall. Its receipts became widely accepted and traded at or above their stated florin value. The bank was supposed to back its receipts with 100 percent coins, but the bank secretly started issuing unbacked receipts in the form of loans and account overdrafts. Over time, the ratio of coins to receipts fell below 30 percent. When several large bank borrowers defaulted, the depositors presented more receipts than the balance of coins, and many depositors suffered losses. The bank was ultimately closed by the city of Amsterdam.

If Libra is successful, it could easily succumb to the same incentives that undermined the operations of the Amsterdam Exchange Bank. There will be demand to borrow Libra, and Libra resellers will want to lend Libra to make profits. The Libra Association will face tremendous pressure to create new Libra currency without full asset backing. This will expose Libra currency holders to the credit risks created by association lending.

Libertarians have applauded the Libra cryptocurrency project for breaking the government monopoly on providing transactional money. They argue that, unlike the government, a private provider might be disinclined to debase its currency. Perhaps that is true. But history shows that Libra is just a modern incarnation of an exchange bank, and it will face strong incentives to lend it. Libra is ultimately a bank, and it should be required to abide by all the laws and regulations that apply to traditional banks.

Paul Kupiec is a resident scholar with the American Enterprise Institute in Washington. He served as the director of the Center for Financial Research at the Federal Deposit Insurance Corporation and is the former chairman of the Research Task Force of the Basel Committee on Banking Supervision.