Some have proclaimed Zuckerberg's dive into digital currencies as (one of) the drivers of the recent renaissance in cryptocurrencies (as scale goes to the mainstream); others fear Facebook's Libra is a 'trojan horse' to centralized (not de-centralized) control of billions of people's wealth and an acceleration of the push for a cashless society (as rate go negative almost globally and policy-makers lose control of the status quo).

Rabobank's Wim Boonstra breaks down the arguments on both sides, arguing that Libra could be "potentially a welcome addition to the financial system" but ending on an ominously totalitarian note...

Summary

A consortium led by Facebook recently announced the introduction of a new cryptocurrency, the Libra. Unlike most other cryptocurrencies, the Libra will be fully covered by financial assets. One of the aims of the Libra is to connect billions of people who do not yet have access to financial services to the financial system. The effects of the Libra will therefore first be felt in emerging markets, but soon this crypto can also manifest itself elsewhere. If the Libra actually gets off the ground, it potentially also has a greater impact on the financial system than other cryptos.

Introduction

A consortium led by Facebook recently launched an initiative for a new crypto currency, the Libra. The first reception in the media and with politicians was quite sceptical, even verging on hostile. This is related to the poor image that Facebook has built up in recent years. The combination of the name ‘Facebook’ and the words ‘new cryptocurrency’ in one sentence seems to trigger a lot of emotion. Which is a pity. Because the Libra is not a typical cryptocurrency and, just as important, Facebook is only one of many initiators of the Libra. Studying the underlying documents shows that this is a very interesting initiative.

To begin with, the consortium that was organized by Facebook, the Libra Association, is certainly impressive. It includes a number of large, reputable companies in the field of payment transactions (Mastercard, Visa, Paypal), new business models (eBay, Uber), telecommunications (Vodafone) and Fintech. All in all, there is a lot of knowledge behind this initiative. Partly because of this, at first glance the concept of the Libra seems to be more intelligent than many other cryptocurrencies. For example, Bitcoin was immediately said to be technically advanced, but economically obsolete (Economist, 2011). This criticism does not apply to the Libra, as the economic side has also been carefully considered. More on that later.

Another important difference between many cryptocurrencies and the Libra is that from the outset the Libra Association seeks cooperation with legislators and regulators in the field of consumer protection and the prevention of abuse of the Libra for criminal transactions (Catalani et al, 2019). The Libra Association therefore seems not to be opposed to the regular system (as many cryptos do), but sees itself as a valuable addition to the existing system and therefore wants to participate fully in it. It is noticeable, however, that the Libra White Paper doesn’t mention whether monetary and banking regulators have been approached as well.

As we shall see, it will be clear that the Libra, if successful, can considerably strengthen competition within the system and moreover may grow into systemic relevance. Which, of course, will alert every supervisory authority in the world

The Libra: covered by assets

Most crypto currencies do not have any coverage. That means that ultimately their underlying value is zero. That is one of the reasons why they fluctuate greatly in value, as there is no underlying value that can serve as a benchmark in price formation. The resulting price volatility makes a cryptocurrency such as Bitcoin highly unsuitable as regular money. The Libra, on the other hand, will be fully covered by high-quality financial assets, such as high-quality short-term government bonds of good liquidity. If the use of Libra grows, the underlying assets will grow as well. If, on the other hand, people surrender Libras en masse, this will lead to a decrease in the size of the Libra system, but the liquidity of the cover will have a relatively limited effect on the price.

A demand-driven circuit

The size of the Bitcoin circuit is predetermined and Bitcoins must be "mined". As a result, there is no logical correlation between the amount of economic activity and the size of the Bitcoin circuit. Libra does this differently. It does not pursue a monetary policy, the White Paper argues, it is not going to actively influence the amount of Libra. The size of the Libra circuit is precisely question driven. More Libra comes into circulation when people buy Libra and thereby hand over assets to cover; the opposite happens when people buy back those assets and return Libra for that purpose. In this way, the Libra is managed as a currency board, in which the money supply of a country automatically moves one-on-one with the size of the foreign exchange reserves. The actual transactions go through specially designated parties ("authorized sellers"), which must guarantee liquidity of the Libra. Here people can also trade Libra among themselves, so the size of the total outstanding amount of Libra only changes if demand exceeds supply or vice versa.

A supplement to the existing system

The Libra is not launched as a world currency, which ultimately must replace other currencies. On the other hand, it must be seen as just a supplement to the existing currency. It is known from the specialist literature on optimum currency areas that the whole concept of a universal world currency is absurd (Mundell, 1961). In the structure of the Libra, countries keep their own national currencies. The Libra circuit overlies it, as it were, as a sort of currency basket, whereby the composition of the underlying assets determines the value of the currency basket. The exchange rate of the Libra against the participating currencies will therefore be relatively stable, but is not entirely certain. It is, as it were, a weighted average of the exchange rates of the financial titles included in the underlying reserves. In this regard, the Libra can be compared to the ECU, the European currency basket that preceded the euro (Boonstra, 2018). However, the Libra is likely to have a broader composition than the ECU, which naturally included only European currencies. Another comparison is with a money market fund, which issues marketable liabilities and fully covers them with short-term money market paper.

A relatively stable crypto, but only in relation to the underlying values

It is of course not yet clear from which currency the underlying assets of the Libra will consist. As stated, their exchange rates will ultimately determine the rate of the Libra. At the same time, the Libra Association wants to guarantee a high degree of tradability of the Libra. This also means that the underlying assets must have a high degree of liquidity. The logical consequence is that the Libra can only be covered by assets in fully convertible currencies. Weak countries cannot deliver the high-quality assets in their own currency that the Libra covers. This considerably limits the choice, because many currencies are not fully convertible and therefore have no capital controls. The Chinese renminbi, for example, does not yet qualify in this regard.

The foregoing means that the rate of the Libra is therefore primarily determined as a weighted average of the exchange rates of convertible, predominantly Western currencies. Viewed from a weak currency, the Libra will therefore tend to appreciate structurally. This makes it attractive for residents of countries with a weak currency and / or high inflation to store their assets in Libra. This is on the assumption that they will find counterparties that are willing to hand over Libra in exchange for their weak currencies. This could also mean that if the Libra circuit could evade restrictions on capital movements, the Libra could play a role in capital flight.

Earnings model not yet completely clear

The business model behind the Libra is still unclear, which maybe one of the reasons why many observers react rather suspiciously towards this initiative. The assets in which investments are made are relatively low-yielding. However, costs will be charged to the user per transaction. The costs of the Libra will be determined by, among other things, the design of the underlying payment system (which will be based on blockchain technology) and by the costs that will have to be incurred in order to comply with all relevant laws and regulations. Maybe the Libra Association hopes to make money out of selling transaction data to third parties. Here the reputation of Facebook may be not very helpful.

Possible impact

If the Libra gets off the ground this can be bad news for many existing cryptocurrencies. The intelligent design and powerful consortium behind it make the Libra potentially superior to existing crypto currencies. For the time being, the price of the Bitcoin has not really responded to the announcement of the Libra. It has actually increased in value, which is surprising, to say the least. If the Libra would gain track and reaches large volumes, the demand for high-quality, liquid and short-term financial assets to cover it can lead to upward pressure on the price of such assets, and therefore a further fall in interest rates on the short side of the yield curve.

Libra has the ambition to connect the 1.7 billion people who do not yet have a bank account to the financial system. In order to be successful, Libra must give them access to a cheap and efficient payment system, with low and predictable margins between purchase and sale prices. They start with the group of people who do not yet have a bank account, but who already have a mobile phone. That would already be about 1 billion people. Furthermore, according to the Libra Association, half a billion people would not have access to financial services, but would have access to the internet. In this way, the Libra can contribute to accelerating the large group of people who do not yet have access to financial services. This allows the currency to play a major role in developing countries. This will certainly be the case if the Libra blockchain could also process transactions in local currency. The chance that this will happen is real. This is because Libra will have an open character, for example where the source code is completely transparent. This means that parties can build their own applications and integrate them with the Libra. As a result, local currencies can also play a role and closer integration with the existing economy is feasible.

But the consequences of the arrival of the Libra will not be limited to emerging countries. The Libra can also play a major role in eliminating payment inefficiencies in economically more developed countries. In general it can be said that the more inefficient the domestic payment system is, the faster and more robustly the effects of the Libra can be felt. That is good news for the payment service providers in our country, because the Netherlands has a highly efficient and effective cashless payment system, although that should not lead to complacency. Because under pressure from innovation and competition, the aim must constantly be to further improve things.

To conclude

Personally, I don’t like cryptocurrencies. In my opinion, they are hyped, have no backing at all and in their current shape most of them will have no future. It takes a lot of convincing to get me enthusiastic about anything that even vaguely looks like a cryptocurrency. Moreover, I don’t like Facebook. However, Libra gets me excited as an economist. In short, if this project goes live, the world gets a new cryptocurrency, but this time it is a cryptocurrency that can potentially make its impact felt in not only the financial but also the real world. It may also make most other cryptos irrelevant. Which I applaud.

So far, Libra exists only on paper. This is a major disclaimer. However, on paper, the Libra design looks really good. Time will have to tell whether or not this consortium will succeed in launching the Libra along the lines sketched in the underlying white paper. If they do, it potentially may mark the beginning of a major redesign of the global financial system. Whether you like it or not.

Leaving one major question: why hasn’t the IMF never considered to launch the SDR in such a way? That would really have been a game changer...