Finance

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Libra is a cryptocurrency that is going compete against digital cash as the de facto transactional currency of the internet.

Why Libra?

Despite the explosion of new cryptocurrencies in the last decade, the world is still lacking a true, decentralized, digital currency that can be used for everyday transactions.

Right now Bitcoin leads all cryptocurrencies in transaction volume. But this volume is still dwarfed massively by the likes of Visa & Mastercard.

Note that the Y-axis is a Logarithmic scale.

One of the main problems with cryptocurrencies like Bitcoin is that the price is so volatile. No one wants to pay for something using Bitcoin if the price fluctuates by 20% day over day. In addition, a large portion of Bitcoin owners are investors who want to hold on to it, instead of using it to pay for goods & services.

Low transaction throughput, latency, and large fees are also problems. Unless you’re using the lightning network, it is prohibitively expensive to use Bitcoin to pay for small transactions.

The coffee rule: “If I can’t buy coffee with it, the fees are too high for day-to-day use”.

How is Libra Going to Take Over Digital Payments?

So how does Libra beat Bitcoin and other cryptocurrencies?

The answer is 3-fold.

Engineered Price Stability

Libra is a stablecoin, which means it is a cryptocurrency designed to have low price volatility. Libra achieves this by being pegged to “stable” basket of currencies and short-term financial instruments.

Stablecoins are by no means, anything new. The closest and most well-known comparison to Libra that we’ve seen is USDT.

USDT was a huge debacle for a myriad of reasons. In my opinion, the two of the biggest reasons for its failure were due to the fact that:

Tether claimed that USDT was backed 1:1 by USD. But the problem was that you could never reliably redeem your USDT for USD. A stablecoin without a reliable redemption mechanism is weak against price speculation. Tether had difficulty securing legitimate banking relationships. Business and personal accounts were reportedly used to deposit Tether reserve dollars. This caused $30 million of USD to be lost/stolen.

[Libra will be] supported by a competitive network of exchanges buying and selling Libra. That means anyone with Libra has a high degree of assurance they can convert their digital currency into local fiat currency based on an exchange rate. — Libra Whitepaper

Libra is addressing problem #1 by supporting a competitive and prolific network of exchanges that facilitate the on-ramp and off-ramp between fiat currencies and Libra.

Once Libra are easily redeemable for their underlying assets, arbitrageurs will quickly eliminate any price discrepancies between a single Libra, and what the underlying asset is worth. This is the same mechanism that ETFs use to make sure that the trading price is equal to the underlying net asset value.

The second problem is even easier to solve. Facebook and the collection of huge corporations that are on the Libra governance board have immense influence and power. They will not have trouble finding banking relationships.

2. Libra will be Widely Accepted

Another big reason why cryptocurrencies are not being used to pay for everyday goods & services is that most businesses simply don’t accept cryptocurrency. If we simply glance around, it’s clear that businesses that accept cryptocurrency as a means of payment are still the exception and not the norm.

We can expect this to change. Libra’s governing entity, otherwise known as the “Libra Association”, consists of some of the largest technology companies in the world. As a part of the association, each company is incentivized to spread the adoption of Libra. And where better than the platforms they already own.

Promoting Libra across Facebook, Spotify, Paypal, Stripe and Uber alone would trigger a massive shift in consumer adoption.

We should also expect that the association will work on making it easier for businesses to accept Libra as a form of payment. Going back to the previously mentioned point about price stability, business owners will be more likely to accept cryptocurrency payments if they are not worried about price fluctuations.

3. Scalable Blockchain with Low Transaction Fees

In 2018, Stripe ended support for Bitcoin on its payment platform, citing fees and long wait times as the main cause.

In order to have a faster, and more scalable blockchain, Libra is planning to only include a low number of validator nodes on a permissioned network in the beginning. Initially, only the founding members of the Libra Association are able to act as validators.

While this may be significantly quicker and cheaper, it does come with a trade-off. At the start, the network will be highly centralized. In the future, Libra plans to move towards a proof-of-stake, permissionless system, where anyone can become a validator node if they have enough Libra. A portion of interest collected by reserve assets will also be used to offset operating costs, thereby reducing transaction fees.

In addition to increased throughput and lower fees, Libra’s blockchain plans to have these features:

Ability to create generic resources types on the network — Libra is just the first one.

Smart contracts — Move as the Turing-complete, programmable language

The Libra protocol uses an account-based data model to encode the ledger state instead of UXTOs like Bitcoin — More suitable for smart contracts

Byzantine fault tolerant system — 33% of validator nodes can be bad actors and the system still works

Cost of computing power on the network is paid by using gas — similar to ETH.

An eventual transition towards a proof-of-stake, permissionless system.

4. Pseudonymous Identity Management

“The Libra protocol does not link accounts to a real-world identity. A user is free to create multiple accounts by generating multiple key-pairs. Accounts controlled by the same user have no inherent link to each other.” — Libra Whitepaper

The biggest worry behind Libra has been privacy concerns. Many detractors worry that Facebook’s will use Libra to further enable its brand of surveillance capitalism, at the expense of the end-users privacy. After all, how much money we have, and what we pay for is extremely sensitive personal information.

So it was a nice surprise to see Libra opt for Bitcoin’s pseudonymous identity management model. In the Libra network, there is no such thing as a user identity. You create as many accounts as you want without tying the account to a real-world identity.

Each account has a public key, which is used to identify the wallet and a private key which is used to authorize transactions.

While you can bet that Facebook is tracking you when you are using Libra on Facebook, it seems that they’ve opted to help users protect their individual privacy.

Risks for Libra

Like any ambitious project, Libra does not come without its risks and obstacles. The following are some of the main ones that I’ve identified.

Negative Real Interest Rates

Libra is fully backed by a reserve of real assets. A basket of bank deposits and short-term government securities will be held in the Libra Reserve for every Libra that is created, building trust in its intrinsic value. — Libra Whitepaper

The Libra Reserve relies on interest accrued from the underlying assets it holds to compensate validator nodes and to offset the transaction fees incurred by the network.

The only problem is that is looking more and more realistic that real interest rates could go into negative territory. The 2-year government bond yields in Japan and Europe are negative. The US 10-year treasury bill is at 1.97% (negative after adjusting for inflation).

To put into perspective how serious this issue is, the IMF has been floating the idea of negative global interest rates as a future status quo.

If the Libra Reserve can’t reliably earn interest revenue by parking its reserve in government debt, it will have to search for yields elsewhere. The problem with other assets is that they are typically more volatile than government debt. If the value of the underlying assets pegging Libra falls below par, consumers may lose confidence in Libra’s ability to hold the peg.

If the Libra reserve becomes large enough, the additional demand for government debt could actually end up pushing interest rates even lower.

It’ll be interesting to see how this plays out in the future. Will Libra move to a fractional reserve policy, or will Libra eventually completely remove the reserve once enough people believe in Libra’s staying power?

If so, Libra could have a serious impact on the supply of money, and subsequently inflation.

Tied to the Global Financial System

At the end of the day, Libra is tied to the global financial system (at least right now). If the system blows up, which is very unlikely, then coin cannot hold its peg.

This is what makes Bitcoin so markedly different. Bitcoin is not tied to the existing global financial system. Its value is derived based on market demand and reinforced by its own scarcity.

More likely to bend to the will of Regulatory Authorities

Although Libra claims that it wants to “bank the unbanked” and transform the world into a better place, we can stop pretending that Libra was created for altruistic reasons.

Fundamentally there’s value to be created and captured. We can expect Libra to lobby governments to allow the currency to be deployed as is. But there is a risk that various governments will push back.

Pseudonymity allows for “black market” activities, and money laundering. While Libra claims that they have an internal system which flags this kind of behavior, it’s very unlikely that they will be able to catch everyone.

If the government cracks down on Libra for not having enough KYC/AML, I don’t think Libra will fight back tooth & nail against them in the name of privacy. It’s more likely that Libra will compromise with the government and compromise on user privacy in order to arrive at some kind of middle ground.

Right now the “Bitcoin playbook” has worked.

Bitcoin's playbook to get regulatory approval. Credit to Eric Wall.

Libra will try to follow in Bitcoin’s footsteps. Time will tell whether regulatory bodies will allow this to continue.

Politics & Centralized Governance?

Libra will begin as a completely centralized network. At the start, only the founding members will be able to act as validators. They will have complete reign over the product roadmap, and all other matters to deal with governance.

While Libra promised that it will move to a permissionless system, doing so will be difficult from both a governance perspective and a technical perspective.

There could be further problems that arise due to politics, and tensions across association members. Perhaps the association members will find that it is not in their best interest to move into a permissionless system. Perhaps association members will be tempted to push Libra towards a future that is worse for end-users, but better for themselves.

What Does This Mean for Bitcoin?

Even if Libra usurps Bitcoin as the de facto digital currency used for day-to-day transactions, it is likely that Bitcoin will still be able to retain its value as the #1 cryptocurrency.

Bitcoin is still a better store of value

Bitcoin is not pegged to any asset. It doesn’t care if the existing global financial system explodes. In fact, I would bet that we would see an increase in Bitcoin price if the financial system exploded, for the same reason the price gold would increase.

Bitcoin’s value is solely determined by demand and scarcity. Bitcoin does not suffer from inflation. It’s deflationary.

Improvements to scability to come

Maybe not in the next month, but it’s likely that Bitcoin will receive updates which will allow for it to compete on a scalability perspective.

If throughput increases, latency decreases, and fees become tolerable, the only challenge for Bitcoin to overcome is price stability.

About the Author

Written by Anthony Xie

I’m the founder of HodlBot.

I’m a big data nerd. I like to talk about all things data, finance, and crypto. You can find me on Twitter here.

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