Facebook is very knowingly exploiting a very specific gap in regulations and technology made possible by the cryptocurrency industry that will allow their planned “Libra” cryptocurrency to flow into the black market economy while still being compliant with traditional financial entities’ compliance policies.

(I don’t use “black market economy” as a bad word here. The right to financial services should be universal, since leaving the control to gatekeepers creates a tool that is much more likely to be successful at oppressing people than at keeping the bad guys out. The problem with the Libra is that it’s a part of Facebook’s broader surveillance capitalism strategy. I’m a privacy proponent and I usually spend my free time writing guides on Privacy & Cryptocurrencyfor the Human Rights Foundation. In a previous life, I built cryptocurrency exchange platforms.) How the “exploit” works The exploit works by following a playbookthat was written by the Bitcoin industry. The exploit emerges in the gaps of a little puzzle consisting of a few key players: Cryptocurrency exchanges (“on- and off-ramps”) where you can buy and sell Bitcoin for dollars

Banksthat give the exchanges their bank accounts

Regulatorswho set the know-your-customer (KYC) & anti-money laundering (AML) rules

Blockchain analysis firmswho monitor cryptocurrency transactions for “suspicious activity”

Bitcoin users who buy and sell Bitcoin at cryptocurrency exchanges and then distribute them into the global Bitcoin ecosystem Here’s a diagram showing how they view their relationships with each other:

The basis of the exploit lies in combining the pseudonymity of Bitcoin’s public key cryptography with the transparency of the Bitcoin blockchain. The transparency gives the participants in the diagram above the ability to surveil the Bitcoin system and produce reports that ticks all the boxes necessary for regulatory compliance. But the pseudonymity of the system still makes it easy enough for anyone with a computer to circumvent those exact surveillance methodologies when it’s necessary (more info here & here).

In the world of financial surveillance, those surveilling know they’re not going to catch every bad guy. It’s typically enough that you can demonstrate that you’re able to provide insight into a sufficient portion of transactions coming into your platform and that you possess far-reaching blacklisting capabilities and keep updated lists of blacklisted entities. And because nearly all activity in the Bitcoin system originates from speculators who typically do not bother to circumvent surveillance, the pie-chart diagrams the blockchain analysis firms produce on behalf of their clients will indeed look compelling.

What this numbers-based exercise completely fails to capture is the underlying potential embedded in the pseudonymous design to circumvent surveillance whenever and wherever it is needed.

To understand this better, by analogy, let’s say that a government wanted to surveil 3D printers, so that no one prints guns in their homes. To make sure that 3D printers are not being used for this purpose, every 3D printer starts coming with government-installed webcams attached to them.

As soon as this happens, websites start popping up with software to patch your printer to send a static video stream to the webcam to hide your activities. Now, let’s say 98% of the 3D printer owners do not have any interest in printing guns or manipulating the video stream, so they just leave the webcams on. If the government was a blockchain analysis company, they would produce a diagram with detailed reports showing how they’ve effectively observed and cataloged 98% of all 3D printing activity, and that 3D printing is one of the most transparent systems in the world and that the country is safeguarded against 3D-printed guns.

That’s essentially how the system of Bitcoin surveillance works today. The on- and off-ramps may be regulated, but the Bitcoins themselves are fickle and leak through their cracks. This is an amazing deal for Bitcoin because it means it can both trade at regulated venues and serve the institutional market while at the same time trickle down into the hands of every person from every walk of life on the planet. Transparency and pseudonymity — it is the ultimate combination that any aspiring form of digital currency should try to emulate for global reach.

And with the Libra, Facebook is intentionally cloning both of these two properties. Listen closely to what David Marcus says in the video below. David Marcus is the Director of Libra and VP of Messaging Products at Facebook, but he is also a Bitcoin fan and up until recently sat on the Board of Directors of the largest cryptocurrency exchange business in the United States: Coinbase.

Facebook's new cryptocurrency is the best of both worlds: it will be regulated to prevent money laundering and allows people to use digital cash, says Facebook's David Marcus. Watch the full interview with @TheStalwart ▶️ https://t.co/bB2910DxXv pic.twitter.com/dBGz6y9HXS — Bloomberg Crypto (@crypto) June 18, 2019

Why Facebook is doing this

The reason why Facebook is doing it is because they believe the plan has a chance of working. And if it is successful, it pushes an enormous amount of the regulatory responsibility (KYC/AML) of operating the on- and off-ramps away from Facebook and to the cryptocurrency exchanges where the Libra is traded. It’s letting the market figure out a way to give people access to the Libra that works, any way that works, just like it has worked for Bitcoin for 10 years. In fact, opening up the opportunity for anyone to run a Libra exchange means that there’s probably even going to be some exchanges that will try to avoid KYC/AML regulations altogether, furthering the Libra’s reach into the world.

Many cryptocurrency exchanges have been operating without licenses and without any particular regulatory oversight in the past, and some still do today. And whenever one gets shut down or implements KYC/AML restrictions, another one pops up somewhere else that doesn’t, sometimes by people who are unaware of the fact that they’re breaking any rules. And sometimes, not even the regulators in that region are aware whether any rules are being broken.

The LocalBitcoins platform which helped people to meet in person to trade Bitcoin for cash envelopes successfully operated without ID requirements forseven years before being forced to remove the option earlier this month.

But the “gap” isn’t fully gone yet. There still exists platforms such as Bisq and Hodl Hodl where people are able to circumvent these types of regulations. Here’s a quote from a blog post that Hodl Hodl recently posted when LocalBitcoins shut down in Iran:

The main difference between Hodl Hodl and other P2P cryptocurrency exchanges is that we do not hold user’s funds and do not have KYC/AML procedures. Hodl Hodl is also cheaper than most of the other P2P exchanges, with a maximum fee of 0.6% per trade.

So, by combining the properties of pseudonymity and transparency into their own Libra blockchain, Facebook hopes to achieve this sweet spot of simultaneous regulatory compliance and regulatory arbitrage, allowing the Libra to spread all over the world like wildfire while other businesses shoulders the heat. And why wouldn’t it spread like wildfire? The Facebook app family (Facebook, Messenger, WhatsApp, Instagram) is home to ~2.5 billion users. And the Libra, being backed by a basket of national currencies and government debt securities, is probably going to be a more stable currency alternative than what anyone else can provide in today’s world except for maybe the Federal Reserve.

It’s an e-commerce play, duh

Ted Livingston did a great write-up on what the long-term ambitions are with all of this in what he calls the WeChat Playbook. Basically, the most plausible scenario is that once you’ve sold your current money for the Libra, Facebook is going to do everything they can to make sure you never need to take your money out of its family of apps again. They will do this by offering you the ability to pay for everything there; sending money to friends, shopping online, paying inside physical stores, paying your bills, buying airplane tickets, bus tickets, and even tipping beggars on the street.

Critics are going to complain that the Libra will be a tool for Facebook to extract even more data about its users, to which Facebook is going to respond that they have no special insight or control over the Libra blockchain, because they are just one of 100 validator nodes from the Libra Association. This is mostly true, so save yourself some time and don’t fall into this argument trap.

That doesn’t mean that Facebook isn’t going to be able to harvest data about the purchases that occur within their own app ecosystem. Facebook has already begun clawing at this today with the roll-out of in-app purchases in Instagram (buying from brands without leaving the app) and Facebook Marketplace. If the Libra is your currency of choice and the Facebook app family is its natural home, the conversion rate between you and the targeted ads Facebook shows you will likely increase considerably. With one-click purchases, the advertising companies will always be just one click away from your money. And who makes money from that, except for the advertising company? The company selling the ad space!

And then we haven’t even mentioned that the Libra’s backers will be able to extract enormous interest earnings from the fact that the Libra Association is sitting on giant piles of everyone’s cash in the “real world” while everyone else is just sending around funny Libra tokens on a blockchain in the cloud.

The Libra Masterplan

Simply put, the Libra Masterplan is borrowing pages from the Bitcoin playbook and the WeChat playbook both at once. If successful, it makes the Libra accessible to everyone on the planet while offloading the regulatory burden of operating the on- and off-ramps to other business. With the massive network effects of its ~2.5 billion user app ecosystem, it has the potential to create the largest digital money platform that has ever existed, where it can record all purchases you make and market goods and services to you on a daily basis while leveraging the fact that Facebook already knows more about you than almost anyone else.

What happens next (and what this means for the cryptocurrency industry)

In the grand scheme of things, a successful Libra is probably going to do more for Bitcoin in terms of warming users up to the idea of cryptocurrency than nothing has ever done in the past. Bitcoin increased in value by more than 10% over the past weekend, and is nearing a 15-month high. Moreover, since the Libra is a “stablecoin” at the mercy of central banking monetary policy, it doesn’t pose a significant threat to Bitcoin as an investment vehicle. Thus, a successful Libra is probably a net good for Bitcoin. That said, the regulatory response to the Libra during the coming year is going to carry significant consequences to the Bitcoin industry in the short-term, as I lay out below. I see four potential scenarios moving forward.

Scenario 1: No Libra Launch

Regulators put a stop to Facebook’s plans before they even materialize, citing privacy issues, or that they do not like the idea of Facebook sitting on such vast sums of reserves, or fears that the Libra would have a destabilizing effect on the economy. Everything goes back to normal.

Scenario 2: Libra launches, but with KYC

In this scenario, regulators are okay with the reserve structure but see through the Libra transparency-pseudonymity masterplan. The Libra Association can attempt to please regulators by restricting the blockchain to only process transactions coming from wallets that have been verified with government ID, such as Facebook’s own Calibra wallet. While this is a possible outcome (and technically easy for them to implement), it also eliminates the entire purpose of the Libra blockchain.

In this case, the Bitcoin industry could be in trouble as well, because it is currently exploiting that exact same transparency-pseudonymity loophole that allows it to fit nicely into the regulated financial market.

Scenario 3: Libra launches, without KYC (good for bitcoin case)

In this scenario, the Libra launches in the exact form as they envision it today. Ideally, this means that there isn’t anything wrong with the Bitcoin playbook either and we can all stop stressing. The Libra and Bitcoin can then compete with each other, or complement each other, on their own merits.

Scenario 4: Libra launches, without KYC (bad for bitcoin case)

In the worst case, regulators take note of the transparency-pseudonymity loophole, but notices that the Bitcoin project has a wildly different relationship to privacy compared to the Libra. In Bitcoin, the project’s developers and supporters are always seeking new and innovative ways to eliminate the effectiveness of the blockchain analysis firms. And there’s no “Bitcoin Association” you can regulate if things start going south. It is possible that the Libra brings so much heat to the cryptocurrency industry that in the turmoil that erupts, the Libra is the only cryptocurrency that survives the regulator’s scrutiny on the virtue of being the absolutely easiest cryptocurrency to control and surveil.

Thanks to Joey Krug for useful feedback.