Four Reasons Why Libra Could Fail
Once again Facebook is at the center of controversy, this time with its plans to introduce its own cryptocurrency, Libra. It must overcome four key challenges, however, and even then it is not clear what Facebook ultimately hopes to accomplish with this venture.
In my article two years ago, “What Advisors Need to Know About Cryptocurrencies,” I ended with these two sentences: “And watch this space. The fun may have only begun.” Well, the fun is continuing. Facebook’s recent Libra proposal has been met not only with excitement but with howls of dissent. By the time the dissenters have cut Facebook’s proposal down to size, it will not only be far less exotic, it will be better for the users Facebook aims to serve as well as for Facebook itself.
The Libra proposal: the basics
Facebook has proposed to launch a new cryptocurrency through a Switzerland-based not-for-profit called the Libra Association. The currency is to be backed by a reserve fund called the Libra Reserve, containing safe assets in a variety of major currencies, mainly short-term government securities.
The Libra Reserve will be funded by money from the purchases of Libra. For each purchase of Libra made with a fiat currency, such as the dollar or the euro or the yen, safe assets will be purchased by the Reserve in a designated basket of currencies in designated proportions.
The Libra Association is planned to consist of 100 members, each of which will have one vote and will contribute 10 million U.S. dollars to seed-fund the Reserve, in order to create the initial Libra and cover administrative costs. Association members will be compensated out of the interest earned on the reserve assets.
There are 27 Libra Association members so far, in addition to Facebook itself, including financial companies like Mastercard, Visa, and PayPal; technology, telecommunications, and cryptocurrency companies like eBay, Uber, Vodafone, and Coinbase; venture capital firms like Andreesen Horowitz and Union Square Ventures; and nonprofits like Mercy Corps, Kiva, and Women’s World Banking.
The Libra white paper vows that, “authorized resellers will always be able to sell Libra coins to the reserve at a price equal to the value of the basket;” that is, the Libra Reserve acts as a “buyer [of Libra] of last resort.”
Transactions in Libra will be recorded in a decentralized ledger called the “Libra Blockchain,” a database with similarities to the blockchains used by cryptocurrencies bitcoin and ethereum.
The Libra Blockchain will be a “permissioned” decentralized ledger, in the sense that only the Libra Association members will be permissioned to amend the database; however, anyone will be able to access it. The Libra white paper says that within five years, it will move toward becoming a “permissionless” decentralized ledger like the bitcoin and ethereum blockchains.
The Libra Blockchain will be capable of implementing “smart contracts,” algorithms that automatically trigger actions, such as payments, when a specified set of conditions are met. (With the advent of the “internet of things” or IoT, smart contracts could trigger actions such as turning on the air conditioner, or release of stored electricity into the grid from a Tesla car battery.)
The Libra objections
Objections to Libra fall into four categories: its creators and association members cannot be trusted; it will pose great potential for financial system destabilization; it is not needed; and, it is not a cryptocurrency.
I’ll take up these objections one by one. First:
It is not a cryptocurrency
Of the four objections, this one has the least merit. It is raised mainly by cryptocurrency purists.
Libra, as proposed, possesses the basic characteristic defining a cryptocurrency, namely the digital signature. Account information in Libra will be encrypted. Transactions can be initiated by an account holder only by digitally signing the transaction, using the account holder’s “private key.” No one without access to the holder’s private key can create encrypted transactions in that account. The identity of an account’s owner cannot be determined by accessing the database.
Purists complain that Libra’s decentralized ledger is not really a blockchain (even the proposers admit that it is not). But that is not necessary for it to be a cryptocurrency. Furthermore, although the database itself will not have the blockchain structure, transactions will be processed in blocks.
Some purists argue that if it is permissioned, it is not a cryptocurrency because it is not truly decentralized. This is, of course, a matter of definition. But most cryptocurrency experts, even most purists, would admit that cryptocurrencies using permissioned distributed ledgers are still cryptocurrencies.
Facebook, and the Libra Association members as a group, cannot be trusted
Several negative articles about Libra highlight the widespread doubts about Facebook’s trustworthiness. Facebook, they say, has enabled users’ data to be misappropriated, has allowed hacks that stole large quantities of user data, and has broken promises about data privacy.
Because of doubts about Facebook’s trustworthiness, and in spite of Facebook’s claim that Libra and its data will be completely separated from Facebook, these dissenters argue that Facebook cannot be trusted to refrain from mining Libra data for its own profit-making purposes.
Furthermore, because the 100 planned Libra Association members can amend the operating procedures if a two-thirds majority agrees, they could amend them – motivated to seek increased profits – in a way that poses more danger to users or to the financial system. For example, they could decide to invest the Libra Reserve in more risky investments.
This brings us to:
It will pose great potential for financial system destabilization
Libra’s creators are claiming that they will peg the value of the Libra to the value of a basket of currencies. But given the shaky history of currency pegs, the Libra white paper’s statement that, “authorized resellers will always be able to sell Libra coins to the reserve at a price equal to the value of the basket” sounds like famous last words.1
Speculation in the value of Libra relative to currencies in the reserve basket will be inevitable, driving its value out of line with the value of the basket of currencies to which it is pegged. This could lead to runs on the Libra, creating demand for the underlying currencies faster than the Libra Association can keep up.
Furthermore, the white paper says that the Libra Association will, “establish policies and procedures that establish how the association can change the composition of the reserve basket.” This seems to assume that the association will be able to change the peg smoothly, without being front-run by speculators and arbitrageurs. This is a poor assumption.
Introducing the Libra is similar to introducing the euro, except that there are only 340 million people in the eurozone using the euro, compared to Facebook’s 2.4 billion active users – and the eurozone has a central bank that manages the value of the euro, while Libra’s creators say they will do no macroeconomic management. Some commentators worry that this will make it more difficult for policymakers to control inflation.
There is no need for it
This objection ultimately carries the most weight. The Libra white paper begins with a “Problem Statement” in which it says that billions of people globally “have access to the world’s knowledge and information, high-fidelity communications, and a wide range of lower-cost, more convenient services,” but, “large swaths of the world’s population are still left behind – 1.7 billion adults globally remain outside of the financial system with no access to a traditional bank, even though one billion have a mobile phone and nearly half a billion have internet access.”
Libra’s purpose is apparently to bring low-cost financial services to the unbanked. But this problem is already being solved, without the introduction of a new cryptocurrency. Use of Kenya’s M-Pesa, through which users can make and receive payments without having a bank account, has spread to several other African countries and to India, Afghanistan, Romania, and Albania.
It is true that transfers of funds from migrant workers back to their families in their home countries can be expensive, but their cost is declining. Two years ago a company in Hong Kong briefly provided a service by which housekeepers from the Philippines and Indonesia working in Hong Kong could transfer funds to their home countries using bitcoin. This worked well until the price of bitcoin transactions increased greatly due to bitcoin’s blockchain constraints. But now transfers can be made at 7-11 kiosks that are relatively low in cost.
Bitcoin is also used in countries with unstable currencies, or rigid government controls on currency transfers, such as Venezuela and Argentina. But these are the only cases I’m aware of where a cryptocurrency can solve a serious problem, and they are limited. Introducing Libra is overkill.
What will happen?
The company often called the Facebook of China is Tencent, which owns the popular mobile app WeChat, which is similar to WhatsApp, which is owned by Facebook.
But WeChat also has a mobile payment feature, WeChat Pay, with nearly a billion users. In China most transactions are cashless and carried out through a mobile app, either WeChat Pay or Alipay, which was started by Alibaba, China’s equivalent of Amazon, as its payment mechanism.
Just as WeChat started its highly lucrative payment feature WeChat Pay, it is obvious in retrospect that Facebook would want to add a payment feature to Facebook. With 2.4 billion Facebook users, the network effects would be likely to rapidly make “Facebook Pay” the dominant payment app.
Why is Facebook trying to do this by creating a new cryptocurrency? WeChat didn’t create a cryptocurrency in order to launch WeChat Pay, and it certainly didn’t need to. Why is Facebook trying to do it?
I don’t know why Facebook is trying to do it this way, but given the strong resistance to Libra from economists, the U.S. Congress, and various commentators, it seems likely that the Libra proposal will be withdrawn and Facebook will fall back on launching its own payment app much as WeChat did.
Perhaps Facebook proposed launching Libra as a stalking horse for the payment app it will ultimately introduce – to prepare the ground, to create a sensation that will garner enormous amounts of publicity, or for some other reason, such as to continue its reputation for moving fast and breaking things, or just to experiment with cutting edge technology.
Whatever the reason for the Libra trial balloon, it will burst. Inside it we will find just another payment app. But the Facebook payment app will quickly catch fire, propelling – at last – Western countries into the company of cashless societies where China already is.
And this will not be a bad result for society, nor for Facebook. Perhaps the Libra trial balloon will turn out to have been a useful thought experiment. Continue to watch this space; the fun may have only begun.
Economist and mathematician Michael Edesess is adjunct associate professor and visiting faculty at the Hong Kong University of Science and Technology, chief investment strategist of Compendium Finance, adviser to mobile financial planning software company Plynty, and a research associate of the Edhec-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, was published by Berrett-Koehler in June 2014.
1 The proposed Libra peg is, strictly speaking, a currency board, in which reserves must cover at least 100% of the value of the outstanding currency. Currency boards have succeeded in some cases, but failed in others. To my knowledge all have been pegged to a single currency, not – like Libra – to a currency basket, which poses additional problems.