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Before hitting the “like” button on Facebook’s cryptocurrency project, it is wise to consider some serious issues created by this new form of private sector tender. Competition is good, but only if this new cryptocurrency provides consumers with a new form of “money” that maintains its value, facilitates cost-efficient transactions and does not create financial stability risk. Measured against this standard, Libra falls far short. Instead, Libra carries all the risks of a completely unregulated banking system.
Libra is not a digital currency, it’s a security. It is a claim on a managed basket of debt securities in multiple currencies — a managed multi-currency collateralized debt obligation, or CDO. In 2008, CDOs backed by subprime mortgage bonds were instrumental in causing the financial crisis. Today, those holding Libra must trust that the Libra Association — an unregulated group of 28 founding corporate members lead by Facebook and based in Switzerland — will manage Libra for the benefit of those holding Libra and not for the profit of Libra Association members.
The basket of assets backing Libra will be comprised of “interest-bearing bank accounts and short-term government debt securities in multiple currencies chosen to minimize volatility, so holders of Libra can trust the currency’s ability to preserve value over time.” The mix of assets in the basket can be changed at any time by a two-thirds vote of Libra Association members.
Association members are not required to invest capital (as banks would be) in proportion to newly issued Libra coins, so Association members need only risk their initial capital investment (minimum $10 million). And yet all the fees and profits generated by Libra accrue to the Libra Association members. If Libra takes hold, the Association members’ ability to profit from leveraging Libra processing fees and reserve asset interest payments is virtually unlimited.
There is no regulatory mechanism to stop the Libra Association from loading up on high-risk reserve assets to maximize their members’ profits. In fact, today many of the liquid government bonds of stable currencies like the Euro are trading at negative yields. To generate a profit, the Association will be forced to hold high-risk bonds in the Libra asset basket. It is a huge leap of faith to believe that the Libra Association will sacrifice member profits to eliminate default risk in the assets backing Libra.
Consumers can transfer Libra to other Libra wallets using the services of a “Libra validator.” Validators are Libra Association members who chose to process Libra transactions. Validator fees are not limited by regulation, will not be fixed, and will increase as the demand for Libra transactions rises. Consumers must specify a maximum processing fee when submitting a Libra transaction but may need to increase the fee they are willing to pay in order to get a Libra validator to process their transaction.
Initially Libra will target countries with inefficient financial infrastructures and mismanaged currencies — countries with a large underbanked population. But those promoting Libra as a godsend for the underbanked may be disappointed. Libra balances do not pay interest and Libra wallets are not insured. Consumers must buy Libra from authorized Libra resellers in a process analogous to buying a security. It will cost more to buy a Libra than to sell a Libra. The reseller, a Libra Association member, pockets the bid-asked spread which could be large, especially when purchasing Libra using out-of-favor currencies like the Zimbabwean dollar. For many, the transition to Libra will be an expensive proposition — more expensive perhaps than transacting in dollars or Euros.
With all the costs involved in using Libra, it is unclear if Libra will be cheaper than transactions using current systems and government money. Libra may be as easy as a cell phone app to use, but the cost of using Libra may be high — and only visible to consumers after they start using Libra. By then, it will be very expensive to cash out.
Similar to Libra, banks hold assets to back currency deposits. But unlike Libra, permissible bank asset holdings are tightly regulated. Banks also hold mandatory reserve balances and must invest a minimum amount of equity capital for every dollar of customer deposits they receive. Additionally, banks are periodically examined by government regulators. Bank deposits are government insured and banks have a central bank to provide liquidity in emergency situations. History is witness to the many reasons banks are subject to strict supervision and regulation.
CDOs like Libra can be mismanaged and virtual wallets can be hacked. Should an incident create panic among Libra users, a run of redemption demands will radically increase the price of executing Libra transactions. Libra reseller bid-asked spreads will widen as resellers fire-sale Libra reserve asset holdings to meet redemption demand because there is no Libra central bank to provide emergency liquidity. A run on Libra has the potential to create catastrophic losses for Libra holders.
It would be wise for government leaders to consider whether the protections in place to ensure the safety and soundness of traditional bank deposits and fiduciary operations should also apply to the Libra world of private cryptocurrency. If Libra’s founders somehow have solved the age-old problem of the moral hazard in banking without capital requirements, safety and soundness regulation and periodic examinations, it would be a true breakthrough.
Before hitting the “like” button on Facebook’s cryptocurrency project, it is wise to consider some serious issues created by this new form of private-sector tender. Competition is good, but only if this new cryptocurrency provides consumers with a new form of “money” that maintains its value, facilitates cost-efficient transactions, and does not create financial stability risk.
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