Libra Cryptocurrency Puts Facebook at the Global Economy’s Roundtable

September 18, 2019 | Article

By Shane Husar and Michael Felch

Only a few days after Facebook announced its cryptocurrency, Libra, the U.S. House of Representatives called upon Facebook to cease implementation of Libra and its digital wallet Calibra. The fear is “that these products may lend themselves to an entirely new global financial system that is based out of Switzerland and intended to rival U.S. monetary policy and the dollar,” according to Rep. Maxine Waters in a recent article. Needless to say, Facebook has regulators, financial institutions, crypto-enthusiasts and the world on high alert.

What is Libra
Libra is Facebook’s proposed global digital cryptocurrency, which will be used as the medium of exchange for commerce on the social network’s platform. Libra is classified as a “stablecoin,” whose purpose is to provide a stable unit of account or low volatility in price, similar to current fiat currencies such as the U.S. dollar. A stablecoin achieves price stability by “pegging” its price to an existing fiat currency or stable asset, such as the U.S. dollar. In order to “peg” the price of Libra to a set of assets, Facebook will establish the Libra Reserve, consisting of fiat cash deposits and short-term government securities, and maintained in accounts centrally located in Switzerland.

What is cryptocurrency?

The definition of cryptocurrency, at its most basic, is a digital or virtual currency that exists online. “Crypto” refers to the different cryptographic techniques employed in the decentralized payment system to prevent counterfeiting and fraudulent transactions.

By solving for stability, Facebook believes it will instill trust in its currency, similar to how other currencies were introduced in the past, such as the U.S. dollar with the Federal Reserve. It’s important to note that the Libra cryptocurrency will not be “pegged” to a single currency, but rather, backed by multiple assets and the value of a Libra in any of the underlying currencies may fluctuate. To control for this fluctuation, the reserve assets are evaluated and chosen by a “neutral” nonprofit organization called the Libra Association, which will be responsible for maintaining these assets and executing the investment strategy.

All the transactions using the Libra cryptocurrency will live on the Libra blockchain. The blockchain source code is open source, which means that developers globally can access it and review for potential improvements. However, despite this fact, the Libra blockchain is a permissioned, enterprise blockchain—at least initially. The Libra Association will act as the validator nodes to maintain the blockchain. The long-term goal is to decentralize the platform and migrate it to a permissionless platform, like the Bitcoin or Ethereum blockchains.

The Libra Association’s Role
To execute on Libra’s mission, a governing entity called the Libra Association was created. The entity is an independent, nonprofit membership organization headquartered in Geneva, Switzerland, which is designed to coordinate the agreement among its members while they pursue the development of the network and manage the Libra Reserve. The association is governed by the Libra Association Council, which is comprised of one representative per validator node. Each member is required to make an initial investment of $10 million among other technical requirements and cannot represent more than 1% of the vote. Through the association, the validator nodes align on technical (network development) and financial (reserve asset allocation) strategy. The association is also the only party able to create (mint) and destroy (burn) Libra. Coins are only minted when authorized resellers (ex. U.S. Government) have purchased the coins from the association with fiat assets (ex. U.S. dollar) to fully back the new coins, and coins are only burned when the authorized resellers (ex. U.S. Government) sell Libra to the association in exchange for the underlying assets (ex. U.S. dollar). How one becomes an authorized reseller has yet to be defined, but given that authorization or “permission” is required, this doesn’t bode well for their goal to move to decentralization or a “permissionless” protocol in the future.

Libra’s Path Toward Decentralization
All cryptocurrency is evaluated based on their merits of decentralization. In other words, their ability to minimize trust. Facebook has recognized this fact and has explicitly stated one of their important goals is to move toward decentralization over time, which the Libra Association intends to do within five years.

Their current plans to operate and prepare for the transition include:

  1. A requirement of a minimum $10 million fee. The concern here is this will only allow financially well-endowed organizations or individuals to participate. This creates a reliance on founding members and high barriers to entry and centralizes trust. The participation fee will have to drop significantly to increase membership and improve decentralization.
  2. Their stated mission is to partner with organizations to promote financial inclusion. Trust will be hard to minimize if involvement is only targeted at the organizational level vs. individual level. Misaligned incentives could be hard to separate.
  3. Validator nodes, represented in the council, have the ultimate power. Membership, however, is approved and limited by the council. The council is expected to increase the number of validator nodes over time as they evaluate the network. If the limit is exceeded, the member with the lowest stake (amount of Libra in custody) will be removed from the council. A select group, in this case the council, dictates membership, which means the reliance on founding members will have to be carefully monitored.

Despite the Libra Association’s stated goals, principles, and mission to become permissionless, they also don’t use these words to hide that the Libra protocol is a permissioned blockchain. Libra is centralized, will continue to operate that way for the foreseeable future, and people have taken notice. One of those parties is the U.S. Government.

Where Libra Fits in the Financial System
When Libra’s mission to provide a global currency was stated, nations were put on notice. The implications here quickly become significant, as a global unit of account signals a replacement of the current reserve currency in the world. The reserve currency relies on the monetary instrument that is final settlement, so if the Libra were to become the method in which final settlement occurs for future transactions, then nations have a justifiable reason to be concerned. Influence and/or leverage is imparted to the party that controls the currency involved in final settlement of any transaction, which is why the U.S. government has instructed Facebook to cease development. The current monetary and financial infrastructure in place today, controlled in large part by the U.S., is at risk.

On a macro perspective, governments, and the U.S. especially, currently benefit from seigniorage, which is the profit made by the government issuing a currency. If Libra is a replacement for the currencies that governments issue, then the demand for that fiat is reduced, which in turn, reduces the profit generated from creating that currency. No nation is going to willingly forgo this profit, hence the inherent risk that Libra creates. However, Libra will have to comply with government regulation to operate, so the expectation would be that governments use this to their advantage in the fight for control.

From a micro point of view, community banks use customer deposits to issue loans and facilitate commerce within the United States and other developed countries. Individuals currently deposit money in these institutions because of the backing and support governments and central banks provide to ensure their money is safe. However, the appeal of the “full faith and credit” is waning. As payment alternatives continually cut into the pool of available deposits, and consumers, especially millennials, perceive less intrinsic value in maintaining their deposits locally, Libra provides additional lure to pull those deposits away from local banks. By requiring individuals to deposit their money with the Libra Association to receive Libra coins, Facebook is establishing the reserve necessary to stabilize the currency and legitimize the marketplace. If Libra becomes an acceptable unit of account to purchase goods, it may further strain the connection between a consumer and their local bank. A borrower’s credit worthiness may also be easier for Facebook to evaluate compared to traditional avenues due to the social graph they generate from your use of their platform. Overall, community banks will have less leverage than governments to combat the competitive risks imposed by Libra.

Learn how blockchain and cryptocurrency are affecting the banking industry

U.S. lawmakers are convening with their global counterparts to discuss the Libra framework. Delegates from the Financial Service Committee met in Switzerland in August with Adrian Lobsinger, the Swiss Federal Data Protection and Information Commissioner, to discuss data integrity and protection surrounding Libra. While Facebook continues to take the position of working through the existing regulatory framework, rather than around it, very little has been revealed about the project beyond the initial whitepaper release and U.S. regulatory hearings, much to the frustration of regulators globally. Regulatory challenges also included necessary checks and balances associated with anti-money laundering (AML) and know-your-customer (KYC) regulations, in which there is diversity in practice globally. One of the primary goals is for Libra to bank the “unbanked,” which may be hard to bring on users to the platform that originate from countries with an underdeveloped regulatory/financial structure. These are all challenges and questions that need to be answered.

Facebook’s Libra announcement has not been met exclusively with resistance. In some instances, it has created a new sense of urgency and acceptance of other cryptocurrencies. For example, New Zealand recently made it legal for employers to pay employee salaries in cryptocurrencies, assuming the cryptocurrency can be easily converted to fiat currency. In China, the central bank is nearing launch of its own digital currency, viewing Libra as “a threat to payment systems and national currencies.” However, maybe the greatest sense of urgency is amongst governments in developing countries dealing with hyperinflation and lack the stability of their developed counterparts.

Banking the “Unbanked” – Targeting Developing Countries
Facebook believes there are several benefits for Libra, including the ability to provide access to financial services for those located in hyperinflationary economies or who have remained outside the financial system altogether. While this is indeed important, providing access to financial services for individuals that are in nations with stable currencies won’t be as impactful as delivering access to those in nations with significant inflation. However, the lure of this proposition is undeniable. As noted in Libra's whitepaper, an estimated 1.7 billion adults globally remain outside of the financial system, even though one billion have access to a mobile phone. In addition, cash is still the primary medium of exchange globally, and the cost of moving cash globally is quite expensive. This issue is specifically true to those with less money that utilize remittance services such as Western Union to send funds to their families in other countries. If user loyalty and retention are a large influence on the lifetime value (LTV) that Facebook likes to evaluate their products by, then there may not be a better opportunity for Libra to generate customer loyalty than providing an escape from financial repression.

Looking Ahead
There is no doubt that Facebook made a profound statement with their introduction of Libra. It is an effort to establish a global marketplace and banking platform among their users which can help open the financial system, and the opportunities it provides, to those who previously were denied access. However, in embarking on a project that can have such a geopolitical impact, they have put many stakeholders on notice. The reactions to the Libra launch have been mixed, and the hurdles to bringing Libra to production will be significant. If nothing else, it has thrust stablecoins and cryptocurrencies further into the limelight. Pull up a chair, Facebook. Welcome to the roundtable.

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