Updated: Sep 21, 2019
The quiet lull of August before central bankers convene for their annual conference at Jackson Hole, Wyoming provides time for thinking seriously about what the Libra proposal tells us regarding the evolution of the economy in the Distributed Age. Policymakers should worry for four reasons: Jurisdiction, Competition/Antitrust, Systemic Risk, and Monetary Policy.
The Libra Economy Demystified
Let’s start with some concrete data. Twenty eight (28) companies comprise the initial Libra Association. If we count Facebook and Calibra as two separate companies, the total is 29. They fall into five categories: consumer-facing goods and services (11), payment services providers (6), venture capital (5), blockchain/cryptocurrency technology (4) and non-governmental organizations (NGOs)(2).
This constellation of companies creates profound policy dilemmas far beyond the well-known data privacy and anti-money laundering issues raised by Congressional and European policymakers this summer.
Four Reasons for Policymakers to Worry —
Distributed Age Challenges
As discussed in this Atlantic Council blogpost, the Libra Association creates jurisdictional challenges for policymakers. By choosing Switzerland as its headquarters, two powerhouse jurisdictions regarding the digital economy (the United States and the European Union) have been shut out from exercising primary oversight authority over Libra. Under certain scenarios, transatlantic regulatory policy competition could ensue as the US and the EU seek to influence Swiss authorities to favor one policy over another.
Swiss authorities will be in the lead regarding creation/issuance of the Libra currency and its management. This is no small task. True to its distributed ledger roots, the Libra Association will create a secondary market for the purchase and sale of Libra tokens through “authorized resellers” that functionally look and sound a great deal like traditional intermediaries (broker-dealers, investment banks, exchanges). These intermediaries will “transact large amounts of fiat (currency) and Libra in and out of the reserve.”
Market operations may thus end up being subject to local laws in BOTH the EU and the US even as decisions about those operations are made at the central headquarters in Switzerland. Libra Association members themselves will remain subject to jurisdiction in their Home countries.
When individual tasks are split up into different types of entities spread around the world, the jigsaw puzzle of overlapping jurisdictions challenges the ability of sovereign authorities to exercise their responsibilities.
2. Competition/Antitrust Law
Many initially jumped to the conclusion earlier this summer that the Libra proposal must be anti-competitive due to the vertical integration between the issuer of the payment token, the recipient consumers, and the merchants. It is tempting to see the potential for market dominance and pricing abuse given the recent history of competitive problems associated with winner-take-all platform business models (e.g., Google, Amazon).
But it’s just not that simple. Consider the relatively skimpy White Paper released by Facebook (which remains the sole source document). The White Paper indicates that Libra will only operate a parallel payments system, not require payment in Libra. Proving anti-competitive or monopolistic pricing will require real-life examples of price divergences for the same product across currencies used to settle the purchase transaction.
Monopoly may also be challenging to prove, at least initially. Remember that the key to competition law is the definition of “the market” in order to determine whether a company has achieved a dominant or monopoly position in that market.
It is hard to see that the current configuration of companies assembled under the Libra platform create anti-competitive pressures in the market for hotel rooms because a large range of alternative hotel platforms (e.g., AirBnB, Hotels.com) are not included. The same is true for taxi services, even though Uber and Lyft will bristle at the notion that they are taxi services. Ebay may be a massive online platform for used goods, but they are not the only one… Amazon and Alibaba also play in this space and they remain outside the Libra project….at least for now.
3. Systemic Risk
In its simplest form, systemic risk is the transmission of destabilizing agents across boundaries. The best analogy in the physical world is with infectious diseases and chemical chain reactions; linguisitically, policymakers even speak of “contagion risk”. For an excellent and wry long read on systemic risk, see this 2017 Medium post. For an excellent mathematical description of systemic risk, see this post from the London Mathematical Library whose image I happily borrow today.
Traditionally, central banks and financial stability regulators (including multilateral institutions like the International Monetary Fund and the Bank for International Settlements) assess systemic risk vulnerabilities and articulate rules to rein in risky practices at financial firms that can generate systemic risk. Twice a year, the IMF’s Financial Stability Report assesses a parade of horribles denoting global systemic risks. Major central banks publish similar reports regularly.
“Big Tech” creates big headaches because technology companies that avoid serving an intermediary role deprive regulators of jurisdiction.
The Financial Stability Board earlier this year in February, May, and June publicly fretted about the policy challenges raised by such Big Tech companies which increasingly provide intermediary-like functions but sit just outside the regulatory perimeter. This Medium post analyzes those statements and provides a good starting point when considering the jurisdictional jujitsu that policymakers will have to execute in order to address potential systemic risks raised by the Libra proposal.
Policymakers globally have been taking action far more than they have been talking about distributed ledger technology all year as this activity chart indicates:
Cryptocurrency and blockchain enthusiasts will tell us there is no reason to fret because if Libra transactions occur through a distributed ledger then the automatic authentication and instant payments execution eliminate potential systemic contagion risks like bank runs.
But wait….significant parts of this ecosystem will not operate on an instant payments basis. The ecosystem includes significant lending activity at the microfinance level, the retail credit card level, possibly wholesale merchant invoice-based finance AND institutional/VC lending/investment.
Lending requires repayments at specific points in the future. The risk of non-payment (i.e., default) and the consequences of non-payment generate ripple effects across balance sheets and trading platforms. The same is true for multi-year grants because recipients rely on grant funding to enter into multi-year supplier contracts. The nodes of the distributed ledger can transmit a chain reaction of failed payments due to default.
What happens to intermediaries if the Libra credit chain breaks down?
How will intermediaries cover Libra losses in the event of defaults?
Can Libra-denominated loss recognition be insulated from the broader balance sheet exposures denominated in traditional “hard” currencies?
How do banks and securities regulators set capital requirements for the risks associated with intermediating Libra-denominated transactions so that risks and losses in one jurisdiction do not generate cross-border spillovers?
The Libra White Paper provides no insight into these questions.
4. Monetary Policy
The composition of the Libra Association sketches an outline for an alternative kind of economy for the 21st century. The Libra rhetoric regarding inclusiveness is not just hot air. It is real
The ecosystem envisions individuals around the world paying in Libra for travel, transportation, luxury goods, used goods, and music — but not real property, education or food.
It envisions those individuals borrowing and repaying debt in Libra at the micro-level (Kiva, Women’s World Banking) and through credit cards (Visa, MasterCard) even as it envisions their merchants accepting payment and perhaps obtaining receivables-based finance in Libra (Stripe, Mercado Pago, PayU).
And it envisions a range of humanitarian and scientific research being positively impacted by Libra through donations and grants (although the White Paper is fuzzy on whether NGOs would receive donations in Libra).
It is a lovely, idealistic world in which people happily exchange their hard currencies for Libra which in turn sets off a chain reaction of financial inclusion and charitable donations because high volumes of hard currency redemptions to the Libra Association increase the volume of Libra tokens in distribution.
But note that the exchange rate will not be at parity: Libra Association documents regarding “The Reserve” indicate Libra will be issued to individuals at an undetermined “narrow spread above or below the value of the” currency basket backing the Libra token.
What counts as a narrow spread? More importantly, if the system is designed to generate fewer Libra than hard currencies who benefits — individuals holding the scarce currency (Libra) or entities holding and investing the hard baseline currencies (the Libra Association)?
If you are a citizen in a country subject to exchange controls (ahem, China, Venezuela, North Korea, Iran, etc.) or a country whose currency traditionally has experienced high levels of inflation (ahem, many emerging economies) you are likely to run, not walk, to exchange your local currency for a Libra token. Presto! Instant increased purchasing power because you unloaded risky currency and acquired a token accepted by certain merchants globally which is pegged to stable (but so far not-yet-named) currencies issued by countries half a world away.
If the Libra Association limits convertibility only to the currencies represented in its basket, some very real, practical limits may exist on the extent of the inclusion benefits promoted by the Libra sponsors. How can someone in an emerging market repay a Libra microloan in Libra if that person does not have hard currency to exchange for the repayment and if that person cannot earn Libra through retail transactions?
Limiting the kind of currencies eligible for exchange into Libra may also generate increased demand for the currencies in question, creating pressure on exchange rates in the hard currencies. This would create real headaches for monetary policy, of course.
Central bankers should worry about these potential new supply & demand dynamics. And there is more —
If the Libra token goes viral as its sponsors hope, then a significant volume of economic activity will occur in a parallel economy through a distributed ledger which generates little to zero information for the formulation of economic policy.
Consider the following policy conundrums created by a parallel but opaque pegged economy:
How can an economist assess aggregate demand or price elasticities if a substantial amount of payments for, say, taxi services and hotel bookings occur outside the formal economy?
How can economists and central bankers make good decisions about optimal interest rates if the transmission of those interest rates in the economy is buffered by the fact that some substantial percentage of the transactions will be immune from the tightening or loosening of the price of money?
How can economists measure the impact on demand for individual currencies in the Libra basket without access to an audit trail in the distributed ledger?
What kind of transparency and data will the Libra Association and its intermediaries provide to markets, central banks, and regulators regarding redemption rates, exchange rates, transaction volumes, etc.?
Crypto enthusiasts will crow that central banks will soon face real competition from real free markets. Even if they don’t like the stablecoin, pegged nature of the Libra token, they will love the idea that a parallel economy powered by Libra will operate independently of monetary pricing managed by central banks.
But for so long as Libra remains pegged to “fiat” currencies there will be also be a feedback loop. Trouble in the “hard” currencies will generate pricing and transactions dynamics for the Libra Association and its authorized distributors that even instant payments in a distributed ledger will find difficult to contain. The history of pegged currencies and currency boards is not pretty. Pegs break, often dramatically.
Monetary policy has been in uncharted (zero lower bound) waters ever since the financial crisis of 2008. It is about to head into open, deep water if the Libra token takes off.
A version of this post also appeared on Medium.