Possible risks in Facebook’s pursuit of a ‘stablecoin’ Maria Demertzis is Deputy Director and Jan Mazza is a Research Assistant at Bruegel Facebook recently unveiled its plan (white paper) to launch a new digital currency, called Libra, in the first half of 2020. The company’s scale as the largest social media service in the world coupled with its failure to appreciate its influence over modern democracies, led to more fears of global dominance following the announcement. The project is powered by the Libra Association, composed of 28 founding members, including large corporations active in payment systems aiming to reach 100 members by the date of the launch. The white paper also discusses the creation of Calibra, the digital wallet on which Libra will operate. The Libra Association is set up as a non-profit Swiss-based foundation and is in charge of the management and policy of the whole infrastructure. Businesses can become members, insofar as they meet specific criteria and contribute with an initial investment of at least $10 million. In return, members are entitled to voting rights in the Libra Association Council (one vote each $10 million investment, up to a limit) and run a validator node of the permissioned blockchain. While the white paper discusses the broad philosophy of the new product, it is not a detailed description of how it will operate, leaving therefor a lot still quite open. One important point revealed, however, is that the Libra aims to be a stablecoin. This is one of the most important problems of other cryptocurrencies like bitcoin. The value of the Libra will be based on a basket of stable assets. The composition of such a basket could vary over time in response to “significant changes in market conditions.” Libra creation should work as follows. Initial investors will create a pool of assets, the reserves. The Association then decides on the composition of the basket and pegs the Libra to it. For any Libra created (minted), there needs to be a unit of the corresponding basket of assets. Authorised resellers purchase Libra coins from the Association by providing in exchange fiat assets to fully back such coins that are added to reserves. Users then can request Libras from the authorised resellers. Reserves will then be fully invested in low-risk short-dated interest-bearing assets, the revenues of which will serve to cover operating costs and pay out dividends to founding members. The reserves and the promise to have a stable and thus well sought out currency is at the heart of Libra’s business model. But can Libra really be a stable coin? If the underlying assets are stable, the Libra will also tend to be stable. And yet, the price of the Libra will also depend on the commitment to supply coins at the speed demanded. This is not a trivial matter as the Association will have to back new coins with the underlying assets. Consider an occasion in which a Libra hype leads to a very high demand for coins (not unlike what we have seen for bitcoins). To preserve the value of one Libra, the Association will have to mint new coins at the rate demanded and back them up by buying the assets in the underlying composition. It is not obvious that suppliers will be willing to do that for any level demanded. Then one of two things can happen: either supply will not match the increased demand, in which case prices will go up. This by itself implies that Libra can be subject to bubbles. Or, the Association increases the value size of the underlying basket by changing the composition, equivalent to a currency appreciation in order to reduce demand. Either way, the value of one Libra depends crucially on the Association’s commitment to keeping it stable. But unlike central banks that have a public function, it is not clear that the Association has the same function and thus the same level of commitment. Barry Eichengreen argues that “…the Fed can raise and lower interest rates and thereby affect the value of the dollar. But what prevents Facebook and its 28 corporate partners — the likes of Uber — from changing the composition of the Libra basket and altering its value as they see fit? What prevents them from changing the rules of the game midstream?” We will come back to this point further down again. But what about risks? The fact is that we will not understand the risks in full until the Libra is up and operating. For the moment, the biggest risks that arise are also the features that make it potentially a big success: scale and accessibility. There are 2 billion Facebook users worldwide that will be the potential user-base at Libra’s disposal (Figure 1). By comparison, Bitcoin owners were estimated in 2017 to be 7.1 million worldwide. Given such a scale, as indeed the Governor of the Bank of England Mark Carney said in the Monetary Policy Forum in June this year, the Libra could become “instantly systemic” on launch day and should, therefore, be put under tight regulatory scrutiny1. In a recent report, the BIS has discussed the complex trade-offs that will arise “between financial stability, competition and data protection.” One such complex case arises from Calibra, the digital wallet (cryptocurrency exchange) on which Libra will be stored. Currently, there are around 200 cryptocurrency exchanges on which more than 1,600 cryptocurrencies are bought and sold. Libra has the power to push its users to apply its own digital wallet, just like Amazon had the power to push their Kindle ebook reader to all its customers that used its other services. The potential for a massive user base can lead to monopoly power for the issuer, but can also lead to severe financial vulnerabilities from system failures (either deliberate and fraudulent or simply erroneous). Furthermore, the white paper argues that users who store their Libras at Calibra will share no information with other Facebook extensions (such as Whatsapp or Instagram) about the content of outgoing and incoming transactions. However, the single most important concern voiced in all reactions since the Libra announcement has been about distrusting the way Facebook operates, and particularly with regards to data privacy. Libra, therefore, appears to start with a sizable trust deficit that may hinder its promised popularity. There is substantial scope for regulation to prevent either unfair competition or indeed protect the consumer. But an important ambition outlined in the white paper is also increasing access. This payment service, the paper argues, will promote financial inclusion by “banking the unbanked.” The paper describes the role Libra can play in third world countries by mentioning the vast pool of people sending or receiving remittances as one of the key targets of the venture, along with “1.7 billion adults globally… 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.” Can the Libra deliver this ‘access’ by becoming a global currency, and still remain a stablecoin? We do not believe that cryptocurrencies are good candidates of replacing sovereign currencies, in particular in the developed world. By contrast, such currencies, and in particular stablecoins, like the Libra, could be a good candidate for replacing (or at least running in parallel to) national money in countries with unstable and weak sovereigns. And in fact, since the intention according to the white paper is very much to reach those that are unbanked and stimulate financial inclusion, they may become quickly popular in developing countries. We see three problems here. The first adds again to the possibility of reducing competition. There exist already a number of successful providers of mobile phone payments systems. However, while this industry is booming in Africa, the potential for scale might wipe out any competition, thwarting local financial innovation initiatives. The second problem relates to the stability of the Libra. Can the authorised resellers accumulate third world currencies and provide basket assets to the Association in order to acquire Libras? The more popular Libras become in the developing world, the more difficult it will be to issue new coins against the stable basket. Or will profits generated in the developed world help subsidise payments in the developing world? All of these issues will still need to be clarified2. The third stems from the ambition to improve the user experience by making transactions easier and quicker. Libra should be used for “paying bills with the push of a button, buying a cup of coffee with the scan of a code or riding your local public transit without needing to carry cash or a metro pass.” But the ease of transactions, comfortable though it is, comes with important risks. A recent study based on US survey data done at the Global Financial Literacy Excellence Centre, “ … show(s) that Millennials who use mobile payments are at a greater risk of experiencing financial distress and engaging in financial mismanagement.” In fact, “those who use mobile payments are nearly 16 percentage points more likely to overdraw their checking account and 23 percentage points more likely to turn to alternative financial services.” Annamaria Lusardi, one of the authors of this report, argues that “Those who use mobile payments show lower levels of financial literacy and worse financial management practices than non-users.” Therefore, reducing the threshold in terms of easiness of digital transactions may actually increase financial vulnerability, in particular amongst those that are the most financially illiterate. Libra needs to rethink how easy it wants transactions to be when the levels of financial literacy are very different within and between countries. This is a particularly pertinent point as those who are likely to be attracted to the Libra, namely those who do not have a bank account and need to transfer or receive remittances, are also the most likely to be the least financially literate. Indeed figure 2 below shows that countries that have increasing needs to access banking services are also those that are the least financially literate. One needs to be very cautious about drawing conclusions. There is ample evidence that developing countries have increased financial inclusion and have empowered many by providing simple financial solutions in mobile appliances. However, these are very targeted solutions to specific problems. The uniformity of Libra may fail to capture the specific needs of various developing countries while exposing them to risks that relate to poor financial understanding. The global regulatory environment had taken the view till now that the value of crypto assets in circulation in not sufficiently sizable to pose financial stability risks. They are, however becoming increasingly vigilant of the potential regulatory gaps that might need to be addressed. The FSB Chair Randal K Quarles referred to the need to contain the risks that arise from financial innovation and particularly, “…(a) wider use of new types of crypto-assets for retail payment purposes would warrant close scrutiny by authorities to ensure that that they are subject to high standards of regulation.” The issuance of the Libra may just accelerate that. Endnotes 1. And recently even President Trump talked about the need for regulating cryptocurrencies. 2. There is also the issue as to whether the Libra is convertible to all developed world currencies. If it is not then the issue of financial inclusion is stopped in its tracks. Facebook is a corporate member of Bruegel and contributes less than 1% to our annual budget. Facebook has not been involved in the writing of this post. This article was originally published on Bruegel
The global regulatory environment had taken the view till now that the value of crypto assets in circulation in not sufficiently sizable to pose financial stability risks

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Figure 1. Monthly active Facebook users

Source: Bloomberg

Figure 2. Financial literacy and potential Libra users

Source: Bruegel based on S&P Global FinLit Survey and Global Findex dataset (World Bank). Notes: "Increasing need for banking services” is measured as the difference between the % of people sending/receiving remittances in the previous year and the % of people that have a bank account.

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