Wilfred Daye, Head of Financial Markets, OKCoin, DeFi Alliance Scholar
On June 18, 2019, Facebook, through its new subsidiary Calibra, announced the plan to launch Libra, a global and digitally native reserve-based cryptocurrency with the goal of enabling money transfer in a low cost and secure way to serve 2.5 billion unbanked people in the world. Libra will function as a ‘stablecoin’, meaning that it will be backed by a reserve of real assets. The digital wallets that store the Libra cryptocurrency will be offered to use via Facebook as well as Facebook’s messenger apps, including WhatsApp.
Libra Association based in Geneva, Switzerland, is an independent, not-for-profit membership organization, which will oversee the development of the stablecoin. As shown in Exhibit 1, there are 28 members from industries include payments, technology, telecommunications, blockchain, venture capital, non-profits, and academic institutions. The ultimate goal for the Libra Association is to have 100 geographically diverse founding members. The governance structure suggests that each founding member will have one vote in the Libra Association Council and will be entitled to pro rata share of allocated dividends from interest earned on the Libra reserve.
Exhibit 1 Founding Members of Libra Association
Here, we offer our insights on Libra and its implications for broader cryptoasset market. First, we define ‘stablecoin’ as a distinct cryptoasset class; then, we highlight political and regulatory responses leading up to the U.S. Senate Banking Committee and House Financial Services Committee hearings, on July 16 an 17, respectively. We further examine the implication of Libra to payment ecosystem. Lastly, we describe how Libra will shape the long-term development of cryptoasset market.
Defining Stablecoin
Stablecoin is a subset of cryptocurrency backed by a real-world asset(s) e.g. dollar, gold, bitcoin, hybrid assets, etc. Stablecoins are price-stabilized and not subject to high volatility. They incorporate Bitcoin or Ether features: programmability (e.g., smart contract integration), efficiency (e.g., low-to-zero transaction fees, fast settlement times), fungibility and open (i.e., permissionless) access. Stablecoins also provide a liquidity solution for cryptoasset exchanges as most exchanges can't accept dollar or euro deposits.
There are two main types of stablecoins: algorithmic and asset-backed. Of the 57 stablecoins reviewed in the ‘Global Cryptoasset Benchmarking Study,’ algorithmic represents 23%, and asset-backed represents 77%, of which 33% is made up of traditional collateral and 44% crypto collateral. The algorithmic stablecoins employ a set of rules expressed in software code that attempts to match the supply of the stablecoin with demand. In comparison, an asset-backed stablecoin design is one where some asset is held in reserve to support the stablecoin’s exchange rate.
The US dollar is the most common stability benchmark and is utilized by 66% of all stablecoins. Other benchmarks include other fiat currencies (e.g., euro, yen), commodities (e.g., gold), and inflation (e.g., G10 average country inflation). Exchange of cryptocurrency for sovereign currency through a third-party exchanger is generally money transmission and requires Money Transmitters Licenses (MTLs) and the issuers and administrators potentially need to register as Money Service Businesses (MSB) as mandated by FinCEN.
Stablecoin issuers need to be aware of securities law to avoid potential regulatory risk. In December 2018, Basis, a stablecoin, shut down its operations and returned all of its remaining funds to investors. Basis uses bond and share tokens to expand and contract the supply of tokens in order to maintain a price peg; therefore, it is limited to accredited investors and requires know-your-customer (KYC) and anti-money laundering (AML) checks.
Basics of Libra Stablecoin System
Libra stablecoin system employs two-token system, a seigniorage shares LIT and a stablecoin Libra, through algorithmic and dynamic asset allocation. Specifically, Libra is to be backed by a portfolio of assets called the ‘reserve’. It holds a relatively stable value, and runs on permissioned nodes, backed selected partners or ‘members’. When the reserve is first created the funds will come from either investors purchase of Libra Investment Token (LIT) or converting fiat to Libra. As the reserve size grows, more users converting their fiat to Libra.
Libra Investment Token (LIT) is the governance token of the network that allows members to own and stake in the network. The members contribute to consensus and governance by operating a ‘validator’ node on the network. As the network expands and matures, the Libra system will transition from relying on LIT to Libra coin ownership, allowing decentralized governance from Libra Association members to end-users. The profits from Libra reserve would come from interest on the reserve, designed to keep Libra’s value stable. In other words, all interest carry is diverted to the companies backing Libra’s governing body through LIT, while Libra holders earn nothing, unlike holding fiat assets in a bank’s interest bearing account.
Libra reserve will invest in low volatility liquid assets denominated in multiple currencies such as, bank deposits, short dated government securities. To certain degree, Libra reserve and the Hong Kong Monetary Authority (HKMA) currency board have similar features, but the HKMA only manage the US dollar; Libra is a multi-currency system, which has significant more moving parts. Reaching for yield in low or even negative interest rate environment has been challenging problem for central bankers and asset managers globally. As assets with high credit rating, low inflation, low volatility, high liquidity are required for maintaining stability of Libra reserve; managing reserve to achieve positive carry requires significant investment experience and skill set while exercising fiduciary responsibility.
From corporate governance perspective, Facebook’s involvement in Libra will be managed through a regulated subsidiary called Calibra to ensure separation between social and financial data of the end-users. The Calibra subsidiary will operate a digital wallet in which users can store their Libra currency and make payments electronically, both online and in physical stores. Calibra will be operated separately from Facebook's other businesses, and user data related will not be shared with Facebook's other applications unless authorized by the user.
Highlights of Political Concerns
The stars appear not to be aligning for Libra, which has suffered a barrage of bipartisan governmental and regulatory criticism and has recently been under scrutiny from a number of regulators and lawmakers who have expressed concerns around its potential to upend the global financial order. Here we briefly highlight the crescendo of criticisms from politicians.
On July 2, 2019, House Financial Services Chairwoman Maxine Waters (D-Calif.) requested that Facebook and its partners immediately halt the development of Libra until mounting concerns about its impact are addressed.
Federal Reserve Chairman Jerome Powell calls for halt to Facebook's Libra project Speaking at a House Financial Services Committee on July 10, 2019. Powell stated that Libra raised ‘serious concerns’ around privacy, consumer protection and money laundering as well as more general financial stability. The Treasury Department-led Financial Stability Oversight Council will apply its power to designate financial firms as ‘systemically important’ and subject them to stricter Fed oversight, echoing ‘too big to fail’ (TBTF) concerns voiced by Chairwoman Maxine Waters earlier.
On July 11, 2019, President Donald Trump was not ‘a fan’ of cryptocurrencies, whose value he said was based on ‘thin air’ and facilitated illegal behavior over his Twitter account, again, highlighting significant bipartisan concerns.
Furthermore, Democrats in Congress are considering a new bill that would explicitly ban large platform companies from performing banking functions. If introduced, the bill would be a direct rebuke to Facebook’s plans with the Libra Association. According to the draft of the bill, ‘large platform utility’ is defined as a technology company with an annual global revenue of $25,000,000,000 or more...predominately engaged in the business of offering to the public an online marketplace, an exchange, or a platform for connecting third parties.’ Therefore, it would ban any involvement with Libra as affiliation with a financial institution.
On July 15, 2019, Treasury secretary Steve Mnuchin expressed his concerns that criminal could use Libra to carry out illicit acts. ‘The Treasury Department has expressed very serious concerns that Libra could be misused by money launderers and terrorist financiers,’ he said. ‘We will not allow digital asset service providers to operate in the shadows.’
During the Senate Hearing on July 16, 2019, the consistent voice is that the U.S. should ‘absolutely’ lead the world in rule-making for cryptocurrencies while the debate was focusing on Facebook’s recent troubled past with U.S. regulators. Unsurprisingly, in House Financial Services Committee hearing the next day, Chairwoman Maxine Waters again asked Facebook to halt Libra's development until regulators can take action. She also introduced draft legislation aimed at banning Libra altogether. The tense discussion was focused on Facebook's fitness to run a universal currency, and showcased Committee members' distrust of Facebook.
At the heart of all these concerning voices, we see that lawmakers and regulators alike cast doubts about Facebook’s credibility as a ‘behaving’ corporate citizen. Facebook’s potential violations on privacy, GDPR implementation, and data use set the tone for the regulatory responses. Concerns around Facebook’s ability to operate the platform safely spur regulation. Even though, the Libra whitepaper suggests an information barrier between Facebook and this data in Libra, but Facebook’s track record on data usage renders such promises less than credible.
Simply put, U.S. government do not trust Facebook.
Regulatory Risk
In June 2019 cryptoassets reached an estimated market capitalization of $250 billion, whilst this is a rather modest sum in terms of global markets, it is a remarkable rise to prominence considering this asset class was only created exactly 10 years ago. In a recent study by the Financial Stability Board (FSB) it was stated that cryptoassets ‘do not pose a material risk to global financial stability at this time’. The driving force behind this sentiment was the relatively small market share that cryptoassets currently possess. The report also recommended ‘vigilant monitoring is needed in light of the speed of market developments’.
Facebook’s Libra challenged the above view squarely. Facebook has over 2 billion active users and 90 million merchants on its platform; it has the scale to challenge sovereignty of a country. We understand Facebook’s motivation of implementing the current cryptoasset strategy. With creation of a frictionless, scaled payment option, Facebook will be in a strong position to leverage its full-stack of social media commerce toot kit, i.e. Instagram, Facebook, Messenger, and WhatsApp.
Here, we point out few major regulators that have jurisdictions and mandates to regulate Calibra and Libra.
U.S. Department of Treasury
U.S. Department of Treasury focuses on misuse of virtual currencies by money launderers, terrorist financiers, and other bad actors. Money transmitters of cryptocurrency, including stablecoin, must comply with the relevant Bank Secrecy Act (BSA) obligations and register with the Financial Crimes Enforcement Network (FinCEN). FinCEN is a bureau of the U.S. Department of Treasury. Its mission is to safeguard the financial system from illicit use, combat money laundering, and promote national security through the dissemination of financial intelligence.
The Libra whitepaper states that ‘Libra Blockchain is pseudonymous and allows users to hold one or more addresses that are not linked to their real-world identity.’ This is clearly inconsistent with Anti-Money Laundering (AML) and Bank Secrecy Act (BSA) rules. In U.S., and other countries, banks that have not met these criteria have faced significant fines, jail time and costs to ensure their information systems meet regulatory standards. In the Senate Hearing on July 16, 2019, David Marcus, the Head of Calibra, stated that Libra through Calibra would indeed connect real-world identities to addresses. Any request from a government agency to freeze a transaction will be met with compliance.
U.S. Securities and Exchange Commission
On July 16, 2019, U.S. Securities and Exchange Commission Chairman Jay Clayton told Reuters that he has not personally discussed Calibra and Libra since it was announced but ‘was interested’ in hearing from the company.
Libra Investment Token (LIT), the governance token of the network, allows members to own and stake in the network. The members will receive carry interest from reserve management. Indeed, it is a security instrument that has similarities to Exchange-traded Fund (ETF) or a fixed-income instrument. We expect that SEC will examine Libra stablecoin system and determine if Calibra and its constituents are ‘Broker-Dealers’, in which case, Financial Industry Regulatory Authority (FINRA), authorized by Congress, will also need to step in.
Central Banks.
June’s G20 Summit in Osaka discussed the potential global implication of cryptoassets like Libra and central bankers globally have the mandate to understand and regulate Libra. Many of the world’s most influential financial regulators, including the Financial Stability Board, U.S. Federal Reserve, Bank of England and Bundesbank, have issued statements that they will carefully examine Libra. Led by the European Central Bank, the Group of Seven (G7) nations have set up a high-level forum to examine the risks of digital currencies to the financial system on July 17 and 18, 2019 in Paris.
Central Bankers’ concerns regarding Libra are sound. It is not a stretch to imagine that widespread take-up and usage of Libra could result in the coin being able to become a free-floating currency itself, which in turn could make it a supranational currency beyond the control of governments and central banks. Once Libra becomes well established in countries, national governments will lose control of their money supply and lose monetary policy as a tool of economic expansion or contraction. Governments will also lose the capacity to impose capital controls to prevent capital flight. All of these may destabilize to the global financial system.
Libra challenges Central Bank authority while utilizing Central Bank assets as backing for transaction. We expect significant regulatory response from Central Bankers. Vice Chair Quarles (who doubles as Chair of the Financial Stability Board) said one of the mandates coming out of the G20 meeting in July is for the FSB to look at stablecoins... ‘We will be deeply engaged over the next several months’ on this topic.
In response to Global Financial Crisis (GFC) of 2008, Financial Stability Board (FSB), in consultation with the Basel Committee on Banking Supervision (BCBS) and national authorities, has identified global systemically important financial institution (G-SIFIs) or asset manager. The implication of Calibra being categorized as ‘global systemically important’ is profound and puts Calibra at the top of the list for the most regulated entity in the world, with stringent capital requirements, governance structure, compliance and reporting requirements, multitude of regulatory oversight.
We need to understand the benefit of Libra system in the context of the elevated political and regulatory risk.
Next-gen Payment System
Libra may be able to improve cross border commerce by functioning as a ‘utility token’. It will hold money ‘on platform’ such as gift cards, SQ Cash App, and etc. One can also construe that it is a ‘utility token’ on steroids, which allows rapid and wide adoption through commercial and capital partnerships under various Facebook sponsored incentive programs. With Visa and MasterCard as Libra’s founding member, Libra has positioned itself as the underlying highway for payment flow, a secured intermediary between traditional currencies and certain marketplaces.
Here, we play a devil’s advocate and offers a divergent viewpoint.
From payment perspective, Libra stablecoin adds little marginal value to the existing payment network. We offer several counter-examples to illustrate that a successful payment rail doesn’t need a stablecoin or cryptocurrency. WeChat and Tencent have transformed the Chinese payments industry with their digital wallet applications without ever using a platform toke or a stablecoin. In fact, developed economies globally already have real-time payments, while majority of developing economies do. US consumers have been sending funds through peer-to-peer networks, such as Zelle, PayPal, Venmo, and others for years. Corporations have been sending money real time via the clearinghouse (TCH) real time payment network. The Fed already runs an Automated Clearing House (ACH) network and Fedwire.
The pain point is highlighted at cross-border payment system, which can take 1-3+ days, which Libra may be able to ameliorate. However, most likely, Libra users will suffer from shallow liquidity when exchanging fiat into Libra and vice versa as adoption ramping up over time. Libra will not able to compete with the global foreign exchange markets with over $5+ trillion average daily volume (ADV).
For the un-banked or under-banked population of the world, the benefit of Libra is clear. Many of Facebook’s 2.5 billion users reside in places with low financial services penetration. They can purchase goods and services sold with Libra. However, they are also the most vulnerable to financial scams due to lack of financial literacy, credit history, and overall ecosystem support. Financial education should be on the top of list for Calibra in its development of Libra system.
As aforementioned, the amount of political and regulatory pushback to Libra has been significant. MasterCard, Visa, and PayPal’s participation in the Libra Association expose these members to unwanted political and regulatory attention and risk. As the Libra initiative is pushed forward, the potential for closer examination and regulatory scrutiny will grow. We don’t see significant commercial benefit from participating in Libra Association. Perhaps, MasterCard, Visa and Paypal perceive their participation as a cheap call option on Libra with $10 million premium. Such optionality can easily be worthless if the political and regulatory opposition seem too daunting for them.
The payment incumbents will not risk long-term profitability and earnings potential for Libra initiative. Indeed, Libra commitments aren’t particularly firm yet; the founding members have opportunities to leave the consortium. For instance, the MasterCard executive handling the Libra relationship hinted in a Reuters article, ‘Facebook's cryptocurrency ambitions face privacy concerns, political backlash’ that there have been discussions with lenders who are waiting to see how regulators and consumers respond to the project before deciding whether to join.
“Head I Win, Tail I Win”
While the regulatory threat to Libra appears to be real, Libra brings fundamental debates around cryptocurrency and highlights the threat of the technology to government-controlled monetary systems. We argue that Libra propels cryptoasset industry to front and center of global policy makers and improves its global adoption. We offer four major points that Libra delivers, regardless of the eventual outcome of its effort.
First, Bitcoin and other cryptocurrencies will benefit as more people searching for a more robust and censor-free financial privacy in this new digital age. Libra and the conversations it sparked, is the best news for Bitcoin, the de facto base cryptocurrency. Second, Libra intends to build a new global digital identification system, which will fundamentally change ecommerce in a blockchain-enabled economy. Third, Libra forces re-examination of international monetary system as it challenges Central Bank authority. Fourth, we suggest that the launch of Libra will likely trigger the launch of a range of other competing proposals.
Libra will fuel motivation for nationalization of payment schemes and modernization of incumbents. We can expect that JPM’s Interbank Information Network (IIN), powered by Quorum, a permissioned variant of the Ethereum blockchain, leverages its AML/KYC connectivity across 259 banks globally and JPM Coin to step into blockchain-enabled payment network.
Libra and the conversation it generates prepare the cryptoasset market for a secular bull run.
Wilfred Daye is Head of Financial Markets for OKCoin. DeFi Alliance Scholar
He joined from Noble Capital International LLC (NCI), where he was President and Senior Portfolio Manager in foreign exchange trading. Before NCI, he was a Managing Director and a Member of Executive Committee at PeerIQ, applying machine-learning analytics to consumer credit models. Prior to FinTech space, he was a trader and an Executive Director of Structured Finance at UBS, responsible for trading, portfolio construction and risk management of securitized products. Prior to UBS, he was a senior quantitative analyst for structured credit products at Deutsche Bank. He was a quant for credit trading at D.B. Zwirn and Barclays Capital. He began his career as a CMBS desk analyst at Lehman Brothers. He holds FINRA Series 7, 63, 79 and 24 licenses. He was NSF doctoral fellow in Pathology at Norris Comprehensive Cancer Center and holds a Master’s in Financial Engineering.
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