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Facebook Libra: Weighing The Pros And Cons

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Facebook Libra: Weighing The Pros And Cons

By now you’ve probably heard of Facebook’s latest take-over-the-world proposal: Libra. And perhaps your clients, family and friends are asking you about it already. What is it? Does this affect me? Should I care? In this article we’ll examine this question from the perspective of the investment advisor faced with answering these questions.

Libra is Facebook’s attempt to enter the cryptocurrency world. And with Facebook’s reach and market dominance, this attempt could well be successful. But what is it, exactly? Well, according to the whitepaper put out by the Libra Association, Libra is a cryptocurrency whose goal is to facilitate the creation of a parallel financial infrastructure that isn’t necessarily tied to any specific country, currency, or existing regulatory framework. The natural question is: how does Libra propose to do this?

Backed by a basket

Libra claims that every token issued will be backed not by promises, nor by dollars, but rather by a “basket of bank deposits and short-term government securities […] held in the Libra Reserve”. Instead of the value of the Libra being tied to a specific currency (usually dollars, known as a stablecoin), its value will fluctuate based on prevailing exchange rates and the specific composition of the basket. This immediately raises some interesting questions:

  •  How is this basket determined, and how does it change over time? The Libra whitepaper says that “the association may occasionally change the composition of the basket…” but doesn’t specify exactly what processes and events would lead to those changes. It’s early days yet, but potential investors will need to get a lot more detail on this question in order to understand how Libra value will change over time.
  • Currency deposits pay interest. Will Libra deposits do the same? The answer is a clear no: the currency basket in which Libra will hold the money backing it will pay interest, but that interest will be kept by the association and investors the so-called Libra Investment Token.
  •  Where is this money being held? The whitepaper states: “The reserve will be held by a geographically distributed network of custodians with investment-grade credit rating to limit counterparty risk.” Again questions: who determines the counterparty risk? Are these geographically distributed custodians insured against each other’s failure? Under which set of laws are disputes resolved?

Other questions also present themselves. In particular, what happens when your real-world job pays you in dollars but most of your expenses are denominated a currency whose value fluctuates with respect to the dollar? Imagine living in the US but getting paid in Japanese yen.

Even if the volatility of this currency pair isn’t significant, it’s still subject to occasional large swings. It’s hard to make good financial plans when your expenses can change unpredictably compared to your earnings.

The answers to these and other questions are critical to evaluating the stability and reliability of any means of exchange. And they’re doubly important when we’re dealing with an attempt to create a universal currency that crosses borders and jurisdictions.

Wither regulation?

Speaking of jurisdictions, how does the regulatory framework operate for such an undertaking as Libra? It’s one thing for early adopters and cyberpunk enthusiasts to trust in the Bitcoin free- for-all approach to regulation for speculation and curiosity, but another thing altogether for people to do so for everyday purchases and transactions.

It’s especially interesting that, in the entire text of the whitepaper, the word “regulation” appears exactly once: in a boilerplate statement about “collaborating with regulators and experts” to combat money laundering. There isn’t any detail about how the Libra Association will deal with all the real-world considerations that financial institutions and investment professionals deal with every day: money laundering, know-your-customer, fee structures, fraud, payment protection, and numerous other issues. Again, this is a whitepaper so perhaps it’s still early, but the minimal coverage of the issue doesn’t inspire confidence.

Judging by the nearly-immediate reaction by politicians and their orbit in Washington, others also seem to have significant concerns. Especially in light of the string of data-privacy and other scandals that have emerged from Facebook in the last few years, it seems reasonable to ask: if Americans barely trust Facebook to show ads, will they trust them with the basis for the country’s financial life and all the data contained in it?

Of course, the Federal Reserve is likely to have significant concerns too. If Libra becomes a sort of lingua franca of exchange online, and as more of our life goes online, the ability of the Fed to manage and affect monetary policy will take a significant hit. It’s unlikely the Fed will take this loss of seignorage rights lying down.

Smart contracts ain’t so smart

Perhaps the most underreported aspect of the Libra announcement is that Libra isn’t just a new currency. It’s also a new pseudo-legal system for enforcing contracts. This feature, known mostly as smart contracts, transforms the language of contracts from English into computer code. Proponents of this system argue that this is for the better. No more imprecision or debate about the meaning of a contract: instead the contract’s specifications are encoded in immutable code on the blockchain and the payments are handled automatically with no human involvement.

While I can see the attraction of this pure ideal, the world’s messy reality makes this a dubious proposition. Trust and nuance and interpretation, far from being a bug of our current civil legal system, are exactly the sort of features that are necessary for any well-functioning contractual mechanism. The world’s complexity means that to fully specify every situation, every corner case, would require thousands or millions of lines of computer code. And as we know, code has bugs.

Whose job will it be to check the code which regulates the contracts that you enter into every day? Well, it’s either your job or the job of someone you trust at least as much as you would trust your bank or your financial advisor. Again, it’s going to be an uphill battle for Facebook to convince the world they should be that entity.

Conclusion

It’s early days for Libra, and there’s a lot of excitement about it both positive and negative. But as information and proposals come out about it, it’s worth keeping in mind some of the questions we’ve raised here. When people ask you what they should do, if it’s something they should think or worry about, the best advice so far seems to be “wait and see”. Crypto has already seen is fair share of booms and busts, but so far, the effects have been well-isolated to a small subset of people. This one could well be different.

As with all things that affect our livelihoods, the most important questions are the most boring- seeming ones: who has the power, who gets to decide what happens. Until we understand in details the answers to those questions, for most of us it’s likely a case of “thanks, but no thanks.”

 

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