Libra, the cryptocurrency backed by Facebook (FB) (and the other members of the Libra association) was announced on Tuesday. The web site and the white paper refer to the new currency as a stable currency:
"Libra is designed to be a currency where any user will know that the value of a Libra today will be close to its value tomorrow and in the future."
The stability is guaranteed by the intrinsic value of the coin, a result of the assets that back the value of the currency. These assets are called the "Library Reserve". The white paper refers to the similarities of this mechanism and the currency board that some currencies with fixed exchange rates use:
"... the mechanics of interfacing with our reserve make our approach very similar to the way in which currency boards (e.g., of Hong Kong) have operated. Whereas central banks can print money at their own discretion, currency boards typically only print local currency when there are sufficient foreign exchange assets to fully back a new minting of notes and coins."
This reference to currency boards is confusing and misleading. In fact, it is surprising that given the vast knowledge we have about how fixed exchange rates work, the white paper does not present a more precise description of how the value of Libra will be managed. It also confuses the fact that there are assets backing the currency with the notion of fixed exchange rates and currency boards. And it does so by playing to the myth that traditional fiat currencies are not backed by any assets.
Let me clarify each of these issues.
Assets = Liabilities
Fiat money is backed (one by one) by the value of the assets in the central bank balance sheet. Any central bank that issues a traditional fiat currency has assets which have a value that is identical to the liabilities it has issued (same as with Libra). This does not guarantee the stability of the currency. The stability comes from the commitment of the central bank to a certain monetary policy that ensures that the value of the currency remains stable relative to the value of goods and services (i.e., stable and low inflation).
Fixed Exchange Rates
Some central banks go beyond an inflation target and implement monetary policy by anchoring the value of their currency to another currency (that is seen as stable), what we call fixed exchange rates. Fixed exchange rates require:
a) an announcement by the central bank of a parity relative to another currency (or basket of currencies),
b) the commitment to intervene in foreign exchange markets to ensure that the value of the currency is what has been announced.
The simplest example is to announce a fixed price relative to another currency (say, 1 to 1 to the US dollar) and then commit to sell or buy unlimited amounts of the local currency against US dollars at the pre-announced price. This ensure that the exchange rate stays fixed.
In the case of Libra, there is no such commitment (at least not yet). There is some loose statement that the value of the currency will remain stable relative to a basket of currencies, but no details on whether an explicit commitment will be announced. If such a commitment does not exist, then we are in the world of flexible exchange rates, where credibility has to come from some sort of inflation target announcement that is delivered over time.
When a central bank fixes the exchange rate and commits to intervene to defend the currency, there can be concerns on whether it will be able to do so if the currency is under attack. While all central banks have enough assets to buy back their liabilities, many of these assets are domestic assets. While in theory one can control the value of the currency though these domestic assets (and interest rates), having a large pool of foreign assets that a central bank can sell to intervene in the foreign exchange market is seen as an additional guarantee that the commitment to fixed exchange rates will be honored. This is what is known as a currency board. In its extreme form, the central bank holds enough foreign assets to buy back its supply of local currency.
But this is not quite what the design of Libra promises. Unless the currency composition of its balance sheet happened to match the basket of currencies that is used to fix the exchange rate. But this would be an unusual and confusing system, because as the currency composition changed, the basket used as a reference for the fixed exchange rate would also change.
Libra: Not a currency board and not a fixed exchange rate (not yet)
In the absence of a proper fixed exchange rate and a credible mechanism to maintain it, Libra looks more like a standard flexible exchange rate currency. Its stability will depend on its credibility. Referring to the fact that there are enough assets backing its supply is not a good argument (that argument applies to any central bank issuing fiat money).
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.