On June 19th, I wrote a piece arguing that Silicon Valley firms could easily disrupt Wall Street. I suggested potential successful opportunities and some businesses to avoid. Lo and behold, that same day Facebook (FB) launched Libra. To my amazement, Libra seeks to implement none of my recommendations. It plans to offer an alternative payments mechanism for the unbanked; a service that has been beaten to death by the financial incumbents.
In the earlier article, I made two suggestions.
- Accept a reasonable return for your services. Replace a service that costs too much to deliver too little.
- Keep it simple.
Libra appears to be the antithesis of my suggestions. It is vague. Incredibly complicated. Some experts have characterized it as a cynical money grab on behalf of the wrong Silicon Valley firms.
However, it is early in the game; too soon to definitively analyze the quality and price of Libra's services. Here, I compare Libra's objectives to those I believe are most likely to disrupt the financial system in the coming decades. Long story short, Libra is on the wrong track.
According to Libra, "Libra's mission is to enable a simple global currency and financial infrastructure that empowers billions of people." We can begin by thinking about this.
Simple global currency. Libra seeks to be "the internet of money." What does that mean? First, Libra's objective is to permit low-cost international transfers using a cellphone. This is part of the broader goal of bringing financial services to the unbanked.
There are three specific fictive tactics floating in Libra's sea of vagueness.
- Libra is a blockchain.
- Libra is "backed" by a "reserve" of conventional assets.
- The independent Libra Association governs Libra.
Libra is a blockchain. Libra has no plans to realize this first objective for years, not a current plan. There will be firms that perform the role of "validators," presumably validators of individual blocks in the blockchain.
There are two kinds of extant blockchain validators; "proof of work" validators and "proof of stake" validators. Proof of work validators are firms that are rewarded by being first to identify a block. Proof of stake validators are members of a preset membership engaged for block identification. Libra plans the latter.
A curiosity is that the validators "execute" the transactions rather than simply validating them, a fundamental no-no among cryptocurrency enthusiasts since it creates a hierarchy of "primary" transactors and "secondary" transactors who need a primary to execute their transactions. Not egalitarian. This is one of many reasons critics, for example, Nouriel Roubini, believe Facebook misuses the term "blockchain" in describing Libra.
Libra is "backed" by a "reserve" of conventional assets. Specifically: "A basket of bank deposits and short-term government securities will be held in the Libra Reserve for every Libra that is created." This makes Libra a "stablecoin," a coin with a value determined externally, with reference to currency values in the case of Libra.
There are several ways to determine quantities of reserves and the relationship between Libra value and currency values. However, a fund with value determined by a basket of currencies is certainly not a novelty. Moreover, Libra does not clearly explain how they will relate portfolio-to-coin amounts and prices.
On the other hand, if Calibra (the firm that will conduct transactions for Libra) only applies for money transmitter licenses as it proposes, it cannot provide backing for Libra at all. Calibra will need an affiliation with an investment management firm that can issue shares supported by the assets, making Libra more like an ETF than a blockchain.
A key issue is whether Calibra - a Swiss non-profit - intends to re-hypothecate its assets, introducing systemic risk. A related issue is the stated intent of Calibra to use the interest earnings from investor assets to pay its partners in the Libra Association.
In sum, whatever inefficiencies, systemic risks, and opaque use of customer money exist before Libra, there will be more of the same post-Libra.
The independent Libra Association governs Libra. This association is notable primarily for which firms are not members. There are no commercial banks or other major financial institutions. Also, no major Silicon Valley players, Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and Amazon (NASDAQ:AMZN). Mostly, it is the usual Silicon Valley financial suspects, PayPal (PYPL), Spotify (SPOT), Uber (UBER), and Lyft (LYFT).
The status of the Libra Association will be the critical factor determining Libra's future. If, for example, the Swiss regulators designate it a regulated commercial bank, the use of some of the risky income-generation methods of current money transfer services, such as float management and securities rehypothecation, would be limited or eliminated.
In summary, the economics of Libra seems to boil down to whether Calibra is an unregulated shadow bank or an ordinary commercial bank. That, in turn, depends upon whether Facebook has enough influence with governments and bank regulators to escape the appropriate rules that would put the firm on a level playing field with other financial institutions.
How does Libra fare in the light of my two criteria?
- Does Libra accept a reasonable return for its services? Does Libra replace a service that costs too much to deliver too little?
Too soon to tell. Libra could apply for the appropriate investment management and deposit-taking licenses. It would then be on an appropriately level playing field with its competitors. As I indicated in the earlier article, however, there would need to be substantial coding and market structure innovations to make it more efficient than the money-losing competition. Else, it will create massive systemic risk, which major market regulators won't allow.
- Is Libra simple?
Not too soon to tell. The level of complexity is enormous for a startup financial institution. Moreover, Facebook has rushed to press before working out most of the central efficiency and profitability issues. Libra's future will only be more complicated. We will not need to worry about Libra's effect on finance for at least five more years.
What would be a better plan?
First, make less arrogant assumptions. It helps to be Facebook, but being Facebook is not enough to successfully disrupt the entire financial system. Facebook is not content replacing commercial banks. It intends to replace central banks as well. That is not going to happen.
Second, consider the principles of warfare. Granted Facebook only contemplates competition, not warfare, but proposing to replace central banks moves the firm very close to warfare. A successful campaign plan has several classic characteristics.
- Identify the enemy center of gravity.
In finance that is obvious. Transactions are the center of gravity. Transaction innovations succeed when they move larger quantities of savings to informed investors more cheaply.
The subject goes unmentioned in Libra white papers and technical documents. Instead, Libra proposes an altruistic plan to provide services to the unbanked. A worthy objective but not a disruptor. If successful, the public would indeed benefit. However, value added to the global economy from that source will be slim and none.
- Identify the weak point in the incumbent defense and attack it.
Existing deposit-taking and money transfer services poorly serve the public. Perhaps Libra perceives that to be a weak point. However, quality bank services for low-income customers do not exist because the incumbents have been caught napping. These incumbents simply have failed to find a moneymaking solution, due in large part to the governmental obstruction and foot-dragging that they face. Regulators will not give Libra an easier road than they will give the incumbents. Given Libra's pledge to separate its activities from those of Facebook, it is hard to see what technological advantage Libra perceives.
- Identify the end game.
Why does Facebook think breakthroughs they achieve will not pass quickly from Libra to commercial and central banks? The regulatory and legal position of the incumbents is permanent and will never be Facebook's exclusively. The best Facebook can hope for is coequal status with the commercial banks. The firm will never be able to retain a separate currency. A currency market-basket fund, yes - but with no government guarantees. Moreover, an insured government clone of the basket fund would follow immediately upon Facebook's success, should Facebook's currency become economically significant. This fund would make short order of Libra's.
The currency basket is a bad idea. If it works, the government will capture it. Facebook should stick to the dollar. Granted relying solely on the dollar leads directly to Fed jurisdiction, but central bank jurisdiction is an inevitable implication of Facebook success. Live with it now.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.