This is the second in a series considering Facebook’s (FB) new currency, Libra. Facebook describes Libra here. I will contrast it with recent financial innovations, then with another proposed financial market instrument, Exchange Originated Instruments (EOIs), described here. In the earlier article, I questioned Libra's viability. This comparison sheds some light on the purpose, intended user, regulatory issues – more importantly, on the path Libra must follow to achieve success.
It also exposes the vast gaping holes in the exposition of Facebook’s description of Libra. To date, Facebook has sent a dinghy to attack an armada.
What are the differences and similarities?
The similarities. Similarities owe much to previous financial innovations. This table compares characteristics common to EOI and Libra with existing financial instruments.
Libra and EOI
|Existing financial market or instrument|
Purpose-built funds that hold familiar common assets.
New financial instruments, designed to meet customer needs.
Targeted customers of both are institutional and retail investors.
Replace some existing financial infrastructure through greater efficiency (lower transactions costs, or greater liquidity, unmet customer needs).
ETFs, mortgage-backed securities, and financial futures.
Firms managing both funds will be non-profit.
Exchanges before the turn of the 21st century.
Facebook intends to create a new currency.
Dollar-denominated financial instruments.
EOIs will only be investment and risk management vehicles. EOIs seek to liquefy the bond market and create a more viable LIBOR substitute.
Listed on other existing exchanges.
EOIs will be traded on a purpose-built exchange since the exchange creates the EOI and manages its value daily.
The Regulator. Several regulators have potential jurisdiction in both cases. In the United States – the Fed, the CFTC, and the SEC, plus various state regulators. In the UK, the three financial regulators, the Bank of England (BOE), the Financial Conduct Authority (FCA), and the Financial Services Authority (FSA). In Switzerland, the Swiss Financial Market Supervisory Authority (FINMA).
Competition in laxity. Historically, regulator competition in laxity has been an important factor in the success of disrupting innovations. When the CME introduced Eurodollar futures, our plan was to take advantage of the competition between the BOE and the Fed for the US dollar deposit market and financial derivatives jurisdiction. At the time, the Fed was questioning whether financial futures should exist at all, on one hand, and whether the Fed could assist the New York Stock Exchange in capturing new financial futures like Eurodollar futures, snatching them away from Chicago.
Perhaps the possibility that the whole shebang could move to London might be a reason for the Fed not to wake the bear, we reasoned. The result was shared regulatory authority. BOE took regulatory responsibility for the LIBOR fixing, the CFTC took responsibility for futures trading. The New York Stock Exchange lost the war with Chicago for domination of financial futures markets.
Today regulatory rivalry is still an important factor. Swiss regulators are particularly hungry, following the closing of tax loopholes for offshore money. London regulators are also hungry following the drought in the LIBOR market and loss of European and American business due to Brexit.
Libra intends to use regulator competition in laxity, incorporating its Libra Association in Geneva, Switzerland. EOIs will follow the regulatory path of least resistance, choosing among the regulators of the three countries. US regulation is particularly problematic for both instruments since a case can be made for either CFTC or SEC regulation. EOIs may arguably be classified as securities or as futures contracts, or both.
The wild card for Libra is its plan to be a currency. That plan will certainly face careful regulatory scrutiny and probable legal tests in both the United States and the United Kingdom. It also adds the Fed and the BOE to the list of probable regulators.
Regulatory permission for Libra to use its liabilities for retail payments would be massively significant throughout financial markets. It would open the door for every ETF to seek the same status. Certainly, the major stock index funds, such as the Vanguard 500 Index Fund (VFINX), the Fidelity 500 Index Fund (FXAIX), the Schwab S&P 500 Index Fund (SWPPX), and the T Rowe Price Equity Index 500 Fund (PREIX) would apply for like permission. This would be a game-changer for the underlying competition between investment houses and commercial banks. Truly revolutionary.
Interest income from the instrument
The financial instruments compared to Libra above pass their income and capital gains through to their investors. Facebook's plan to keep the interest that might be paid to Libra investors tells us two things.
- The plan gives the lie to the Libra Association's non-profit status. If Libra succeeds, owners of Libra will be minting money.
- The designers of Libra are young. They don’t remember that for most of financial history, 5% was a reasonable yield on a low-risk instrument. The difference between 5% interest and no interest at all is enough to break Libra.
There are also existing ETFs based on a basket of currencies, for example, the WisdomTree Emerging Currency Strategy Fund (CEW). These funds pass their income and capital gains through to liability-holders, giving them a leg up on Libra.
EOI seeks no currency status, intending to be one financial instrument among many. Nonetheless, at first blush, the overnight version of EOI has a stronger case for currency designation than Libra. EOI would be valued in dollars.
EOIs are simpler than Libra and spelled out in more specific detail. EOIs are different in several respects from ETFs. The structure of EOIs is more explicit in part because EOIs are much simpler than Libra.
However, it is hard to avoid the impression that Libra was announced without considering important necessary specs. Facebook seems to be making them up as it goes along. Here are some important details found in the EOI but omitted in Libra.
- Rather than marking the fund to market at the close using a broker-dealer to bring portfolio value to market value, the difference in EOI portfolio valuation and market value at the close would be closed using margin payments and receipts from traders short the instrument. In that way, EOIs are more like futures than ETFs.
- EOIs will not rehypothecate their assets, creating less systemic risk than ETFs.
- Transactions in EOI normally don’t require settlement, like futures but different from ETFs.
- EOIs are spot instruments, presumably different from futures. However, the CFTC might decide EOIs are futures.
- EOIs have simultaneous transaction and settlement, different from ETFs, which conduct transactions and settlement separately.
Libra is silent about its status in every case above.
The crucial difference
At the end of the day, Libra is more ambitious, yet less well-developed. Facebook plans to replace national currencies and potentially the commercial banking system. The scope of this proposal may exceed the world’s appetite for acceptance. Facebook leaves too much to the imagination to be taken seriously by many. Read, for example, Martin Wolf’s article here.
On the other hand, why should Libra limit itself with its first press release? All Facebook needs to do is use the word cryptocurrency – that is enough to put Facebook’s competition on the back foot, and the globe’s regulators in disarray – despite the reality that Libra is not a cryptocurrency and not a blockchain. Certainly, the Facebook proposal got greater attention because Libra’s white paper dropped the cryptocurrency bomb.
EOIs are boring by comparison. They are built only to replace the high-volume fixed income instruments that lost liquidity dramatically following the Financial Crisis. By focusing interest on a few simple instruments traded on a single venue, and managed by institutional investors, EOIs intend to break free of the SEC’s National Market System, on one hand, and to place a barrier in the path of intermarket arbitrageurs on the other.
By focusing volume and open interest in one location at one point in time, and by designing fixed income instruments to meet the needs of transactors instead of corporate issuers, EOIs should only take volume from existing spot and futures exchanges, not governments and banks.
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.