Facebook's Libra Faces A Sisyphean Challenge

Aug. 27, 2019 4:45 PM ETMeta Platforms, Inc. (META)18 Comments6 Likes
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Summary

  • The offer of low-cost, real-time, reliable and secure transfers of money traveling at digital speeds to consumers and businesses alike has undeniable appeal worldwide.
  • The U.S. payments space is still measured in days rather than milliseconds at a growing cost to households and businesses alike.
  • Bringing a digital version of community lending to emerging markets underserved by traditional financial services could be a benefit in the abstract.
  • While prescient in scope, Libra currently remains untenable in a real-world application.
  • From regulatory oversight to sovereignty risk to more basic issues of trust and privacy protection, Libra faces a Sisyphean challenge to influence regulators to take the leap.

There is little question that Facebook (FB) has the necessary scale to bring its cryptocurrency project Libra to many of the globe’s financial services markets. Libra will actively court Facebook’s ready market of 2.41 billion monthly users worldwide. Further, the company plans to integrate Calibra, Libra’s digital wallet, into the platforms of its 1.6 billion WhatsApp and its 1.3 billion monthly Messenger users. Scale is the least of Facebook’s concerns.

The offer of low-cost, real-time, reliable and secure transfers of money traveling at digital speeds across the nation and around the world every hour of the day, week and year would constitute a major upgrade of a moribund U.S. payments regime whose monetary transfers to consumers and businesses are still measured in days rather than milliseconds. In the financial services space, the buying and selling of securities is instantaneous, but cashing out a security still takes three days—by statute. The resulting system underscores both the underlying power of the banking and financial services industries and the lack of outside competition in the payments space. Unsurprisingly, not a single bank is part of the 27-member, Geneva-based Libra Association. Large financial services firms are also conspicuously missing from the initial line-up.

In the emerging market space, Libra could provide an even broader platform for those lacking access to banking services. Roughly 1.7 billion households around the world lack a bank account or access to even the most rudimentary of financial services. Annual remittance flows totaled $632 billion through the end of 2017, with India ($68.967 billion) and China ($63.860 billion) comprising just over 21% of all remittances for the period. Still, the logistics of storing and using bitcoin is a challenge in many parts of the EM and frontier market space, particularly in areas with no reliable access to the internet.

Internet access aside, digital currencies where transactions can be readily recorded, archived and presumably taxed present their own unique set of challenges. Then again, the fact that Ant Financial’s Alipay and Tencent’s Tenpay own 92.7% of the Chinese mobile payments market is not lost on Libra’s designers. Still, India and Indonesia, two of the biggest EM markets outside the Chinese market, appear less than eager to promote cryptocurrencies within its jurisdiction.

Arguably, the Libra project is one of the most ambitious attempts at introducing cryptocurrency to Main Street investors to date. While prescient in scope, Libra currently remains untenable in a real-world application. The myriad issues created by the project—from regulatory oversight to sovereignty risk, to more basic issues of trust and privacy protection—make the cryptocurrency’s projected 2020 launch laughably unrealistic. Erecting a regulatory infrastructure around a national cryptocurrency is a daunting task that, at present, begins from scratch. It would be years in the making, even with the will to take on such an endeavor. At present, it is a logical stretch to assume that standing governments would welcome a foreign-based digital currency that systematically circumvents its local regulatory oversight.

Nonetheless, Libra’s June announcement created a certain buzz among bitcoin enthusiasts and investors alike (see Figure 1, below). Added help came from Deutsche Bank’s estimate of about $16 trillion in sovereign debt now carrying a negative yield worldwide. Added momentum came courtesy of Chinese traders who piled into the cryptocurrency after the Peoples Bank of China allowed market forces to send the renminbi through the psychologically important Rmb7 to the dollar threshold for the first time since the 2008-09 financial crisis.

The ongoing easing of monetary policy by the European Central Bank, the Bank of Japan and now the Federal Reserve has not only fueled the recent rally in U.S. Treasury bonds, which briefly extended the yield curve inversion to two years in duration for the first time since 2007. The 30-year bond fell to a yield of 1.91% mid-month, the lowest yield on record. The yields on sovereign debt in Germany, Holland, Denmark and Switzerland out 30 years in duration remain negative. Gold futures since the beginning of June are up over 18%, a six-year high (orange dotted line). And through it all, the trade-weighted U.S. dollar (black dotted line) set a new high last week, squeaking past its previous high set in 2002.

Figure 1: Bitcoin against the Dow Jones Precious Metals Index and the 10-year US Treasury Price Index

By its very nature, Libra is likely a perennial work in progress. While cryptocurrencies largely uphold the age-old dream of replacing fiat money and expunging taxing authorities, the lack of a financial tether to a tangible store of value, a government—or both—makes for transactional uncertainty and, accordingly, a cumbersome mechanism for broad-based exchange. Libra promises to eliminate this shortcoming by a backstop of reserve currencies, government securities and other safe assets. As a result, Libra would act as a variant of a currency board. Hong Kong (HK) comes to mind as U.S. dollars fully backstop HK dollars. The setting of interest rates and the conduct of monetary policy, of course, is outsourced to the Federal Reserve.

Libra also takes on the flavor of a payment platform, a digital version of PayPal. Unlike PayPal which clears through JP Morgan Chase (JPM), Libra will not clear through any clearing house. The payments space offers Libra its clearest business opportunity. The global average cost in fees for the transfer of $200 is about 7% through the first quarter of 2019. Across the frontier markets of Africa and small islands of the Pacific, that cost averages about 10%. In 2014, non-bank U.S. households paid monthly fees in the range of $10 to $30 for the use of a prepaid debit card. In most high-income countries, interbank transfers clear in a matter of seconds. Here in the U.S., the process is often several days in the making, with even longer settlement waits between smaller and rural banks. Most credit cards are far from free for either consumers or businesses, with the latter paying 2% to 4% for each transaction while the former pays an average of 16% in interest for rolling over monthly balances.

Much of the debate around speeding up U.S. payments, however, comes from delays placed on direct deposit salaries and wages, prompting the Federal Reserve to launch its own payments platform dubbed FedNow. FedNow will be a real-time, nation-wide payments and settlement platform. The proposed system will be available to banks of all sizes, parting ways with the Clearing House bank group that currently covers about half of US demand deposit account, mostly banks in large metropolitan areas. At this juncture, it is not clear whether FedNow would be available to non-bank financial services, not to mention individual payment settlements. FedNow was introduced in a speech by Fed governor Lael Brainard in Kansas City early this month. FedNow is not scheduled to go live before 2024.

Libra’s stablecoin design also resembles that of a money market fund that wholesale and retail investors have used since the 1970s as a short-term, interest bearing investment for cash. Fixing the shares of a money market account to a $1/share furthered the cash analogy. While bitcoin’s market value is determined by holders at any particular moment in time, Libra’s stablecoin design pegs market value to its reserve basket of securities and currencies. The design could eventually allow providers to hold central bank reserves, likewise blurring the distinction between Libra and fiat cash over time.

Is Libra intended to take the place of fiat cash? The long-term libertarian answer to the question would likely be in the affirmative. Current public policy proclamations on the subject are much more nuanced. Checks, debit cards, credit cards, store issued points, frequent flyer miles, Italy’s proposed mini-BOTs, the IOUs California issued in 2009 and countless other retail issued value propositions are parallel currencies. None of these variants on cash have conveyed any notion of being legal tender in the greater economy. Cryptocurrencies fall into this ever-broadening category of parallel currencies. Last week, New Zealand became the first country to allow companies to pay employees in cryptocurrencies. The ruling allows salaries and wages to be paid in cryptocurrencies starting next month, so long as the payments are regular and fixed. According to the ruling, the digital currency must be pegged to at least one marketable currency that can be converted into a standard form of payment, which allows taxes to be deducted under the country’s pay-as-you-go income tax regime.

What was lost in the news headline was the fact that individuals are free to take payment for services rendered by whatever means that are mutually acceptable—from payment in kind to option or stock shares, deferral and now cryptocurrencies. What matters is the method by which non-cash payments are taxed. In the case of cryptocurrencies, the New Zealand tax authorities will treat such payments like ordinary income that can be freely exchanged into conventional currency. Importantly, the revenue bulletin was very careful to define crypto assets as property—not legal tender.

Figure 2: Facebook against the S&P 500

Investors and shareholders alike revealed little in the way of concern with Facebook’s second-quarter earnings report or the running controversy over Libra. Yes, operating income fell to 27% of total revenue, with a post of $4.63 billion. A quick look at Facebook’s second-quarter earnings report reveals revenue reaching $16.9 billion, up 28% YOY. Earnings per share hit $0.91/share, reflecting a one-off $2 billion charge as part if its recent $5 billion settlement with the Federal Trade Commission. An accounting charge of $1.1 billion to correct the deduction of stock options from taxable income combined to deprive shareholders of a $1.99/share for the quarter, beating consensus estimates of $1.88/share. Costs soared to $12.62 billion, up 66% YOY, thanks largely to the FTC settlement. Operating income came in as a result to $4.63 billion, falling to 27% of total revenue. Operating income fell just over 21% from 44% of total revenue in 2018.

Monthly active users (MAU) reached 2.4 billion for the period, up just over 8% YOY, with India, the Philippines and Indonesia providing strong growth in excess of 12%. European users grew at a 2.39% pace, outpacing that of the US at 1.24% growth for the period.

Targeted advertising revenue came to $16.6 billion through the end of the second quarter, up 28% YOY. In the U.S./Canadian market, the company’s biggest, advertising revenue hit $7.6 billion, up 28% YOY. In Europe, adverting revenue was up 24% to $4.1 billion. The Pacific/Asian market, advertising came to $3.63 billion, up 31% YOY. Facebook maintains a strong grip over investors who covet the company’s earning potential from targeted advertising. So far, the rising cost of fines both in the US and Europe remain a fraction of total revenue which investors have largely chalked up to a cost of doing business. Facebook is up over 10% since the June announcement and up 33% on the year. By way of comparison, the S&P 500 index is up 14.25% at today’s market close (26 August).

U.S. lawmakers worry loudly about money laundering, scammers, drug trafficking, terrorist financing and now ransomware—not to mention the looming brouhaha over jurisdictional reach—given Libra’s intended Geneva base of operations. Central bankers worry about the speculative nature of cryptocurrencies whose value derives largely from the unregulated dynamics of market supply and demand—with no overt issuer or guarantor. By way of comparison, fiat currencies are backed by governments, which usually provides the necessary confidence for the exchange of goods and services in the greater economy. Central banks also fear monetary and financial instability as a Libra-based parallel currency systematically circumvents the traditional powers of central banks to set interest rates, conduct monetary policy, oversee its national payments space and preside over its economic sovereignty. National and international regulators fear the concentration of economic and political power in the hands of a profit-seeking private company whose business model uses algorithmically gathered profiles of consumers, businesses and institutions that furthers the company’s rent-seeking aims while scale raises the bar to market entry, dampening competition. Tax authorities have struggled with transactional transparency of digital assets that, by their very nature, are designed for anonymous ownership and transfer with minimal governmental interference—a classic recipe for tax evasion.

All that has been said thus far dances around the real elephant in the room—trust that Facebook will do the right thing. Facebook’s rap sheet to date is hardly inspiring:

  • The Cambridge Analytical data breach revealed serious flaws in the company’s handling of personal data.
  • The FTC approved a $5 billion fine against the company for using deceptive disclosures and account settings to gain access to personal data that was, in turn, sold to ad and app developers in violation of the 2012 consent decree between the agency and Facebook.
  • Ireland’s General Data Protection Regulation office has 11 ongoing investigations in the works against Facebook for mishandling consumer privacy.
  • Facebook’s Messenger Kids app last month allowed children to interact with unscreened users.
  • Facebook failed to prevent Russian interference in the 2016 U.S. presidential elections.
  • The company failed to prevent the spread of rumors that led to civil strife and loss of life in Sri Lanka, Myanmar and the Philippines.
  • The SEC announced a fine of $100 million over claims that Facebook misled investors about the misuse of consumer data.

With Libra, Facebook would add consumer transactional activity in the marketplace to its profile packages—a coveted dataset for targeted advertisers worldwide. Given Facebook’s running history with the mismanagement of confidential data, adding transactional access to the Facebook profile mix available for sale to app makers and targeted advertisers would be expected to draw significant regulatory pushback—worldwide.

The Libra payments platform would also beget a toe-to-toe battle with every central bank it encounters. In high income countries, the regulatory infrastructure to manage and oversee cryptocurrencies is yet to be created. Just how much jurisdictional reach would U.S. regulators, for example, have over a corporate entity organized through a Swiss non-profit association is currently unknown. In the EM space, which is embattled by high inflation and weak financial institutions, the demand for stablecoins could be widespread among households and businesses ravaged by runaway prices for goods and commodity imports priced in foreign currencies. For such EM governments, stablecoins would mean a new and highly intrusive form of dollarization that could create serious headwinds to the conduct of monetary policy and the setting of interest rates, resulting in the inevitable erosion of economic sovereignty.

A key issue of globalization was the notion that capital was always able to move faster and more freely than workers or goods. The embrace of Libra across national and international borders will likely make it all the more difficult for central banks to ensure financial stability at critical moments of economic duress. In crisis situations, Libra could move the local economic barometer in a less than efficacious direction.

Libra is being positioned as a digital version of community lending, a financial service designed to help people around the country and around the world by facilitating the purchase of goods and services in the greater economy. It is more likely that Libra will exacerbate the ever-growing chasm between haves and have nots. Capital will continue to flow toward markets where the cost of investment and doing business are the lowest, the least encumbered and where the best returns may be had. There is no reason to assume that this dynamic will change under the guise of a Libra-based currency regime.

Rather than placing downward pressure on local inflationary forces, Libra could abet pooled small holders of illiquid currencies into the next iteration of so-called hot money perpetually in seek of yield in the face of a global, $16 trillion negative yield pile. The impact on global financial stability of buying a Frappuccino sans currency exchange fees in Ireland, for example, is on an entirely different order than funding Turkey’s short-term current account deficits with new-found crypto-liquidity. The mantra of "move fast and break things" has produced myriad sharp edges.

This article was written by

Douglas Adams profile picture
1.58K Followers
Douglas Adams specializes in macro-economic research and turning theory into practical portfolio applications for clients over the past seventeen years. Mr. Adams recently formed Charybdis Investments International based in High Falls, New York where he is the managing director of a fee-only investment advisory practice with clients throughout the United States. As an author, Mr. Adams has commented widely on a diverse array of topics from Brexit to monetary policy to forex to labor productivity and wage growth. He holds an undergraduate degree from the University of California, a master’s degree from the University of Washington and an MBA in finance from Syracuse University.
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Disclosure: I am/we are long FB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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