26 Jun 2019
Long before he was immortalised with his ‘Moment’, Hyman Minsky observed “everyone can create money; the problem is to get it accepted”. This is exactly the challenge facing Facebook and their new currency - Libra.
In the words of its designers “Libra is designed to be a stable digital cryptocurrency that will be fully backed by a reserve of real assets - the Libra Reserve - and supported by a competitive network of exchanges buying and selling Libra”.
"Those celebrating the end of the traditional banking system or government financial hegemony, hold on.”
The idea is to make moving money around the world - even for those who are currently unbanked - as easy as sending a text message.
Apparently, confidence in Libra will be built over time because “anyone with Libra has a high degree of assurance they can convert their digital currency into local fiat currency”. This freedom of convertibility also allows the total outstanding stock of Libra to grow and shrink with user demand.
Libra looks like a stablecoin, an initial coin offering (ICO), a money market fund, and an exchange-traded fund (ETF) - all in one. And, of course, it sits on a blockchain platform.
But first things first: is it even a currency?
Jostling for position
According to the Financial Stability Board, the standard attributes of a currency are its ability to be a means of payment, a stable store of value, and a mainstream unit of account. Some of these tests are harder to pass than others. For instance, almost any asset - money or otherwise - can be a store of value. Even moneyless barter systems rely on commodities as means of payment.
Certainly Libra’s success at becoming a simple, global currency depends on its widespread acceptance. But does it require becoming a commonly used unit of account?
That would mean its use in the pricing of commodities and global trade generally - and jostling for position with the US dollar. Can it stage such a coup?
A key to Libra’s adoption is being a stable store of value, with its designers claiming “the value of a Libra today will be close to its value tomorrow and in the future”. A big failing of crypto-assets is their extreme instability of price - and stablecoins were created for precisely this reason.
So how will this stability be achieved? Libra will be backed by a reserve of assets to give it intrinsic value. Those celebrating the end of the traditional banking system or government financial hegemony, hold on - the reserve of assets will include bank deposits and short-term government securities in currencies from stable and reputable central banks. Like an ICO, the original investors keep the interest paid on the assets held in the Libra Reserve.
Beyond the benefits of low price volatility, the asset reserve supposedly protects Libra from the bank runs that beset fractional reserve currencies. But this claim is based on a misrepresentation of what it means for a currency to be ‘backed’ and what a bank run means.
Bank runs occur because of a mismatch of asset liquidity and the convertibility obligation associated with bank-issued money, not because there is no backing. Libra will be no different in this respect, since some of its backing will be government (and other good quality) bonds. Central banks, with their ability to be lender of last resort, exist to assist banks in converting non-money assets in the face of a bank run. Libra has no such support.
The Libra reserve will consist of short-dated assets, however, and this will help with liquidity management. These self-liquidating assets are likely to be government bills and repurchase agreements (‘repo’). This makes a lot of sense and means Libra also shares characteristics (and will compete for assets) with money market funds.
A precedent exists for this sort of liquidity management. The traditional English banking model entailed holding self-liquidating assets. To support a nation of shopkeepers and traders, the business of banking consisted of discounting short-term bills of exchange and hence the system’s asset base continually provided the means to retire its money issuance.
(In the US, which was geared up to support the infrastructure - railways, roads, buildings - of a new nation, banks had to find ways to remove long-lived and hence illiquid assets off their balance sheet. Hence securitisation is a largely US invention.)
Another option is for the Libra Reserve could be held on deposit with central banks. But in many monetary jurisdictions such deposits yield zero or even negative rates of interest thereby removing the income necessary to support the currency. The Reserve would earn better rates of interest at commercial banks.
So although the Libra bank will have a flow of funds to help support its convertibility option, the flow will not be in terms of Libra itself. This currency mismatch means that Libra issuance itself is not being managed.
A much better idea (and it seems to be part of their plan) is for the asset reserve to consist of credit assets denominated in Libra. When these are repaid (and this will itself drive the demand for Libra) the stock of Libra will have a natural reduction mechanism.
The Libra bank could become a lender itself and even replace traditional lenders to become a ‘mono-bank’. This is unlikely; it would be better (especially given its initial design) to encourage, and then stand behind, a private Libra credit system as the lender of last resort.
In the meantime, the creation (‘minting’) and destruction (‘burning’) of Libra will be solely handled by ‘authorised resellers’ who have the authority to manage the conversion of Libra to and from the currencies in its underlying basket. These authorised resellers bring to mind the authorised participants (APs) and official liquidity providers (OLPs) who support ETFs and ensure parity between their exchange value and the value of their asset backing.
Yet what remains obscure is how this conversion is to be handled in practice. We know that the value of Libra will track the value of the underlying reserve and the basket of currencies may change ‘occasionally’.
The conversion of coins will depend on the interest rates associated with the currencies in the reserve basket. Higher interest rates in the reserve currencies will increase the opportunity cost - and hence the burning - of Libra coins. It is not clear Libra reduces the power of monetary policy but interest rate changes could test the capabilities of the authorised resellers.
Libra is a new form of stablecoin. The value of Libra will not be pegged to the value of an established currency or even a basket of currencies at fixed exchange rates. Instead its value - and terms of convertibility into other currencies - is linked to the value of the Libra Reserve.
Again, this makes sense, since it solves the problem central banks had with bimetallic standards and Gresham’s Law. If Libra were linked to a basket of currencies in fixed exchange rates then risk-free profits could be made by converting the cheapest currency in the basket into Libra and then converting it back to the highest value currency. To prevent this, the rates would need to change constantly; otherwise the ability to maintain convertibility would dissolve.
Ultimately Libra aims to be a borderless version of PayPal by solving cross-currency payment problems with its own currency. But its usefulness will depend on goods being priced in Libra or its being incredibly cheap to convert in and out of (including price stability while holding Libra).
So it looks very much like the authorised resellers will hold an important position in the Libra system. They are the ones who will have to handle any imbalances in local currency flows and the basket – all at a modest cost to Libra users.
This liquidity-support mechanism is a novel feature of ETFs yet to be tested in a crisis.
Adding to the uncertainty, ETF Authorised Participants are usually large banks or brokers, but very few have expressed an interest in performing the equivalent role for Libra.
James Culham is Director, Institutional Portfolio Management at ANZ
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
26 Jun 2019
10 Jul 2019