02.07.2019 - Studies

A digital Euro to compete with Libra

by Thomas Mayer

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Digitalization would give the euro a viable long term perspective, which it is unlikely to have in the credit money system.

On 18 June 2019 a group of 28 companies led by Facebook published a White Paper proposing the creation of new crypto currency named Libra. The initiative could give the digitalization of money a big boost. Digitalization would also give the euro a viable long term perspective, which it is unlikely to have in the credit money system. Credit money needs a state for its reinsurance that cannot be created for the euro area. Digital money, on the other hand, can exist without a state guarantee.

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Europeans use American platform companies to communicate and shop on the Internet. They use the US Dollar for a large part of their international payments. They may in future have to use a cryptocurrency managed mostly by American platform companies with global reach when they want to pay with digital money. For there is hardly a European company suitable to join the Association created by Facebook to issue and manage Libra, the new cryptocurrency capable of attracting a global community of users. Europeans often complain about their dependence on American platform companies and the US dollar. If they do not want to depend on American digital money as well in the future they should think about creating their own crypto money. In the absence of good alternatives, the euro would be the best candidate for digitalization.

On 18 June 2019 a group of 28 companies led by Facebook published a White Paper proposing the creation of a new crypto currency named Libra. Their goal is: “A stable currency built on a secure and stable open-source blockchain, backed by a reserve of real assets, and governed by an independent association”. For Facebook, the motivation may have been to augment its social media platform with a payment facility similar to the approach of Chinese platform companies. However, there is more to it: In view of the initial backing by renowned companies from Visa to Vodafone the Libra Project seems to be the most serious initiative for the introduction of a new cryptocurrency since the launch of Bitcoin a decade ago. In fact, its consequences could be much bigger.

Libra is designed to be a “stable coin”, i.e., a crypto currency backed by assets. Its purchasing power is not determined by the supply and demand of the currency itself (like Bitcoin) but derived from the assets backing it. The assets are a basket of existing “fiat” currencies created by central and commercial banks that are internationally convertible, liquid and have a stable purchasing power. Thus, the exchange rate of Libra against any of the basket currencies will move in relation to the movement of this currency against the other basket currencies. And the change in value of any other currency against Libra will equal its move against the currency basket. The Libra money stock grows with purchases of users using conventional money for payment, and members of the Libra Association will act as “buyers of last resort” to ensure that the value of Libra (expressed in a third currency) always matches the value of the underlying assets.

Libra is issued and managed by the members of the “Libra Association”. Membership of initially 28 companies is to increase over time to around 100. Facebook played a key role in the creation of the Libra Association, but will in future have the same commitments, privileges, and financial obligations as any other founding member. Facebook created Calibra, a regulated subsidiary, to ensure separation between social and financial data and participate on its behalf in the Libra Association. By bonding with other countries Facebook not only broadens support for its project but also takes these companies out of reach of potential competitors for crypto currencies such as Apple, Amazon or Google.

The Libra blockchain is a new construct built for its users with a tailor-made programming language dubbed “Move”. It is a “permissioned blockchain” with members of the Libra Association serving as “nodes” to validate transactions. Consequently, it has the capacity to process large numbers of transactions in a short time as is needed for serving billions of accounts. However, the presently published capacity of 1,000 transactions per second falls short of the 56,000 transactions in the VISA network. Use of Libra for money transfers is free of charge and allows users to transfer under pseudonyms not linked to their real-world identity. However, identity checks will have to be performed at the points of entry.

The architecture of the blockchain enables simple and fast connections to webshops with one line of code, so that every kiosk could be able to accept Libra as a means of payment at short notice. Should Libra establish itself quickly, the "Internet of Things" and "Industry 4.0" would offer the possibility to link flows of goods to machine-to-machine payments. This could be used to document flows of goods (supply chain track and trace) and, in a further step, to evaluate and utilize the information contained therein. If you take the idea a little further and imagine that essential payment and goods flows are documented and processed on the Libra Blockchain, unexpected possibilities for analysis arise. If, for example, a large company pays three days later than usual, financial market players as buyers of the analysis data could draw conclusions about the liquidity of the company in question. From a technical point of view, there are no limits to transparency and, as things stand at present, banking secrecy rules in blockchain currencies still need to be developed.

The reserve pool backing Libra is designed so as to preserve capital and offer a high degree of liquidity. Thus, the association will only invest in short-date debt securities from safe banks and stable governments with low default probability in countries with low inflation, which are all traded in liquid markets that regularly accommodate daily trading volume in the tens or even hundreds of billions. Interest income will go to the members of the Libra Association. Given these requirements, it is not difficult to guess that the currency basket to back Libra will include mostly G7 currencies (USD, EUR, JPY, GBP, and CAD). With interest rates on short-dated debt in USD, GBP, and CAD still positive, the Association can expect to receive interest income from the start. Assuming the composition of the currency basket to broadly reflect the size of the economies issuing the currencies, the annual interest rate on the reserve would presently amount to around ¾%. Thus, if one billion of users held a Libra Wallet worth USD 1,000 on average, the Association would have an asset base worth USD 1,000 billion and receive interest income of around USD 7.5 billion. It would look like a very big money market fund, which is attractive for its customers not because it pays interest but because it allows non-cash payments without charges.

Libra could become quite attractive for future users for three reasons:

  • It offers low cost peer-to-peer money transfers in any amount over any distance.
  • It promises a high quality means for the store of value (though without interest).
  • It could develop as a unit of account when suppliers on global retail platforms choose to price their wares in Libra.

Considering that Facebook and its affiliates today have already some 2.7 billion users and other Association members such as Visa and Mastercard alone have 1.6 billion users, not all of whom are also Facebook users, the customer potential for Libra is far beyond that of any of the existing currencies.

Not only the experience of the initiators in web technologies (the popular Java Script extension REACT was developed by Facebook) speaks in favour of a fast dissemination. The participation of payment system providers can also be seen as a preemptive move: Instead of being overrun by blockchain-based payment systems, they are taking on the role as operators of validator nodes that commercial banks normally play in the classic processing of payments

Against this, Libra is facing opposition from three groups who all want to preserve the credit money system in its present form to protect their interests. Commercial banks fear that they will lose customers when Libra becomes the preferred means for transactions. Central banks fear that their ability to manage the economy will weaken when a significant part of the outstanding money stock is backed by short-term government credit. And politicians fear that they will become dependent on a big borrower only interested in short-term bills for the funding of government spending. Hence, these groups take an inherently skeptical view of Libra and emphasize potential problems. From their vantage point, Libra could facilitate money laundering, payments for criminal activities and the abuse of private data, expose users to financial risks, create risks to the financial system by amassing a large stock of financial assets, and undermine the effectiveness of monetary policy.

However, many of these fears are exaggerated. Libra should not be more vulnerable to money laundering and criminal activity than existing cash and bank money. Data protection is a general problem in the digital economy and not limited to digital money. Monetary policy has already lost its effectiveness to a considerable extent, even without Libra, and highly indebted states today already depend on the good will of the financial markets. Assuming that one billion users hold Libra wallets worth USD 6,500 on average, the Libra reserve fund would have USD 6.5 trillion assets under management, no more than Blackrock, the largest fund management company of the world. With only short-term investments in highly liquid assets of very good quality, the Libra Reserve Fund would most likely have lower liquidity and default risks than the average investment fund offered by Blackrock or any other fund management company. Moreover, with USD 6.5 trillion assets, the Libra Reserve Fund would account for about 14% of the broad money stock of G7 countries (Figure 1).

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