Monday, September 23, 2019

A fifty-year history of Facebook's Libra

Last week, we finally got some information about what Libra's currency basket would look like.
If you haven't heard, Libra is a proposed global blockchain-based payments network. It is being spearheaded by Facebook along with a coalition of other companies including Uber, MasterCard, PayPal, and Visa.

The hook is that rather than going the conventional route and expressing monetary values using existing units-of-account like the dollar, yen, pound, or euro, the Libra network will rely on its own bespoke Libra unit-of-account as its "base language." Libra originally revealed in its whitepaper that the Libra unit would be defined as a basket, or cocktail, of other currencies. Now we know what that mix will likely look like.

Interestingly, the Libra isn't the world's first private unit-of-account. Back in the 1960s and 1970s, several financial institutions came up with their own bespoke units. I learnt about this strange and fascinating episode courtesy of a very readable paper by two economists, Joseph Aschheim and Y.S. Park.

As I gathered from the paper, the first private artificial currency unit was Luxembourg-based Kredietbank's European Accounting Unit (EUA). Originally devised in 1961 as 0.88867 grams of fine gold, the EUA was soon used to denominate a bond issue by SACOR, a Portuguese oil company. Over the next two decades, Aschheim & Park claim that around sixty or so bond issues would rely on Kredietbank's EUA as their accounting unit.

Between 1968 and 1971, the U.S. Treasury ceased to redeem dollars with gold. When the Smithsonian Agreement—a band-aid attempt to re-cement all currencies to the U.S. dollar—collapsed in 1973, the post WWII system of fixed currencies came to its final end. To help people cope with the sudden babble of floating currencies, several new private units-of-account joined Kreietbank's EUA.

N.M. Rothschild & Sons kicked things off in 1973 with its European Composite Unit, or Eurco. The Eurco was made up of nine currencies issued by members of the European Community, including Deutsche marks, French francs, and Danish kronor. According to Aschheim & Park, Rothshild developed the Eurco "to elicit investors' confidence" in long-term bonds, but as of 1976 only three bond issues had been denominated in Eurcos.

In 1974 Hambros Bank introduced the Arab Currency-Related Unit, or Arcru. The Arcru was comprised of twelve Arab currencies and designed to appeal to Arab investors flush with oil profits. The next year Credit Lyonnais created a bouquet of the ten currencies, both European and non-European, and dubbed it the International Financial Unit, or IFU. This was a far more broad-based unit than the Arcru or Eurco, the relative weights of the IFU's component currencies being based on each country's share of international trade.

Barclays Bank also got into the game in 1974 with the Barclays Unit, or the B-Unit. The B-Unit was made up of five currencies: the U.S. dollar, the British pound, the German mark, the French franc, and the Swiss franc. Aschheim & Park note that whereas the Arcru, IFU, and Eurco were primarily intended for denominating bonds, the B-Unit was designed to be used for making international payments.

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Which makes the B-Unit a direct predecessor of the Libra unit.

Look around you today, however, and not one of these private units-of-account listed below exists. Anyone want to pay me in B-Units? I didn't think so. I think this says something quite fundamental about the market's demand for artificial currency units. Businesses and consumers don't really like to use them.

Table from Aschheim & Park

If private artificial currency units have been failures, what about government-provided ones?

Take the International Monetary Fund's Special Drawing Right (SDR) basket, which has been in existence since 1970, almost fifty years. If there was a demand to make international payments using public artificial units of account, surely commercial banks would eventually have met that demand by implementing SDR-denominated payments systems. Indeed, Aschheim & Park speculate on the possibility in their 1976 paper. It's worth reading this section in full:
"International banks may soon be willing to accept deposits denominated in SDRs because a potential demand for SDR funds already exists, as manifested by recent SDR bond issues by the Swiss Aluminum Company, the Swedish Investment Bank, and Electricite de France. The process, indeed, is already under way. In July 1975 the Bank Keyser Ullmann in Geneva (a subsidiary of Keyser Ullmann of London) announced that it would henceforth accept demand and time deposits denominated in SDRs. These SDR deposits are to be convertible at any time into any currency at the SDR exchange rate applicable on that day. Similarly, in August 1975 the Chase Manhattan Bank in New York instituted a range of banking facilities in SDRs, including loans, deposits, and futures trading. As this process spreads and as more international transactions are denominated in SDRs, banks may begin to allow direct transfers between SDR accounts, internally and then between banks. In consequence, the SDR may be transformed from mere numeraire (international quasi-money) into an outright means of payment (full-fledged international money)."
Again, look around you today. How many banks let you open an SDR-denominated bank account and make SDR payments? None that I'm aware of. Maybe the IMF's SDR was never well designed, or maybe Barclays was too small to drive B-Unit adoption. Or more likely SDRs, B-Units, and the other artificial currency units mentioned in Aschheim & Parks paper are all monetary dead-ends. In pursuing the same path, Libra could be making a big mistake.

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What is it about artificial currency baskets that makes them non-starters? My first post about Libra delved into this question. Let me repeat my argument below to spare you the effort of clicking through.

In an alternative reality, let's imagine that Facebook only allows users to join and converse on its platform after having learnt Facebook's artificial language, Facebookish. English, French, Chinese, and all other languages are banned.

In this alternate reality, all Facebook users understand each other because each one is fluent in Facebookish. Comprehension is a great thing. But hardly any of us would be on Facebook to begin with. Who wants to go through the effort of learning a new language? Not me.

In the real world, Facebook has long since decided against the Facebookish approach. Instead, it supports a multitude of local languages—Arabic, Chinese, English, Hindi, and more. Sure, the drawback is that we can't always understand what other Facebook users are saying. But at least users don't have to go through the hurdle of learning new grammar and syntax. And Facebook has thrived as a result of this simple and obvious design choice.

The adoption of a Libra unit of account is the monetary equivalent of forcing users to learn Facebookish. Sure, at least with Libras we'll all be using the same currency units. But this ignores the costs we'd all have to incur as we learn a new monetary patois. From a very young age we all figure out how to "speak money". We speak in our local unit-of-account. As a Canadian, the Canadian dollar has always been the means by which I describe prices to people around me, and remember values, and engage in cost-benefit calculations. Facebook wants to force us all to learn a new monetary language, a Libra-based one. But in doing so it's setting a huge hurdle to adoption.

So I'll just repeat. No matter how skillfully it goes about designing Facebookish (or Libras), artificial languages and artificial units are dead-ends. They're utopian, and definitely not user-friendly. (Ok, I may have described it all better in my original post, so just head on over.)

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That being said, over the last few months I've been slowly warming up to Libra. Out of the millions of crypto projects that have come out over the last decade, it comes close to the Fedcoin vision I originally outlined on my blog back in 2014, and twice now for R3.

To begin with, a Libra token would be stable (unlike bitcoin) thanks to credible and strong issuers. Since it would be decentralized, the network would be resilient. And since a Libra is a token, and not an account, it should be relatively open for everyone to use. At the same time, David Marcus, the architect behind Libra, is making the right noises about financial privacy. (Whether his intentions are genuine or not, it's tough to say.)

From the Libra whitepaper

I think (and I could be wrong here) that there is a growing desire on the part of consumers for more financial privacy. Unfortunately, governments hew to a post-9/11 mindset that regards privacy as a pervasive threat. Facebook may be one of the only organizations with the financial heft to articulate consumers' desires for more privacy in a way that regulators can't ignore.

Having Facebook as financial privacy advocate is a fragile win, no? It would be too bad if Libra (and whatever level of financial privacy it promises to bring to mainstream consumers) never attains widespread usage because of a basic design flaw, one that obligates us all to adopt the monetary-equivalent of Facebookish

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If not an artificial currency basket, what should Facebook do? I think that most consumers who engage in cross-border transactions want to keep swimming in their domestic currencies up until the last minute. Only at the 'buy now' or 'send now' moment—i.e. when a purchase it to be consummated or funds transferred to a friend—do we want to leave the bubble of our home currency. Pre-accumulating some strange alien token, whether those be SDRs, B-Units, or Libra, just isn't on the table.

If it wants to stay customer friendly, Libra needs to design its network to allow for the flow of tokens denominated in state currencies (U.S. dollars, Chinese yuan, British pounds, Indonesian rupee). And then it needs to design a cheap, transparent, and easy way for these tokens to move from person to person. This is what PayPal does. It's also worked for Transferwise. Visa and MasterCard too. None  of these platforms have created their own curious units, PayPalios or TransferWise-units or Visa-oos. They've allowed customers to remain safely ensconced in their domestic currency bubbles until the final 'send now' moment.

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Putting aside my criticisms of Libra's decision to use an artificial currency unit, what do I think about its choice of basket?

I am left wondering what sort of process David Marcus and the folks at Facebook have used to generate the basket components. Potential Libra users will want to know ahead of time how they can expect a basket's components to be updated as time passes. After all, if their wealth is to be held on the platform, customers will wonder what is to prevent a sudden rewriting of the basket in a way that favors the network at their expense?

One important rule that everyone will want to know is what economic thresholds are being used to filter out or include various currencies. For instance, if the Korean won starts to become a popular international currency, at what point will Libra decide to include it in the basket? If so, would it boot out another currency to make way for the won, or keep it?

The current Libra components are definitely odd, and give no indication of what process the architects are using to populate the Libra basket. For instance, I'm not aware of any selection process or rule that would lead to the Singaporean dollar comprising 7% of what is supposed to be a "global currency." Don't get me wrong. I like Singapore. It punches above its weight. But Singapore doesn't account for 7% of world trade, or 7% of the world's population, or 7% of global anything.

Or why does the euro account for just 18% of the Libra basket while the U.S. makes up a mammoth-sized 50%? The European Union has twice the population of the U.S. and accounts for a far larger share of exports. And where is the Chinese yuan? Exiled for political reasons?

One wonders if the euro's small share has to do with the effect that Europe's negative interest rates might have on network profits. For each Libra it has issued, the consortium will have to keep a Libra's worth of assets in reserve. Far larger profits can be earned it it reduces the euro portion of the basket and increases the U.S. dollar portion. After all, that would mean more exposure to high-yielding U.S. dollar assets and less to negative-yielding European ones. But that's a terribly ad hoc way to construct a currency basket.

My last thought is this. If Libra has its heart set on choosing an artificial currency unit as the basis for its global currency, it should have probably just go with the IMF's SDR basket rather than brewing its own strange currency concoction.

The IMF's SDR basket (source)

Consider how exchange-traded funds which track an index outsource all of the decisions about index methodology and components to third-parties like Standard & Poors, MSCI, and FTSE. This makes the exchange-traded fund more credible. Using SDRs would pre-commit Libra to avoiding conflicts of interest and thorny politics, the IMF becoming the theater for determining the basket. One could find worse third-parties than the IMF.

7 comments:

  1. Superb post as always. Thanks for the earlier paper on artificial currency units. It is odd to see Singapore Dollar be given 7% weight. It should instead be the Canadian Dollar :-)

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    1. Thanks Amol. Yep, the Canadian dollar might make more sense than the Singapore dollar, but the most important is to have an actual rule for generating the basket. We'll see if Facebook ever makes that rule public.

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  2. I consider myself a relatively good economist and have a reasonable understanding of monetary economics, but I always get in a tangle when it comes to SDRs and baskets of currencies.

    What does it mean when we say an SDR or Libra's value is pegged to a basket of currencies. And how will fluctuations in the value of those currencies influence the value of one Libra/SDR when considered in one country's domestic currency?

    I also don't understand how the reserve fund works. I understand the vague notion that Facebook and partners get seignorage from issuing libra (i.e. returns on the asset portfolio backing libra) but what happens to the value of libra if the reserve fund tanks. Do they take on the risk and return in both directions or is there some mechanism for libra token holders to absorb the downside but not the upside.

    Sorry for all the questions, I am just in a colossal muddle about it all.

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    1. A unit of account like the SDR is defined as a basket of currencies. It's simply a mental calculation. We could create a Wills unit of account right now. Just mix 0.2 GBP, 0.5 USD, and 0.3 euros together. Voila, the Wills.

      It's only when an actual Wills financial instrument is created that a peg has to be created. Something has to lock the instrument to the Wills unit of account. If I recall, the IMF has a redemption mechanism. That's what locks tradeable SDR units to the SDR unit of account.

      See more here: http://jpkoning.blogspot.com/2013/05/imf-sdrs-worlds-largest-lets.html

      As for the question of reserves, I'm not sure yet if we know exactly how things will play out if Libra breaks the buck. My guess is that Facebook and its coalition would bail it out. That's what typically happens when a money market mutual fund breaks the buck; its parent or sponsor tops it up.

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  3. What about a private unit-of-account of goods and services (like CPI)? Do you know some examples?

    (I have also a question waiting on the forum, about CPI. Thanks in advance!)

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    1. Hi yyy, of the top of my head I don't know of any private units of account that use a basket of consumer goods and services.

      Sorry about the forum delay, I'll try and get to it. Have been a bit swamped.

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