Streetwise Professor

June 19, 2019

Can You Spare Me a Zuck Buck? Spare me.

Filed under: Blockchain,Cryptocurrency,Economics,Politics,Regulation — cpirrong @ 3:08 pm

To huge fanfare, Facebook announced the impending release of a new cryptocurrency, “Libra.” Except it isn’t–a crypto, that is. Whereas real cryptocurrencies are decentralized, anonymous, unpermissioned, and lack trusted intermediaries, Libra is centralized, permissioned, non-anomymous and chock-full o’ intermediaries in addition to Facebook. It doesn’t really utilize a blockchain either.

Other than that . . .

For the best (IMO) take on the “Zuck Buck”, I heartily recommend FT Alphaville’s extended take–and takedown. I’ll just add a few comments.

First, when it comes to finance, there is little (if anything) new under the sun, and that is clearly true of Libra. The Alphaville stories provide several historical precedents, to which I’ll just add another. It is basically like pre-National Bank Act banking system in which banks issued bank notes that circulated as hand-to-hand media of exchange, and which were theoretically convertible into currency (gold prior to the Civil War) on demand. Libra is functionally equivalent to such bank notes, with the main distinction that it is represented by bytes rather than pieces of paper.

Facebook attempts to allay concerns about such a system by requiring 100 percent backing by bank deposits or low-default-risk government bonds, but as historical experience (some as recent as 2008) demonstrates, although such systems are less subject to runs than liabilities issued by entities that invest the proceeds in illiquid assets, they are not necessarily run-proof.

Furthermore, the economic model here isn’t that different from the 19th century bank model because the issuer can profit by investing the proceeds from the issue of the currency in interest bearing assets, and pocketing the interest. Those buying the currency forego interest income, and presumably are willing to do so because of it reduces the costs of engaging in various kinds of transactions.

This type of system faces different kinds of difficulties in low and high interest rate environments. In high rate environments, the opportunity cost of holding the currency is high, which leads to lower quantity demanded. In low rate environments, the revenue stream may be insufficient to cover the costs incurred by the intermediaries. This creates an incentive for asset substitution, i.e., to allow backing the currency with higher risk assets (with higher yields) thereby increasing insolvency and run risks.

I note in passing that low interest rates destroyed the traditional FCM model which relied on interest income from customer margins as a major revenue stream (as Facebook is proposing here). Ask John Corzine about that, and look to the experience of MF Global.

Why introduce this in a low interest rate environment? Maybe this is a kind of loss-leader strategy. The opportunity cost of holding Libra is low now (given low rates), so maybe a lot of people will buy in now. Even though the benefits to the issuers/intermediaries may be low now (because the interest income is low), they may be counting on customer stickiness once there is widespread adoption. That is, those who hold Libra when the cost of doing so is low may stick around even when the cost goes up substantially. That is, Facebook and its partners in this endeavor may be counting on some sort of switching cost or some behavioral irrationality to reduce the interest-rate sensitivity of demand for Libra.

Good luck with that. (For another example of nothing new under the sun, read up on disintermediation of traditional banks when interest bearing money market mutual funds came on the scene.)

I would also suggest that Libra has some disadvantages as a medium of exchange. For one thing, since assets will be held in multiple currencies, it creates currency risk for virtually everyone who uses it. For another, it involves additional cost to move from fiat into Libra and from Libra into fiat. This reduces the value of the Libra as a medium of exchange because of the resulting difference in cost in using it for within-network and off-network uses.

This last point relates to something else in the Libra white paper, namely, the claims that the currency will be a boon to the “unbanked.” This makes zero sense.

The reason that some people don’t have bank accounts is that the cost of servicing them (reflected in fees that banks charge) is above the willingness/ability of those people to pay for those services. There is no reason to believe that Libra reduces the cost of servicing the currently unbanked. Furthermore, the value of the services provided is likely to be lower, and substantially so because inter alia (a) the lack of brick an mortar facilities that low income people need for check cashing/depositing and cash depositing, (b) the restricted network of people with whom they can transact, and (c) currency risk.  Relatedly, it’s hard to see how one can move funds into our out of Libra without having access to banking services. I see the unbanked rhetoric as mere SJW eyewash attempting to make this look like some progressive social project.

The arrogance of Facebook is also rather astounding. Again, this is not crypto–it is banking. Yet Facebook presumes that it can do this without the panoply of licenses that banks must have, and without being subject to the same kinds of regulation as banks.

Because why? Trust me? Suuuurrreee, Mark.

Along these lines, note that the most benign interpretation behind Libra is that it is a narrow bank (100 percent reserve banking). But remember the Fed recently denied approval to TNB (“The Narrow Bank”) USA NA even though it was only going to offer deposits to “the most financially secure institutions” and explicitly eschewed providing retail banking services. Yet Marky et al expect the Fed (not to mention banking regulators in every other jurisdiction on the planet) to stand aside and let Facebook offer maybe (but maybe not) narrow banking services (with added currency risk!) to the great unwashed?

On what planet?

Note the furious government reactions to this, not just in the US but in Europe. Zuckerberg et al were totally delusional if they expected anything different, especially in light of Facebooks serial privacy, free-speech, and antitrust controversies.

In sum, in my opinion Libra faces serious economic and political/regulatory obstacles. Having politicians and regulators hate you isn’t bad per se in my book–it can actually represent an endorsement! But the economics of this are incredibly dodgy. My skepticism is only increased by the misleading packaging (crypto! a boon to the unbanked!) and the congenitally misleading packager.

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  1. I would definitely use a 100% reserve bank that offered Fed rates for demand deposits – even if it had no deposit insurance. I wonder what Connecticut thought about the presumed lack of deposit insurance?

    Comment by Dave — June 20, 2019 @ 6:27 am

  2. Great article however I think a couple of the points you made would be worth further explanation.

    Firstly, transaction costs, surely the main advantage for customers is meant to be convenience – so its really a question of how convenient will it be. If it makes peoples lives easier, even at a small cost, then its worth having.

    Second, how restricted is the network? facebook et al have 2+bn members, not sure what their account requirements would be but surely the idea would be to make it as simple as possible for anyone who’s on facebook, WhatsApp etc to open an account. Plus there’s some big founding partners with significant reach so it would probably be even more.

    But to me the biggest question I have is whether it is correct to assume that issues that have arisen with traditional banking and currencies are fundamental and translate across with out questioning if they are still relevant. You mentioned that in low interest rate environments that the revenue stream (the profit from investing the proceeds from issuing the currency) may be insufficient to cover the costs incurred by intermediaries. However the data that is collected will be a significant source of revenue. Plus is independent of interest rates making it less susceptible to low interest rates and reducing the need for asset substitution.

    Comment by LK79 — June 20, 2019 @ 6:36 am

  3. @LK79–Thanks.

    The relevant question re convenience is: compared to what? Cash? For some transactions (including many legal ones!), Libra is definitely inferior to cash. Venmo or Paypal or any bank operated payment system? Hard to see how Libra will be more convenient than those. Seems less convenient, IMO. Also, even if Libra is equally convenient, it involves greater risk (FX risk) for most users (who will have their incomes and virtually all expenditures in a single currency, whereas the value of Libra will fluctuate with exchange rates).

    Re restricted network, I was thinking more of merchants rather than FB participants. Virtually every major (and minor) merchant accepts cash, credit cards, PayPal, Venmo, etc. Yes, you can use WhatsApp or FB to access the Libra system, but how can you do that without having a bank account or access to an electronic payment system? And if you have those things, why do you need Libra? Also, many merchants are likely to find Libra more of a hassle than it’s worth: how many merchants you deal with actually are willing to deal in multiple currencies? Probably very few. Precisely because of the various headaches involved. Re the 2 zillion or whatever FB users, how many of those would I actually want to send money to/receive money from?

    Re the value of data harvest. Is that a feature, or a bug? I consider this a MAJOR bug. I alluded to this in my post with the mention of the privacy issues. Personally, I all but eschew use of FB precisely because I don’t want to be the product (“if it’s free, you are the product”). Compensating intermediaries in the Libra system via access to my data only makes things worse. That I might share cat videos or vacation photos on FB that it uses to bombard me with ads is one thing: information on my transactions is far more sensitive.

    Comment by cpirrong — June 20, 2019 @ 4:27 pm

  4. The reason that some people don’t have bank accounts is that the cost of servicing them (reflected in fees that banks charge) is below the willingness/ability of those people to pay for those services.
    Isn’t that backwards: the cost to provide the services is above the willingness to pay?

    Comment by dcardno — June 20, 2019 @ 9:25 pm

  5. @dcardno–Correct, and corrected. Thanks.

    Comment by cpirrong — June 21, 2019 @ 4:26 pm

  6. Markey Has presumably been told by his recent hiring the failed pol Clegg (but EU darling) that this idea will be welcomed in EUropeland

    Good luck with that..

    Comment by djm — June 23, 2019 @ 2:02 pm

  7. “The reason that some people don’t have bank accounts is that the cost of servicing them (reflected in fees that banks charge) is above the willingness/ability of those people to pay for those services. ”

    It’s a reason, not the reason. Other reasons include unwillingness to put the money at risk in less than perfect regulatory environments, unwillingness to increase the risk of expropriation in environments with less than perfect rule of law, etc. Maybe facebook is thinking Russia, not the U.S. A billion here, a billion there, soon you are talking real money.

    “Relatedly, it’s hard to see how one can move funds into our out of Libra without having access to banking services.”

    Again, a trivial problem long since solved everywhere with a sizable “unbanked” population. ATM-like machines at every corner, allowing to pay for a zillion of services in cash. Facebook will be / already is just another service in the menu.

    Comment by Ivan — June 24, 2019 @ 2:49 pm

  8. Heh, financing on the interest rate spread…because interest rates will never swing to a point disfavorable to your position. By comparison, Bitcoin is financed in terms of its own accounting unit, so the cost of securing the network scales (up and down) with the value of network, making it intrinsically stable in this respect. (Same for the old E-Gold, which charged a gold-denominated agio fee–and maybe Zuck can ask Douglas Jackson about the sorts of transmitter licenses he would need to avoid house arrest.) One of the earliest critiques of the Ethereum proposal was why did it use its own coin rather than Bitcoin, and the answer was effectively the same as Alphaville’s critique, though expressed in security assmptions rather than finance concepts.

    Comment by M.Rad. — June 26, 2019 @ 11:17 am

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