The future of privately issued digital currency

Such are the prospects for mainstream acceptance for something like Facebook’s Libra. But the hurdles are daunting too.

In 2015, China’s yuan joined the US dollar, euro, UK pound and yen as an elite currency in the IMF’s ‘special drawing rights’ that members can access in emergencies.

The yuan’s ascent to IMF-sanctioned status recognised that the banknotes featuring Mao Zedong’s portrait had become the world’s newest ‘reserve currency’. This tag means a currency is widely held by governments and institutions among their foreign-exchange reserves because it is seen as a store of value.

While the yuan forms a small percentage of world forex reserves, the currency’s elevation to, first, reserve, then, IMF status was controversial. The yuan is not “freely usable” and, unlike the other four currencies, is not market set. Other differences are that Beijing restricts capital flows and China’s financial markets are not deep or wide.

The next currency to deserve reserve status could break even more rules. It could well be a privately issued digital currency that’s yet to exist. Watch out when a virtual currency such as Facebook’s proposed Libra is born. Privately managed money issued by profit-seeking global platforms has the potential to become a mainstream means of exchange worldwide, an achievement that could upend global finance.

A cyberspace currency based on blockchain technology issued by a consumer platform such as Amazon, Apple or Facebook (or China’s Alibaba or Tencent, for that matter) could revolutionise finance for four reasons. The first is that these platforms have billions of users around the world who are likely to use the digital money. The second is that virtual currencies could introduce financial services to the 1.7 billion people in emerging markets who Facebook estimates lack access to financial services. The third is that money transfers within a secure private network could be close to costless, instantaneous and hassle free. Digital currencies would thus take business away from the expensive, inconvenient and sluggish payments, settlement and money-transfer systems that are run by commercial and central banks under country-based regulatory systems.

The last reason is that digital currencies can be designed to conquer the handicap that keeps cryptocurrencies to the fringe; that coded software has no ‘intrinsic value’. The telling advantage of Facebook’s Libra over Bitcoin is that Libra will be fully backed by safe assets denominated in reputable currencies.

No surprise; the prospect of a privately issued digital currency has spurred resistance, even calls that such money should never be permitted. Policymakers worry about letting powerful platforms gain even more influence over society. They fret about privacy and criminal use. They worry e-money will erode control over money supplies and impede monetary policy. Above all, they are wary of possible threats to banking systems.

No matter; a shock to global finance is being prepared. The technology exists. The latent public demand is there. The business opportunity is immense. The most successful currency issued by a digital platform could easily merit reserve status. But regulatory concerns will need to be allayed first and there is no guarantee they will be any time soon.

It could be argued that a digital currency backed by safe state-issued currencies is a security rather than money. But economists define money as anything that does what money should do and a successful privately created digital currency would meet that definition. So why not reserve status if virtual money reaches critical mass? Mainstream acceptance is not assured, of course. Much of the infrastructure surrounding Libra is incomplete. Governments will limit the penetration of digital currencies by insisting that many transactions be in local currency. Regulators might endlessly delay digital currencies. People might shun this form of money. After all, is it even needed in a world already going cashless where further innovations could vastly enhance traditional payments systems? Funnily enough, people in the US are ripe for digital money because the country’s payments system is creaky (though the Federal Reserve is intent on modernising over the next five years). Keen too are people in areas of the emerging world where payments are primitive. Those billions of platform users generally take to new things.

When public demand is high and the technology exists, then something usually happens. In time, if regulators are willing, digital currencies could be widely used means of exchange that enhance the global financial system but make it riskier in new ways too.

Two prongs

Ever wondered why ‘lb’ is the abbreviation for the pound weight measure? The letters come from the Roman basic measure of weight, the Libra. The UK pound’s £ symbol has the same Latin origin. Thus Facebook named the proposed payments system within its messaging services that aims to make money transfers as easy and as cheap as exchanging digital photos.

Facebook’s plan released in June has two elements. The first centres on the currency. A Facebook-led Swiss-based consortium of reputable companies (such as Mastercard and Vodafone) called the Libra Association will issue the digital currency from 2020 and manage the Libra Blockchain on which it will run.

The association’s aim is to make the Libra a global digital currency that is stable, trusted, accepted and fungible (interchangeable). Each Libra issued by the Libra Association will be backed by a reserve of safe securities issued in state-backed fiat currencies held by a custodian network. Libra’s value will be inherently more stable (a ‘stablecoin’) than if it were quoted against just one currency.

Facebook envisages a world where people are confident their Libras will hold their worth, where Libras can be easily exchanged for a fiat currency via exchanges, and where Libras can be used or stored by any organisation (not just Facebook). The interest earned on the Libra reserves will pay for the payments system and flow to the members of the Libra Association as profits.

The second element is that a Facebook subsidiary called Calibra (a word with no exotic origin) will issue a ‘digital wallet’ for people to store, send and receive Libras. (Calibra will perform roles away from Libra as well and the wallet would still work if payments were in state currencies.) The way it works is that people will hand state-issued currency to Calibra that credits them with Libras, while the state-issued currency goes to the reserve. Everyone with a Calibra account will have passed identity checks to prevent money laundering, crime funding and tax evasion.

Libra and its ilk are likely to fulfil a huge unmet demand for easy-to-use, lightning-fast and close-to-costless payment services that can span borders without delays. Such a digital currency is likely to be popular in emerging markets among the unbanked – the World Bank estimates that 31% of adults around the globe in 2018 had no bank or mobile money provider. Digital currencies are likely to be popular with expatriates who pay high fees to send money home – the UN estimates US$613 billion was remitted to global households in 2017 and transaction costs average 7.1%, so there’s more than US$40 billion to be saved. Cyber money offers an alternative store of value to people in the emerging world who have little trust in their state currency. E-money could be used for micropayments – say, two cents equivalent for a paywalled article. That would make the internet more rewarding for many companies.

If popular, digital currencies could usurp state-backed fiat currencies as a medium of payment. The Libra network will compete against traditional debit-card issuers initially and possibly credit-card issuers in time. The network will disrupt forex providers and remittance services. Digital money could threaten traditional banks, if virtual-money networks were allowed to attract deposits and lend money. Such vast possible disruption, however, attracts scrutiny.

Systemic dangers

In August, Australian, Canadian, EU, UK and US privacy regulators jointly posed 14 questions to Facebook on Libra’s privacy protections. They were “surprised and concerned” Facebook had failed to outline the “practices that will be in place to secure and protect personal information”.

Privacy is just one of the many concerns that regulators worldwide have about such money. Digital currencies, by diverting transactions from regulated channels, could hinder the ability of authorities to police their financial systems, especially against crime. E-money could subvert government capital controls that can protect countries from money piling into bubbling investments or bolting suddenly – aims the IMF says justify limiting capital flows. A Libra bank could devastate traditional banks and hamper the flow of credit that fuels economies.

A big worry is that somehow digital money could jeopardise financial systems. Regulators fret that monetary policy could be a less-effective management tool to control inflation if too much of a ‘parallel’ currency beyond their influence were to circulate. This depowering could be magnified in emerging countries if people were to rely on virtual banknotes as a store of value. If Libra were to become mainstream, the Libra Association’s investment decisions could destabilise state currencies and asset prices – think of it as a non-sovereign fund that could be bigger than sovereign funds. Libra’s success could force central banks to issue digital currencies, which could weaken financial stability if savers were to flee traditional banks to hold central-bank money.

Officials worry where virtual money might head once sanctioned and popular. If the digital-currency networks were allowed to lend, a global colossus without government backing might emerge. What’s to stop the Libra Association issuing fiat or unbacked Libras or investing in risky assets? Could Libra be subject to a ‘run’ if everyone wanted state money at once? A different risk is that governments could block Facebook for political reasons and Libra users could face a liquidity problem.

Anti-trust concerns loom too. Many see that these platforms have already created a ‘new paradigm of power’ because their massive user numbers push others to join. Adding a payments dimension could put even more pressure on people to join platforms.

Above all, regulators worry that platform-issued digital money will be a watershed change that will spark unforeseeable financial and political trials. Such concerns prompted Democrat leaders in the US House of Representatives to demand that Facebook cease Libra’s development until officials can analyse its risks. “Failure to cease implementation before we can do so risks a new Swiss-based financial system that is too big to fail,” they said.

Regulators are under pressure to act prudently. Any decision to allow profit-seeking platforms to issue digital currencies will be far riskier and transformative than, say, the IMF’s fudge on the yuan so it could enter its special drawing rights.

Published by Michael Collins, Investment Specialist, Magellan Group