A Libra conversation: Cowen and Catalini

Tyler Cowen asked some questions about Libra and Christian Catalini replied.

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1. The Libra will be backed by a bundle of pretty safe, pretty mainstream assets (I don’t know which ones).  It is presented as one hundred percent reserve, though no system with fluctuating prices and also float really will be pure one hundred percent.  And the reserve is in “low-risk” assets, attention all critics of the Basel capital standards.

(1) Libra will be backed by bank deposits and short-term government securities in currencies from a small number of stable and reputable central banks.

1b. The paper has a chance to say that the custodians will be separately capitalized, with no cross-collateralization, for purposes of Libra protection, but it does not do so.  I would recommend that change.

(1b) Currency is fully backed, and custodians will be able to prove that they are not introducing fractionalization on top of the settlement layer. Even so, you raise an important issue @Libra_ will have to address.

2. The assets in the reserve fund will come from users of Libra (how will they be charged?) and from “investors in the separate Investment Token.”  Furthermore “The funds for the coins that will be distributed as incentives will come from a private placement to investors.”

(2) Two sources of funds: i) investor funds will be used to allow custodians, merchants, etc., to provide incentives for adoption, and will be converted to Libra before being distributed; ii) As the Libra economy expands and users convert more fiat to Libra, their funds are used to purchase more units of the reserve basket through authorized dealers. Intermediaries may charge a fee for on/off ramps.

3. What about the public choice issues?  Won’t banks insist — correctly or not — that this represents competition and part of the payments system, and thus it should be brought under deposit insurance control and taxation, Fed regulation, various bank holding company acts, Monetary Control Act of 1980, and so on?  Have banks ever lost a political battle of this kind?

[No reply]

4. We are told “The association does not set monetary policy.  It mints and burns coins only in response to demand from authorized resellers.”  Maybe, of course there are hundreds of years of debate on that one, google “real bills doctrine,” noting that here we have a semi-dominant private issuer rather than a perfectly competitive banking system.  The association policy on interest rate spreads, floats, and credit, of course, can end up being a monetary policy de facto.  I don’t want to prejudge this one against Libra, since to me the validity of the real bills doctrine is a genuinely open question, but it is worth noting that most economists would not agree with the doctrine in most settings.

(4) The reserve will not be actively managed. Rebalancing of the basket may occur in response to major economic events. Such a change would require exceptional circumstances and a supermajority vote by the association’s council.

4b. Won’t some margins arise where there are fractional reserves, even if Facebook/association/Libra are not the ones doing it?  Imagine that a new class of intermediaries arises, offering some intermediate services between the core system and retail use, but not adhering to the 100% reserve provisions.  The logic behind this tendency seems pretty strong, for better or worse, and it can reintroduce risk into the system.  Someone wants to be holding higher yielding assets and then be making claims on them be liquid through the Libra system.  But Facebook/Libra would not seem to have the power to regulate the surrounding system of intermediaries, or is that somehow to be done through covenant (“you can’t use Libra unless you promise not to pile your intermediaries on top of it”)?

(4b) Great question and something the association will have to work closely with regulators (as in the current system).

5. The crypto angle does seem like a sideshow, for me that is not a problem.

(5) The crypto angle will be key for competition, low barriers to entry and innovation, and because it complements strong local institutions to create global spillovers, see https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3396834

6. Imagine a private payment company issuing SDRs, or some other similar basket, based on 100% backing.  They would offer you new transactions technologies for greater convenience (WhatsApp?), in return receiving access to your transactions data and sharing some of the float and spread all around, to merchants and customers too.  Perhaps that is one way of thinking about how the plan works and where the gains from trade come from?

(6) There will be first-order gains for trade for people who do not currently have access to efficient transaction technology but do have access to a smartphone; for reducing frictions in small online payments and cross-border transactions; etc. A key difference with a private company issuance is the desire to build a true public utility that is not controlled by any single entity. Re: data, we hope that competition between custodians will allow for multiple business models to flourish.

7. Is there a provision in the system for zero or low-interest loans?  Can I send small amounts of “libras,” say to pay my water bill, without first having them in my account?  Might sellers sign up to participate in such a system, sharing part of the credit risk with Libra?  And is there a way to do it, with crypto and layered assets and float and implicit positions, so that all this is not subject to the usual consumer credit regulations?  Is that part of how the system will make money and attract interest?  This is just speculation, my question marks here are literally question marks, not tricks to make you think that is how it will be.

(7) We expect entrepreneurs, startups and existing players to explore a number of new financial applications on the platform.

8. “Who holds intraday credit risk?” is always a question worth asking.

(8) This will depend on the application, e.g. if the wallet used is custodial versus not, if merchant services are available vs not, etc.

9. Does any of this try to arbitrage away the fees earned by credit card companies for their intermediation?

(9) The hope is that the broader ecosystem around Libra will reduce transaction fees and increase competition throughout the financial services chain. For more details on how entities will interact with the reserve (and more!): https://libra.org/en-US/wp-content/uploads/sites/23/2019/06/TheLibraReserve_en_US.pdf

10. What if the market for the underlying currencies and assets is (for a while?) more liquid than the market for Libras?  Say the basket values adjust before Libra values do.  What kind of arbitrage opportunities does that create?  If we know Libras are due to depreciate, is there a higher nominal rate of interest on them, as with traditional currencies in an international multi-currency setting?  What are the equivalents of covered and uncovered interest parity in this setting?  Does a kind of “program trading” arise to perform the arbitrage?  Can perfect redemption be offered credibly while the prices are still out of whack?

[No reply]

I still don’t feel I have a great handle on the plan, but those are my immediate reactions.  You should take them with a grain of salt, as they may be based on misunderstandings or perhaps even plan incompleteness.  I look forward to learning more.

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9 Responses to A Libra conversation: Cowen and Catalini

  1. Squirrel

    “1. The Libra will be backed by a bundle of pretty safe, pretty mainstream assets…..”

    Given that Australian bank account deposits are currently “backed” primarily by a mightily inflated property sector, with numerous associated risks (not least interest-only loans converting to principal and interest), Libra could, in time, be an attractive alternative if it is backed by a somewhat more diverse set of international assets.

  2. Bruce of Newcastle

    I’m still amused that Zuckerberg has named his cryptocurrency after this. Is it a geek thing?

  3. JC

    Questions.

    LIbra sounds a reconstructed version of the IMFs SDR. That never took off. Why should this.

    I can’t get my head around this. If the libra is fully backed component of other currencies then how would transactions be any cheaper than that of the underlying currency or currencies.

  4. Tel

    Is there a provision in the system for zero or low-interest loans? Can I send small amounts of “libras,” say to pay my water bill, without first having them in my account? Might sellers sign up to participate in such a system, sharing part of the credit risk with Libra?

    Those of us in the skinflint trade have a name for this. We say, “Paying your bills a bit late.”

  5. Tel

    If the libra is fully backed component of other currencies then how would transactions be any cheaper than that of the underlying currency or currencies.

    Because it includes long distance shipping of the money. If I want to hand a $50 to my next door neighbour over the fence then it’s very convenient, minimal fees and quite private. However if I want to buy something from a merchant far away (possibly with a currency conversion in the middle) then it’s a lot more painful and I’m up against either high fees or inconvenience or both.

    But anyway, it’s the easy payment system and the fast transaction processing that’s valuable, not the fact that we have some kind of fiat currency backed by other fiat currency.

  6. AH

    It’s a fundamental mistake to back Libra with anything. Gold isn’t backed by anything. If you want to compete with gold you need something that is intrinsicly good enough that it doesn’t need backing. But the fundamental thing about gold is that it is a physical substance that can’t be created arbitrarily. Facebook wants to have a currency that they control and which allows them to impose arbitrary parameters on its use, rather than to create something that is intrinsicly uncontrollable.

  7. John A

    a small number of stable and reputable central banks.

    You will have to find them first!

  8. Confused Old Misfit

    Essentially, the Iron Bank of Braavos is the biggest, most powerful bank in the entire world.
    It has a virtually inexhaustible supply of the essential element of its currency.
    You can virtually weigh it.
    You can virtually touch it.
    You can virtually assay it.
    Iron is there. Iron is real.
    Iron is not a fiat element.
    Only a fiat element can be virtually mined.
    Everyone knows that! (credit Stimpson J. Cat for the final line of the comment)

  9. Ellen of Tasmania

    LIbra sounds a reconstructed version of the IMFs SDR. That never took off. Why should this

    I was thinking that. This could take off just because of the convenience to customers, I guess – and it would seem a bit less ‘global governancy’. Maybe they want it in place to cover any future currency crisis?

    Like everything else, it would be interesting to ‘follow the money’. I’m guessing the same people behind the current banking/monetary system will be behind this if they really think it will work.

    If you look at China and their social credit score system, you could see how the two could converge and ‘money’ could then be rewarded to or taken from people just like social points. Or the greenies idea of ‘carbon credits’. There’s the rub. It’s not the actual system, it’s who is in charge of it and how they can use it. Do you trust (or even know) the people in control?

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