A nerd’s guide to Libra & its messy economics

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The rumors were already circulating but now it’s official. On the 18th of June, Mark Zuckerberg – CEO of Facebook, announced that the company and its partners would be launching a cryptocurrency called Libra. He also announced that the company would be launching an independent subsidiary called Calibra to build services that use Libra. So what does this mean for you and the future of the company whose services we use every day?

Libra 101: The Basics in a Nutshell

At a very basic level, Libra is a cryptocurrency that uses blockchain. You can use it to buy services or transfer money to others. At local exchange points like grocery stores or online, you can buy or convert your Libra coins into cash.

To ensure you have services to use it is where Calibra comes in. Currently, it’s building a digital wallet for Calibra in Messenger and Whatsapp, which will become a standalone app in the future. However, Facebook isn’t alone in this venture.

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Libra is Facebook’s new cryptocurrency (Image credits: Lifehacker)

In his post, Zuckerberg shared that Facebook is joined by payment companies, those providing popular services, non-profits, and venture capitalists. Together, they form the Libra Association. This is a non-profit organization based in Switzerland.

What makes Libra different

At first glance, Libra looks like bitcoin and other cryptocurrencies. But it’s actually not like other cryptocurrencies. This is because the value of Libra is tied to real-world assets. Further, despite utilizing blockchain, it also has a central authority controlling its value.

It’s white paper states, “Unlike the majority of cryptocurrencies, Libra is fully backed by a reserve of real assets. A basket of bank deposits and short-term government securities will be held in the Libra Reserve for every Libra that is created, building trust in its intrinsic value.”

What is the Libra Reserve?

To understand what the means, we need to look at traditional money and its history. In the past, paper money got its value from gold or silver. In other words, you could convert paper money into a fixed amount of gold, which was actually valuable. This system was called the gold standard.

Libra | Facebook | Cryptocurrency
The Libra Reserve is a collection of assets to help ensure its value remains stable (Image credits: Mashable)

It should be noted that this is a simplification. The international monetary system went through many modifications like the Bretton Woods system. But even this system utilized the gold standard for the US dollar, which served as the world’s reserve currency. That is until the gold standard was completely abolished in the 1970s following the actions of the then US President Richard Nixon.

Libra follows this concept where your coins have value because they can be exchanged for cash. To make this possible is why the Libra Reserve exists.This is described as, “a collection of low-volatility assets, such as bank deposits and short-term government securities in currencies from stable and reputable central banks.” This is to tackle a clear problem with cryptocurrencies.

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Typical cryptocurrencies like Bitcoin have gone through massive price swings. Libra aims to avoid this with its Reserve (Image credits: Atomic Wallet)

We’ve seen the value of cryptocurrencies like Bitcoin and Ethereum go through massive swings in price. One day, these cryptocurrencies are worth thousands of dollars, only for the price to plunge the very next day. This is because the price of these cryptocurrencies has largely been driven by speculation.

This has been a major barrier in preventing cryptocurrencies from seeing mass adoption. As such, the purpose of the Libra Reserve is to help ensure the value of its coins remains stable. This is by ensuring that you can always exchange your coins for cash as with the gold standard.

The Libra Central Bank Association

Despite using blockchain like other cryptocurrencies, Libra has a governing central authority. This central authority figure is the Libra Association. Officially, it’s a non-profit and will be tasked with managing Libra through its reserve. Additionally, it will also work towards the widespread adoption of the cryptocurrency and its Move programming language. In other words, this organization will act as its Central Bank.

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Despite using blockchain, the Libra Association is the central authority that governs the cryptocurrency (Image credits: Techcrunch)

Its white paper elaborates on this saying, “The association is the only party able to create (mint) and destroy (burn) Libra. Coins are only minted when authorized resellers have purchased those coins from the association with fiat assets to fully back the new coins. Coins are only burned when the authorized resellers sell Libra coin to the association in exchange for the underlying assets.”

Traditional Central Banks also do the exact same task with traditional cash. As such, the Libra Association would wield a huge amount of power. So who controls it? The governing body of the organization is the Libra Association Council. The council is made of organizations from a number of industries.

Libra | Facebook | Cryptocurrency
The Founding Members of the Libra Association (Image credits: Techcrunch)

These initial members are known as Founding Members. To be a founding member, an organization has to invest $10 million into the project. This investment goes towards setting up a validator node for the Libra blockchain network. Each of these nodes will be tasked with validating Libra transactions.

In exchange for this investment, an organization gets 1 vote as a member of the Libra Association Council. Additionally, they’re also entitled to any interest from the assets of the Libra Reserve. Currently, the council is made up of a diverse set of companies. Some examples being PayPal, eBay, Uber, and Vodafone. You can find the full list of founding members here. Of course, that includes Facebook, which currently only has 1 vote like other founding members through its subsidiary Calibra.

The permissioned Libra blockchain

As you can tell by now, the Libra blockchain isn’t your typical cryptocurrency blockchain. This is an example of a permissioned blockchain. In such instances, only parties that meet certain criteria are admitted to a special in-group that defines consensus and controls the governance of the blockchain. However, this isn’t without its flaws.

Libra’s own website states, “permissionless systems have low barriers to entry and innovation, are resistant to censorship attacks, and encourage healthy competition among infrastructure providers.”

So why go with a permissioned blockchain? The statement also mentions, “The challenge is that as of today we do not believe that there is a proven solution that can deliver the scale, stability, and security needed to support billions of people and transactions across the globe through a permissionless network.”

At the time of writing, the Libra blockchain is only open for testing to developers. This developer preview also includes its Move programming language. This is a programming language designed to help implement custom transactions and smart contracts. However, both of these are still in testing and are expected to be operational only in 2020 towards launch.

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Every Libra transaction has a cost

Though as you dig through the developer documentation, you’ll find that not every Libra transaction is free. Every transaction has a price, which is defined as its Gas Price. The documentation states, “A gas unit is an abstract measurement of computation with no inherent real-world value.” In simple terms, gas is how much you’re willing to pay to use Libra.

Technology is easy. Economics? Not so much

Right now, you know the basics of how this new cryptocurrency works. But there’s still a lot of details missing. To understand those details, we need to take a look at the core problem this new cryptocurrency aims to solve. It’s best explained by this paragraph below from its white paper.

All over the world, people with less money pay more for financial services. Hard-earned income is eroded by fees, from remittances and wire costs to overdraft and ATM charges. Payday loans can charge annualized interest rates of 400 percent or more, and finance charges can be as high as $30 just to borrow $100. When people are asked why they remain on the fringe of the existing financial system, those who remain “unbanked” point to not having sufficient funds, high and unpredictable fees, banks being too far away, and lacking the necessary documentation.

The above can be summarized into 3 keys points as follows:

  • The poor pay more to access financial services
  • Migrant workers sending money back home have to pay a number of fees
  • Many remain unbanked for a number of reasons

Yet, if the cryptocurrency is to tackle this problem, there are many questions it needs to answer. Most of them aren’t really technical. In fact, technology might be the simplest part of the equation. As is the case with many fin-tech ventures, the issue lies in the non-technical side of the equation.

How do you tackle the web of regulations?

The Libra website states, “In the early development of the Libra network, it’s Founding Members are committed to working with authorities to shape a regulatory environment that encourages technological innovation while maintaining the highest standards of consumer protection.”

Facebook | Libra | Cryptocurrency
It wasn’t until they partnered with a local bank that PayHere was able to navigate through the web of regulations. Libra too will likely face similar obstacles everywhere

Trying to shape a regulatory environment to fit your needs is easier said than done. Further, when it comes to fin-tech, this can be a nightmare. For proof, one only needs to look at Sri Lanka. We’ve seen both PayPal and Stripe failing to enter the market due to regulatory inaction. Even local fin-tech startups like PayHere had to navigate a ton of red tape before they could operate.

Facebook and the rest of the Association can’t shy away from these stories. That problem of remittances fees it said it wants to solve? Sri Lankans are people that live with that problem. Sadly, the ugly truth is that these problems don’t have technical solutions.

Where are the banks?

If we look at the list of the Founding Members, we can see one party is missing. There are no banks. One could argue that it’s strange for a venture of this magnitude not to have any banks involved. After all, this isn’t merely about transferring money from one place to another.

Libra is an effort to build a currency. It’s a cryptocurrency. But strip away all the technical machinery like blockchain and Move, you have a normal currency. One that’s managed by a central authority (the Libra Association) and backed by a series of assets (the Libra Reserve) to ensure its value remains stable. It’s a bold gamble with high stakes.

How do you tackle economic challenges?

At the time of writing, there’s little we know about the reserve. As discussed above, it’ll consist of bank deposits and short-term government securities. The only extra detail the white paper adds is, “The assets in the Libra Reserve will be held by a geographically distributed network of custodians with investment-grade credit rating to provide both security and decentralization of the assets.”

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The gold standard was abolished for a number of reasons. One of them being the supply of gold couldn’t keep up with the required demand (Image credits: finra)

The promise of the reserve is that you can always exchange your coins for hard cash. Just like the old Gold Standard with the Bretton Woods system. Yet, it’s important to remember that we abolished this system. This decision was taken for a number of reasons.

But one important one was, as M.J. Stephey describes, “a decision made to prevent a run on Fort Knox, which contained only a third of the gold bullion necessary to cover the amount of dollars in foreign hands.” In other words, the demand for gold in exchange for US dollars, couldn’t keep up with the supply.

Facebook | Libra | Cryptocurrency
Libra aims to help the poor. But the cryptocurrency could hurt them if a population invests in it en masse (Image credits: Annettea Bena)

This is where the economics of Libra get messy. Assuming it sees widespread adoption, then it too could face the same problem. But this is only the beginning. One of the officially stated goals of the new cryptocurrency is to help the poor. Yet as Izabella Kaminska points out, “Except, ironically, the very act of encouraging people to invest in Libra en masse, may spark the sort of local currency depreciation that only worsens the load of poor people in the first instance.”

Another economic risk Izabella points out is foreign exchange manipulation, which is described with the example, “Libra accumulated by, say, Amazon against increasingly depreciated Amazon money would amount to a Libra/Amazon FX rate that benefited the Amazon economy.” Such actions are considered as competitive devaluations. These are rare in the real world as they can have deadly consequences.

Facebook | Libra | Cryptocurrency
Facebook and its partners may have addressed some of the problems of cryptocurrencies. But only by trading them for the complex economic problems of traditional cash (Image credits: Gazette Review)

Similarly, there’s also the risk of copycat currencies arising that are backed by Libra. Additionally, it could also become too expensive to manage the system. In its current form, all interest from the Reserve goes towards the Founding Members to help them manage the system. But as the system scales up, this may not always be feasible.

These are all problems that traditional currencies have faced. None of these are problems are technical. They’re economic problems. It’s true that the Reserve can help stabilize the cryptocurrency. But it also brings the complex problems of traditional currencies as well.

So should you be excited about this new cryptocurrency?

Probably not. Yes, this cryptocurrency is different. But right now that doesn’t necessarily mean it’s better. There are many questions that need to be answered before its launch in 2020. Some of these are technical. One of those being how your privacy will be protected while using it.

Sure, Mark Zuckerberg in his Facebook post said, “Any information you share with Calibra will be kept separate from information you share on Facebook.” Yet, the first versions of the Calibra wallet will be on Facebook Messenger and Whatsapp. By limiting itself to one vote on the Libra Council, Facebook has avoided additional scrutiny.

Facebook | Libra | Cryptocurrency
As always, everything Mark Zuckerberg touches becomes plagued with questions regarding privacy (Image credits: Vanity Fair)

But not all members are truly equal. Some will have more influence than others. Yet, the problem of privacy is a technical one. It’s also one that can be solved if Facebook decided to be serious about it. However, the real problems with its new cryptocurrency aren’t all technical.

The biggest challenges Libra faces are economic. Through its Reserve and Council, it addresses some of the existing problems with traditional cryptocurrencies. But its solutions merely trade these old problems for a set of fresh complex economic problems.

Thus, while it addresses the issues, Libra doesn’t necessarily solve them. Yes, it’s exciting that Facebook, Uber, and a number of other companies are launching their own cryptocurrency. But the economics of this new cryptocurrency still needs work. Will these issues be solved before its launch in 2020? Hopefully. But until then you’re probably better off not being too excited about Libra.

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