Cryptocurrency enthusiasts have always erred in identifying modern money: they have never appreciated the fundamental difference between a token and a promissory note. A token is not a promise to pay something; it merely represents something else in a more convenient form. Rather than carry your coat around with you in a restaurant, you keep it at the door and get a numbered token. Your coat token is not a promise to return any coat on demand; it represents your particular coat. Facebook’s proposed cryptocurrency plays on this confusion between a token and a promise; one might even say it weaponises it. After all, the business of issuing promissory notes that function as money is called banking. Libra is a banking venture dressed up in cryptography.

Facebook claims that Libra coins will be “fully backed” by a set of “reserve” assets. This backing makes Libra a “stable coin” and gives it the ring of a token representing some real asset. But this is plain misdirection. For “backing”, we should read “promising”. To see how this works, think of an old-fashioned money market mutual fund (MMMF) that promises to preserve its net asset value at $1 (promising not to “break the buck”). Like MMMF units, Libra coins are liabilities whose value is derived from the other side of the reserve’s balance sheet: key currency treasury bonds. Libra is therefore a “derivative”: it derives its value from an underlying asset. It has no “intrinsic value”.

Terms like “fully backed” and “intrinsic value” invoke the token idea: one token for one particular coat. Unlike MMMFs, Facebook promises that “it will be possible to convert coins back to fiat at a narrow spread above or below their current value”. Why this spread? The answer is simple: to withdraw your money from the Libra “bank”, the reserve will have to undertake a market transaction to liquidate some assets. A market maker called an “authorised reseller” stands ready to undertake this transaction, and there has to be something in it for the reseller: this is the spread. This is familiar to us from the operations of MMMFs.

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Economist Perry Mehrling has shown us how MMMFs and banks share the same internal logic: that of a securities dealer making a spread. Banks have checking accounts whose “units” they promise to maintain at par (law mandates their spread is 0) with a particular underlying asset: central bank liabilities or “high-powered money”. Banks have a fractional reserve so they are not “fully backed” (most of their assets are illiquid), but this is a difference of degree and not kind. How good your promise is might depend on how large your reserve is (fractional or 100%), but the fact remains that whether it is checking accounts, MMMF units, or Libra coins, it is a promise, not a token.

Authorised resellers make a market between money and Libra for a spread. The entire system is based on the ability of these Libra “primary dealers” to ensure liquidity in the currency-to-Libra market, just as the MMMF ecosystem is based on market making between units and the underlying treasuries, and just as banking is predicated on making a market between checking accounts and central bank money.

So here’s the punchline. If Facebook’s “stable coin” is an MMMF backed by short-term forex assets attached to a blockchain, and MMMFs are shadow banks, then Libra is pitching to be a shadow bank with a blockchain payments system.

Banks make promises, MMMFs make promises, and it looks like Facebook is making promises too. MMMFs are explicit about their promises in committing not to break the buck; banks hide behind the false impression that they are cash warehouses rather than dealers in liquidity with central bank backstopping; Facebook is hiding behind the idea of the token. The structure of Libra suggests that it is a banking model, albeit a very conservative one. It this conservatism just an opening gambit? Will it follow the path of MMMFs, which became too big to fail and therefore had to be backstopped?

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In Bitcoin, the distribution of updating rights to those nodes doing some computational work led to massive mining rigs and super slow transaction times. Recognising this “tradeoff between decentralization and performance,” Libra distributes updating rights oligopolistically to a closed group of “validators”. This, of course, violates the spirit and logic of a decentralised ledger: what is to stop these validators from subverting the ledger any more than a state in control of “fiat money”?

But it is the introduction of intermediaries that is most bank-like. Users of Libra will not interact directly with the reserve, but with authorised resellers and/or exchanges. As more cash is deposited in the reserve, more coins will be “minted”; with withdrawals, coins are “burned.” This vocabulary is again a neat little piece of misdirection: these are just ledger entries for assets/liabilities that are being created and destroyed, as with operations in any MMMF or bank.

Treasury bond markets in key currencies are the most deep and liquid markets in the world, so basing a currency on them might seem like a good idea. But history shows that even the most liquid markets can dry up in a crisis so you had better have access to central bank liquidity backstops. Facebook acknowledges this backhandedly when it says “any Libra coin [users] hold can be sold for fiat currency at a narrow spread above or below the value of the underlying reserve, when a competitive market for exchanges is present” (italics added).

When market liquidity disappears, you need a backstop. But if you have one, you’re already a bank. The most conservative strategies of the best US MMMFs failed in the 2008 crisis because the underlying market making structure, being essentially based on the liquidity of promises, collapsed and had to be backstopped by the ultimate market maker, the state’s bank.

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In mimiciking MMMFs, Libra replicates their moral hazard: the MMMFs became too big to fail and many were bailed out. Central bankers wished they had followed the logic that if it looks like a duck, walks like a duck, it’s a duck (bank). They should not make the same mistake with Libra.

Anush Kapadia is faculty member at the Indian Institute of Technology Bombay in the humanities and social sciences department

These are the author’s personal views

First Published:
Aug 22, 2019 16:25 IST



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