Cumberland Advisors Market Commentary – Libra and Other Cryptocurrencies
Congressional hearings this past week were the first of what are likely to be a number of investigations into Facebook’s proposed Libra cryptocurrency and associated Calibra wallet.
The initial reactions of legislators at the hearings ranged from a desire to support and encourage financial innovation to downright skepticism and hostility. Some of the questioners asked very pointed and perceptive questions, which Facebook’s David Marcus had difficulty addressing. One of the most telling revelations was that it was represented that Swiss regulatory authorities would provide oversight of Libra and Calibra, a spokesman for the principal Swiss agency that oversees data security said that it had not yet been contacted by Facebook representatives. That revelation was critical when it came to some congressional members’ willingness to accept Mr. Marcus’s representations as being credible.
Facebook has made a lot of claims of the potential benefits of the Libra innovation, but some were viewed by Congress as either questionable or highly optimistic. For example, Facebook claims that Libra and Calibra could potentially enable the 1.7 billion or so unbanked customers to have access to a payments system, but it isn’t clear how that might come about. It was pointed out in the hearings that about half the number of the world’s unbanked households are in only seven countries (Bangladesh, China, India, Indonesia, Mexico, Nigeria, and Pakistan). None of these countries are represented at this time in the consortium behind Libra, nor are any of those countries’ currencies included in the reserve fund designed to back the value of Libra. China, which is home to about 13% of the world’s unbanked residents, has even prohibited the use of cryptocurrencies by its citizens.
As was pointed out at the hearing on Wednesday, July 17, one of the reasons that people are unbanked is that they have little or no cash. But to use Libra, a person must have a smartphone and be able to buy Libra with cash. This means that the underbanked in the above six countries and elsewhere will presumably have to buy Libra in using their own domestic currencies, whose value may be uncertain. Moreover, it isn’t clear that local businesses or residents would accept Libra in payment for goods or services – unbanked people are not engaged in international trade, and counting on remittances to generate volume is optimistic. In fact there is a startup and scale issue on a country by country basis that hasn’t yet been addressed by Libra advocates. To this point, the Libra white paper is silent on how currency conversions would take place into and then out of Libra when the currency involved is not one in the reserve, or how the exchange rates would be determined.
Mr. Marcus stated that Libra will be backed by a basket of financial assets, predominantly denominated in dollars, euros, and Japanese yen, thus ensuring its stability; but there was no discussion of how funds paid into the Libra system that are not denominated in the reserve currencies will be handled and/or valued. Will redemptions take place at the rate initially paid or at the current market rate at the time of redemption? If the former, then users in countries with high inflation will quickly realize that they have experienced significant losses in real value and will back away.
As part of the House hearings, there was an excellent follow-up panel of experts – mainly academic lawyers – who raised a number of interesting issues concerning the Libra/Calibra proposal. First, it was argued that the reserve backup structure was subject to potential runs on the reserve assets that could threaten the fund’s stability and ability to convert Libra back into local currencies. Second, because the assets constituting the reserves were either government-guaranteed or federally insured, the Libra reserve was essentially free-riding on government guarantees should the stability of the reserve’s assets be threatened. Third, it was pointed out that the reserve was essentially an investment vehicle generating returns and profits that would be paid to initial investors in the Libra investment tokens, which are essentially securities. The investment vehicle would be a closed and centrally controlled vehicle owned by a group of large corporations and private entities. Fourth, because of the international nature of the proposed Libra structure, no one regulatory body could determine or regulate the rules of operation when it came to knowledge of customers, data privacy, or prudential operators. Furthermore, since other entities and exchanges could be layered on top of the Libra structure, the ability to monitor how those entities might impact customers, data privacy, or system vulnerabilities to hacking and cybersecurity risks could be compromised. In short, the systemic issues raised were analogous to the problems that the government faced when money-market mutual funds broke the buck during the Great Recession and the Federal Reserve intervened to provide emergency liquidity. Finally, at the hearings it was noted that the terms and conditions of the Libra operations are subject to change at any time.
One of the experts who testified, Meltem Demirors, went so far as to argue that Libra was not really a cryptocurrency at all, for several reasons. She noted that it was a closed and centralized system, not an open and decentralized system like Bitcoin, as one example. Libra was designed to be collateralized, unlike other cryptocurrencies that are uncollateralized assets. Investors in the Libra structure receive investment returns, unlike holders of other cryptocurrencies, which offer no such returns. The Libra system also has custodial risk, unlike Bitcoin, for example. Her criticisms, along with those of the other experts who were on the House panel, deserve careful consideration.
Another focus of the hearings concerned where US regulation and oversight would fit in. Since Libra and Calibra would be operated out of cryptocurrency-friendly Switzerland, it isn’t clear how US regulations would apply or how oversight would take place. The assertion (or hope) was that the business and wallets constructed upon Libra would be regulated in the countries in which they were domiciled, but that is just conjecture. The hearings clearly raised many issues and offered few answers.
For those who want to learn more about cryptocurrencies, how they have worked or not worked so far, how they have facilitated criminal activity, and where the key systemic risks are located, we highly recommend the recent statement put out by the Financial Economist Roundtable (FER), a group of nationally and internationally known finance professors and economists. The FER met and considered the issues surrounding cryptocurrencies last year and published their findings, entitled “Crypto Assets Require Better Regulation,” and their report was published in the Financial Analyst Journal and can be accessed online.
FER make several key points, some of which are summarized below, but we recommend the full report (only six pages), which contains a useful summary of the experience with cryptocurrencies to date and offers some good references for those who might want to dig deeper. Here are some of the key points in the report:
- While there may be some potential benefits from cryptocurrencies, and more specifically from the blockchain technology, there are significant risks and costs including use in illegal activities, the illusion of anonymity (the Libra/Calibra model is clearly not anonymous), vulnerability to hacking and theft, and price manipulation.
- Since cryptocurrency models are designed to work across national borders, no one regulator or set of national rules and regulations for privacy and consumer protections can work. The significance of this point seems to have been lost in the House and Senate hearings.
- All cryptocurrencies ultimately need exchanges to work efficiently. To date, exchanges are where the key cryptocurrency vulnerabilities have existed and where most of the hacking, fraud and losses have taken place. Again, the challenge requires an international solution, not merely individual-country regulation.
- Because of the risks, some countries, such as China, have actually banned cryptocurrencies.
FER made several policy recommendations designed to address some of the key concerns but at the same time to allow the experiment to continue.
- In the US, uncertainty exists as to whether cryptocurrencies are securities or commodities, what the tax status of returns earned in cryptocurrencies is, and these issues need to be addressed. The uncertain treatment of cryptocurrencies was highlighted in the hearings as one of the reasons Facebook chose to operate Libra out of Switzerland.
- The exchanges facilitating the conversion between cryptocurrencies and fiat currencies should employ cutting-edge security protections and should be subject to minimum capital requirements.
- Policies should ensure that crypto asset exchanges provide regulator tax reports to regulators and clients that describe all trading activity, like the reports required of US brokers and money market funds via IRS form 1099-B. Such reports would help law enforcement and discourage money laundering.
There is a lot to digest as the world explores the potential of blockchain technologies, and it is appropriate that the approach that Chairman Powell suggested during his testimony on monetary policy that Congress should pursue a cautious deliberation and not a sprint to implementation.
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