No Sandbox for Libra

By Gerald P. Dwyer

The introduction of the cryptocurrency Libra by Facebook has been accompanied by some strong statements. In a recent radio interview, for example, the French finance minister said the Libra “must not and cannot become … a sovereign currency.” His assertion has been widely reported, even though it is silly. “Sovereign” means “government.” And, barring some rather-surprising developments, it is unlikely that Facebook or the other firms behind Libra will become governments. What he meant, perhaps, is that Libra should not become as important a currency as government monies.

With only a difference in emphasis, Bank of England Governor Mark Carney said, in reference to Libra, “Anything that works in this world will become instantly systemic and has to be subject to the highest standards of regulation.” Presumably, missing context transforms the first part of the sentence — “Anything that works in this world will become instantly systemic ….” — into something sensible.

Mark Zuckerberg has been summoned to Washington to appear before Senate and House committees to testify about Libra.

This is quite in contrast to the approach taken by most governments to similar financial developments. With due allowance for current law, governments generally have taken a hands-off approach to cryptocurrency and other firms involved in financial innovation — FinTech. 

FinTech firms are allowed to operate in a “sandbox” without particular regulation of their activities. For example, cryptocurrency exchanges were subjected to basic money-laundering regulation only after they achieved some scale. They still are not subject to the level of regulation applied to the organized exchanges such as the New York Stock Exchange.

Libra was introduced by Facebook, which has become a whipping boy for many. Columnist Peggy Noonan — normally quite reserved — described Mark Zuckerberg as an “imperious twerp” in an article titled “Overthrow the Prince of Facebook.”

The lack of a sandbox for Libra could be due to its introduction by a very big, not-very-popular firm with an unpopular chief executive officer. It also may be due to a forecast that Libra could become important quickly.

Libra could become successful, but there are acknowledged technical issues that must be resolved for that success to happen, and they will take time.

There is a lot of useful information in the Libra white paper and associated technical documents. The following is based on a reading of some technical documents underlying Libra and on scanning some of the other, even more technical documents.

Libra is far from a clone of Bitcoin. Initially, Libra is governed by a consortium of large firms including Facebook with a claim of no special place for Facebook itself. That said, much of the technical work on Libra has occurred in Calibra, a subsidiary of Facebook. It seems likely that Calibra will have an important role.

Libra is a “stable value” cryptocurrency. Bitcoin’s price fluctuates in a way that makes it currently unusable as a store of value, an important aspect of a useful money. Libra proposes to maintain a stable value by holding a basket of government securities from the least-risky governments in the world. The value would not be perfectly constant because Libra would be holding securities in different currencies and exchange rates fluctuate. 

Leaving currency risk aside, Libra would be similar to a money market fund in the United States holding government securities. Such funds cannot legally promise to redeem a dollar investment for a dollar, but they do in practice. They have very stable values. Redemption with Libra would be different from redemption with a money market fund, but the economics of this aspect of Libra’s operation are similar. Libra would be different because the Libras would be transferable. Investments in a money market fund are not.

The central innovation in Bitcoin was the blockchain; Bitcoin’s blockchain distinguishes it from prior attempts to create electronic currency. The Bitcoin blockchain keeps track of transactions in a secure way and is updated to reflect new transactions. This blockchain is what is called “permissionless.” Anyone can add new transactions to the blockchain — no permission by some central authority is needed to participate. The details of the blockchain are somewhat complicated, but they are not necessary for understanding what follows.

The Libra blockchain will be “permissioned,” at least initially. Only designated participants are allowed to add transactions. It is assumed that all participants have an incentive to add only valid transactions. As with Bitcoin’s blockchain, cryptographic tools make it possible to prevent participants from changing past transactions. The blockchain is designed to be updated in real time, with no lag of 10 minutes as in Bitcoin. In addition, it appears to be scalable in a way that Bitcoin currently is not. Far more transactions could be processed in 10 minutes than are possible with Bitcoin currently.

If that were Libra’s only claims, it seems unlikely that Libra would be successful. Visa and MasterCard would have little incentive to participate in a competing venture so similar to their core businesses.

The proposal includes statements that Libra proposes to become “permissionless” over time. This is the big innovation, if it occurs. But it will require the solution of a serious technical problem that has eluded solution so far.

If anyone can anonymously add transactions to a chain of transactions, what is to prevent them from adding invalid transactions? Even silly ones? There has to be a stake that makes it costly to add invalid transactions. The mechanism used in Bitcoin is called “proof of work.” The stake is the computational effort to solve a cryptographic problem and its solution. The other proposed mechanism to date is “proof of stake,” which means that participation requires ownership of the cryptocurrency. Less is known about its possible usefulness. Especially at the worldwide scale envisaged by Libra, serious assurance will be necessary to move away from a permissioned blockchain.

That is not to say that permissionless blockchains based on something other than proof of work won’t happen. They may well, whether or not Libra debuts or is successful. And they may not.

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Gerald P. Dwyer

Gerald P. Dwyer is a Professor and BB&T Scholar at Clemson University. From 1997 to 2012, he served as Director of the Center for Financial Innovation and Stability and Vice President at the Federal Reserve Bank of Atlanta. Dwyer’s research has appeared in leading economics and finance journals, as well as publications by the Federal Reserve Banks of Atlanta and St. Louis. He serves on the editorial boards of the Journal of Financial Stability, Economic Inquiry, and Finance Research Letters. He is a past President and member of the Executive Committee of the Association of Private Enterprise Education. He is also a founding member of the Society for Nonlinear Dynamics and Econometrics, an organization for which he served as President and Treasurer.

Dwyer earned his Ph.D. in Economics at the University of Chicago, his M.A. in Economics at the University of Tennessee, and his B.B.A. in Business, Government, and Society at the University of Washington.