Mass adoption or massive flop?
The modern financial system is in many ways remarkable. With a few flutters of your fingers, you can open a bank account, pay bills, apply for credit, transfer money, or buy a stock. However, this system does not serve everyone. There are 1.7bn unbanked people globally who disproportionately bear high costs for basic financial services. On average, transferring money internationally costs 7% (or higher for less common currencies). Many unbanked live in countries whose economies and currencies are highly unstable.
We deserve a more inclusive financial ecosystem, and (perhaps) surprisingly, Facebook wants to be the one to provide it. On June 18, 2019, Facebook announced Libra, a blockchain-based payment network expected to launch in 2020 that Facebook believes can lower cross-border costs and bring basic financial services to millions of underserved people globally.
If just 15% of Facebook’s 2.4bn global users adopt Libra, it will be more widely used than the U.S. dollar.
On the surface, society should embrace this ambitious mission. Consumers in developed countries need not object: most are more than adequately served by fast and secure credit cards (which provide attractive rewards), checking and savings accounts (which pay interest and are federally insured), and digital payments systems such as PayPal or WeChat Pay and Alipay in China.
However, consumers are understandably wary about concentrating more power in the hands of a company that has squandered public trust through its privacy practices (though Facebook has promised not to intermingle financial and social data), and already officials are voicing concern about systemic risks that Libra could pose to the existing monetary system.
So, will Libra cause a financial revolution?
Instead of upending the global financial system, the more likely outcome is that Libra becomes one among many services — current and future — that help address the world’s financial needs.
Libra faces enormous challenges to drive adoption, not least of which are:
- The acquisition of government licenses,
- The costs of incentives for merchants and users to adopt Libra,
- Fees that third-party wallets might impose (which could erode any savings), and
- The problem of how unbanked users will convert Libra to physical cash.
If Libra does reach mega-scale, it will clash with governments and central banks who could sense a threat to their monetary sovereignty or financial stability. Still, it would be a shame for governments and consumers to wholly reject Libra, which also has the potential to deliver significant value to the 1.7bn unbanked around the world and the 266m migrants who will collectively send $550bn back home in 2019.
To understand what Libra could become, we must explore what Libra actually is, its potential benefits and risks, and how it compares to the many existing payment networks.
How does Libra work?
In the most basic terms, Libra is a securitized digital (“crypto”) currency that aims to enable global payments with near-zero fees.
Facebook is driving the initiative and wrote the code for the open-source blockchain that will underpin the network. However, given that trust in Facebook has dropped by 66% since the Cambridge Analytica scandal, Facebook strategically chose to decentralize control of Libra. Instead, Libra will be managed by the Libra Association, a newly-created consortium of big firms and investors, of which Facebook will be just one node. For Facebook, this strategy has the convenient benefit of broadening Libra’s potential reach to outside the Facebook ecosystem while offloading regulatory and administrative burdens to the Association.
The Libra network will consist of several key components:
- The Libra currency — Whenever a user buys Libra with a dollar, that dollar goes into a reserve fund called the Libra Reserve, and an equivalent value of Libra is created and given to that user, which they hold in a digital “wallet” (such as Facebook’s own Calibra). Consumers will be able to transfer money, make purchases from participating merchants, and cash in their Libra at any point. Every Libra will be collateralized by the Libra Reserve, which will be invested in a basket of low-risk assets denominated in stable currencies (dollars, euros, etc.) to minimize volatility in the value of Libra. The resulting Libra cryptocurrency is known as a “stablecoin”, as opposed to other cryptocurrencies such as Bitcoin, which is unsecuritized, extremely volatile and therefore appeals mainly to crypto evangelists and speculators (only 1% of Bitcoin transactions are used for actual payments).
- The Libra blockchain — In its “purest” form, a blockchain is an anonymous and fully-decentralized public ledger that relies entirely on the participants in the network to validate the transactions (a process known as “proof-of-work”), theoretically removing the need for a trusted intermediary such as a bank or credit card company. This decentralization, however, requires a tradeoff in efficiency. Bitcoin requires huge computational resources and energy for the network to come to a validation consensus. As a result, Bitcoin can handle only 7 transactions per second, while Visa can process tens of thousands. Facebook claims Libra will be able to handle up to 1,000 transactions per second by relaxing some of the constraints that make Bitcoin so inefficient. Instead of full decentralization, the Libra blockchain will be federalized (or “permissioned”) among the Libra Association members, who will validate Libra transactions and govern the blockchain. Though users will have to trust this consortium, eliminating the costly proof-of-work system can drastically increase throughput, reducing processing costs and necessary fees.
- Libra Association — Facebook announced 28 founding members of the Libra Association, including Visa, Mastercard, PayPal, Spotify, Lyft, and others, with the goal of reaching 100 members by Libra’s launch in 2020. In addition to validating Libra transactions, members of the newly created Swiss nonprofit will be responsible for electing a managing director, funding a kitty to incentivize merchant and individual adoption (minimum $10m investment), and recruiting more founding members to stimulate the ecosystem. Members will manage the Libra Reserve and receive a proportionate share of the interest earned on the funds that keep the Libra’s value stable, after expenses. The Libra Association investments will presumably also be used to incentivize partners and developers to “pull” customers through regulatory compliance processes such as Know-Your-Customer and Anti-Money-Laundering, which could add additional friction for users but also reduce fraud relative to other cryptocurrencies (hackers stole $1.7bn in crypto in 2018).
- Calibra/wallets — While anyone will be able to build wallets — or even smart contract apps — on the open-source Libra blockchain, Facebook took the liberty of building its own wallet to support payments and money transfers on its WhatsApp and Messenger apps, aiming to drive Libra adoption through its massive network of 2.4bn users. As such, Facebook will have a distinct first-mover advantage in monetizing Libra, and will have the ability down the road to offer additional financial services through Calibra (e.g., loans or investments) as WeChat and Alibaba have done so successfully in China.
Libra vs. Other Payment Networks
The global payments industry endures extremely high and increasing competition and regulatory scrutiny, especially as economic activity shifts online.
Libra will have to compete against every other form of payment, including credit and debit cards, bank account transfers, digital payment services such as PayPal or China’s WeChat Pay, remittance providers such as Western Union, other digital currencies, and offline payment methods such as checks and cash (which still accounts for 40% of U.S. transactions).
These myriad payment forms evolved to serve a wide range of use cases, customers, and geographies. Many firms are enormous and systemically important. So why does the world need Libra?
The most immediate addressable market for Libra seems to be in international remittances, an industry with fees averaging 7% and costing expatriates $50bn each year.
The permissioned Libra blockchain could bridge the gap between centralized systems like PayPal — which is used by 277m people globally but carries high international fees — and decentralized systems like Bitcoin — whose token is highly volatile and therefore undesirable for purposes other than speculation.
However, it remains unclear how Libra will connect the two “legs” of an international transaction, since at least one leg typically involves cash. Money transfer giant Western Union boasts an expensive network of 500,000 physical sites around the world from which users can send or pick up cash.
Scenarios & Implications
The risk-reward profile for Libra ultimately depends on its future level of adoption. Consider the following scenarios: 1) mass adoption, 2) flops or never launches, or 3) somewhere in between.
1) Mass Adoption
For the sake of analysis, pretend Libra becomes widely adopted and displaces much of the existing payments ecosystem. It not only makes remittances easier for the 266m expatriates globally, but a huge portion of Facebook’s 2.4bn users use Libra for everyday transactions with their smart devices. The Libra Association will have had to recruit hundreds of members (likely including banks, of which there are currently zero members) to contribute billions of dollars in funding to incentivize merchants and consumers to use Libra.
This extreme scenario is, in my view, the least likely outcome, due primarily to two constraints.
- First, Libra will run into stiff competition with the incumbent financial system in advanced nations. Credit cards are widely used because they offer convenience, rewards, and access to unsecuritized credit for their users. Consumers enjoy bank accounts that pay interest and offer federal insurance. WeChat Pay is used by 900m Chinese because everyone already communicates with WeChat, and transaction fees are <0.1%. Libra is unlikely to wholly overwhelm services that provide genuine value for billions of people.
- Second, for Libra to hit critical scale, it will have to overcome collisions with policymakers and central bankers over economic influence. Nations with less stable economies and currencies — whose consumers might actually be better served by Libra — are likely to react strongly against a threat to their financial sovereignty. Furthermore, global adoption will be limited due to government restrictions in China and India, together home to 37% of the world’s population. Facebook and most Western social media networks are forbidden in China, which has already banned cryptocurrency trading and initial coin offerings. Due to India’s increasing hostility to Western tech powers and to cryptocurrencies in particular, Facebook has already confirmed that Calibra will not launch in India.
2) Flops or Never Launches
Now consider the opposite extreme. As of now, Libra is just a whitepaper and test code backed by a group of big firms who have made only provisional commitments (i.e., no one has actually written a $10m check). Trust in Facebook has declined sharply, and officials from the U.S., Europe, and elsewhere swiftly responded with concerns of systemic risks that a dominant Libra ecosystem could pose. There are no precedents for a mainstream application of blockchain technology; expect regulators to err on the side of caution.
Libra’s adoption will be predicated on amicable relations with policymakers and regulatory bodies around the world. A suite of nations may obstruct or delay the launch of Libra, whether to cautiously give more time to assess it or to flat-out forbid it.
Still, it seems highly unlikely that Libra is widely banned before it even hits the market. Libra has a legitimate value proposition — to enable the 266m global expats and their families to keep more of what they make — and it would be a shame (and unlikely consensus) for most or all countries to outright reject a system that could serve a legitimate job for those who need it most. Officials will have to justify why they are deliberately limiting competition for financial services and potentially depriving their citizens of a more inclusive financial system.
3) Somewhere In Between
Given the challenges with each of the extreme scenarios, the most likely outcome for Libra is somewhere in the middle.
Libra could address several pain points for global consumers, especially for the world’s 1.7bn unbanked. Libra could make a dent in reducing global remittance costs. It could serve as another payment option for digital and brick-and-mortar retailers to reduce the burden of credit card fees. It is possible that developers build “smart contract” apps on top of Libra that widen its potential use cases.
However, Libra’s ultimate reach will be capped due to the plethora of alternatives in advanced nations like the U.S., broad distrust of Facebook, and the likely exclusion of China and India. Libra’s launch could be delayed beyond 2020, and adoption could be far slower than Facebook would like to admit.
Libra will not replace traditional currencies, but it could be a valuable alternative for the historically underserved. Libra will also serve as a critical test case for the mainstream application of blockchain technology, signaling either a watershed for innovation, or that expectations had already peaked.