Zuckerberg: The man who would be monetary king

This is just one of a series of Alphaville posts on Libra coin, which we are calling Breaking the Zuck Buck, in which we will seek to show how nonsensical, pointless, stupid, risky, badly thought-out and blockchainless the whole thing is.

Facebook has just announced the full details of its Libra cryptocurrency venture, including details of the founder members of the Libra Association, among them Visa, Mastercard, Uber and Spotify. Its mission, it says, is to make payments cheaper and more accessible.

Whether we can trust them about that is another matter.

Libra could be a social-good venture aimed at “empowering billions of people through the creation of a simple global currency and financial infrastructure” but then again — from the details revealed — it could also be an attempt to gain control of the money supply by a corporation most people think already has more power than it should.

As usual, the truth depends on how things are framed.

But in this post, we're going to argue Libra is nothing more than a brazen attempt to override national monetary sovereignty by creating a global-scale Federal Reserve equivalent — within which Facebook's dominance is veiled by the cunning use of buzzwords like blockchain, DLT, decentralisation and cryptocurrency.

But the Fed is a private organisation too!

A conspiracy theory often circulated by advocates of a return to a gold standard is that you can’t trust the Federal Reserve because it’s actually a private organisation. Or to be more precise, a private organisation structurally dominated by one particular founder bank (JPMorgan). But central banking advocates would argue that’s no conspiracy: the private nature of the Fed was baked into the system by design. The intent was always to create an independent central banking system that ran separate to the state on the basis that government-issued bond systems had failed to achieve monetary stability.

In the years leading up to the Fed’s creation in 1913, the financial thought-leaders pushing the plan were more than aware of the monopolistic implications of such ideas. Unsurprisingly, they were primed for public opposition as a result.

This is why, just like Facebook, they worked in secret (on Jeckyll Island, no less) when trying to establish the key principles of the organisation.

The core components of the plan were hatched by Nelson Aldrich, a Republican, who had been responsible for the creation of the National Monetary Commission in the wake of the panic of 1907.

After reviewing the system, Aldrich became convinced monetary instability related to the system's inelasticity, something which could only be solved by the creation of a private central banking institution. Together with the key bankers of the day, notably JPMorgan, Rockefeller and Kuhn, Loeb & Co, the group proposed the creation of the National Reserve Association, to be capitalised to the tune of $100m by the respective bank members and controlled by the member banks on the basis of their respective capitalisation shares.

Critically, as the Wikipedia page about the history of the Fed notes, the Association would issue currency backed by gold and commercial paper that would be the liability of the bank and not of the government. The government’s only role would be via representation on the board of directors. This proposal became known as the “Aldrich Plan” but was soon also dubbed “The Wall Street Plan”.

As anticipated, when finally revealed, presidential candidate Woodrow Wilson — and the Democrats in general, including Roosevelt — denounced the plan as a scheme “to place the currency and credit system of the United States in private hands not subject to effective public control”.

The cynical view that the association would be run by the incumbent elites and business tycoons of the era — who already posed antitrust concerns in the market — became widespread. In some quarters the plan was even seen as symptomatic of just how much power the Trusts had accumulated over the government. (An echo of the antitrust criticism facing Facebook today.)

In 1984 a San Francisco Fed research paper observed the following about the beginnings:

Criticisms of the Aldrich Plan centred on the highly centralised and privately controlled structure of the National Reserve Association, including the procedures by which its directors (and those of its proposed 15 branches and local associations) would be elected. Those procedures tended to place voting control in the hands of the larger banks because votes were based, in part, on the number of shares of stocks that banks held in the Association.

To get the bill through Congress, the architects knew they would have to convert more democrats to their way of thinking. They began a PR offensive and started to offer some concessions.

Eventually the bill passed, but only after both sides agreed to greater decentralisation within the voting committee, including better oversight of the private entities via an executive arm comprising a government representative. It was the promise of more decentralisation, in other words, that eventually did the trick. Something the architects of Libra seem to have paid close attention to.

Fast forward to 2019 and there are eerily similarities with the global digital reserve system that Facebook’s Libra is attempting to engineer.

There are only two major differences. This time round, no governing body is being asked to approve the scheme via a democratic process — even though the scheme undermines state seigniorage power to the same, if not a greater, degree. Second, blockchain magic is replacing decentralised organisation as the check on private power — even if in all distributional respects it effectively amounts to the same thing.

As Libra’s white paper notes (our emphasis):

The association is designed to facilitate the operation of the Libra Blockchain; to co-ordinate the agreement among its stakeholders — the network’s validator nodes — in their pursuit to promote, develop, and expand the network, and to manage the reserve. The association is governed by the Libra Association Council, which is comprised of one representative per validator node. Together, they make decisions on the governance of the network and reserve. Initially, this group consists of the Founding Members businesses, non-profit and multilateral organizations, and academic institutions from around the world. All decisions are brought to the council, and major policy or technical decisions require the consent of two-thirds of the votes, the same supermajority of the network required in the BFT consensus protocol.

But the analogies with the Fed don’t stop there.

  • Like the Fed, the Libra system has been created in the name of lowering the costs and frictions of cross jurisdiction payments (in the Fed's case, the system was brought about to streamline check clearance across the nation's varying states and lower costs in the process).

  • Like the Fed, the Libra Association will be the only entity capable of creating or destroying its own currency.

  • Like the Fed, the Libra Association will only deal with its own network of authorised resellers (its equivalent of the Primary Dealer network).

  • Like the Fed, the Libra Association will have a minimum requirement for the type of assets it accepts from dealers in exchange for “cash reserve” creation. Currently that constitutes bank deposits (and it's worth asking which banks might be doing the servicing here) and high quality government securities.

  • Like the Fed, the Libra money supply will be managed via the purchase and sale of other assets through the authorised dealer network, who in turn will be able to pocket significant arbitrage windfalls from servicing Libra.

  • Like the Fed, the Libra Reserve intends to act as a “buyer of last resort” for its own currency and — presumably — will also be prepared to lower the quality of the assets it purchases in the event of a Libra coin liquidity crisis.

  • Like the Fed structure, the general public can only access the “global currency” through third-parties or exchanges.

  • Like the Fed, the Libra system plans to use interest rates arbitrage to reward incentivise members (see our SDR post for more on that). Currently that means funding operational costs and dividends to founder members by retaining interest earned on customer deposits — a model PayPal also went for in its early days, before it transpired it would need additional licensing to operate in that way legally.

Unlike the Fed, the Libra system plans to operate as a full-reserve system meaning its reserve requirements will always be 100 per cent. The model is based on a Hong-Kong style currency board, rather than a challenger central bank system, in the hope of avoiding bank runs.

Except . . . Libra already provides caveats that could introduce risk over time. For example, they note that in the event of exceptional circumstances a supermajority vote could allow for the composition of the basket to change. In the case of currency board crises, risks are often linked to the market wrongly anticipating how a board may or may not act to fend off a liquidity crisis in its underlying assets.

Libra equally fails to acknowledge that even fully backed reserve funds — such as Reserve Primary Fund during the 2008 — can experience dramatic fluctuations in the relative pricing of reserves to issued units during liquidity crises. Nor does it acknowledge risks can be thrust upon a fully-backed system via fractioning further down the shadow banking chain.

So what could possibly go wrong?

Answer: A lot. Or at least everything that has already gone wrong for the Fed, plus much more.

A good place to start are some of the issues the Fed architects themselves failed to anticipate:

  1. Gaining membership was not as easy as anticipated. In the end, it took another act of state — the 1980 Money Control Act — to compel all banking institutions to become members of the Federal Reserve system. The act itself was in part brought in to assuage fears that the propagation of the eurodollar markets was leading to the Fed losing control over meaningful monetary aggregates. By applying regulations to all banks equally, there was no longer any reason not to be a member bank. Unless Facebook's Libra has government and enforcement on side, it's hard to imagine how it can compel competitors to sign up.

  2. The Fed's control of the money supply would be significantly undermined by the eurodollar markets, which allowed copycat dollars to be created in huge — often not fully reserved — sums offshore. These offshore equivalents were tethered into the core system via correspondent bank agreements. Libra might think it will be able to control its system, but in reality it will be hard for it to stop a third party in a lighter-touch jurisdiction from using Libra reserves to issue its own Libra-pegged liabilities (which may or may not be fully reserved and may or may not operate to the same KYC/AML standards).

  3. The liquidity of the underlying reserve assets and respective par redemption promises could not be guaranteed — especially when economic flows diverged from the make-up of the constituent reserves.

  4. FX manipulation risk and competitive devaluation arose in the shape of third parties hoarding rather than spending their dollar reserves, so that their own currencies be strategically depreciated versus the value of the underlying reserves. (Libra accumulated by, say, Amazon against increasingly depreciated Amazon money would amount to a Libra/Amazon FX rate that benefited the Amazon economy. )

  5. The cost of managing the system might be greater than the fees raised from members or seigniorage extracted from the system. In the Fed's example, the government was called upon to finance the difference on the condition any unexpected profits would always be transferred back to the government. In the Libra scenario, there is no such government backstop. If income earned from interest is insufficient to cover the costs (a likely scenario in a low rate environment), the system would have to urgently locate other sources of “benevolent” funding to finance the system.

Managing a pegged monetary reserve system isn't all that easy.

Related links:
Will fintechs sink or swim when floats are regulated?
— FT Alphaville
Tencent and Alipay set to lose $1bn in revenue from payment rules — FT
Float management isn’t easy
— FT Alphaville
Is it a bank, a money transmitter, or a Silicon Valley shadow financier? No, it’s just PayPal!
— FT Alphaville
The Chinese MMF that came in from the cold
— FT Alphaville
Crypto fiat coin confusion
— FT Alphaville

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