What exactly is Facebook's Libra Reserve?

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.

Some are comparing Facebook's Libra Reserve scheme, which will back the tech giant's new digital coin Libra, to the IMF's Special Drawing Right (SDR) system. This makes sense. The SDR is the digital “paper gold” system the IMF created in 1969 to help balance international payments and prevent national liquidity or debt crises from destabilising the global economy. It's based on a basket of currencies just like Libra intends to be when it is launched next year.

But the truth is Libra is anything but an SDR system.

First off, the IMF always intended the SDR to be a “supplementary” reserve asset that acts not as a currency or a liability of the IMF, but as a claim to the currencies held by IMF member countries for which SDRs can be exchanged. That means, unlike Libra, it is not backed by a physical reserve of fully funded currencies.

Nor was it ever intended to be a medium of exchange.

Libra, to the contrary, aspires to be used in transactions on a major scale.

In terms of distribution, the IMF allocates SDRs to member countries, and then those countries can exchange their SDRs for currency. Today, the value of an SDR is determined by a specific basket of the most important global currencies — the US dollar, euro, Japanese yen, the pound and China’s renminbi, the latter of which was only added in 2015.

Libra plans an initial incentive-focused distribution (funded by investors) to founding members to encourage adoption by users, merchants and developers, but this allocation is fully prepaid, whereas SDR allocations are theoretical and thus unfunded.

Then there's the issue of redeemability and conspiracy theory.

In the white paper, a veiled reference is made to Nixon's decision to scrap the convertibility window of Fed dollars and gold (our emphasis):

Libra is designed to be a stable digital cryptocurrency that will be fully backed by a reserve of real assets — the Libra Reserve — and supported by a competitive network of exchanges buying and selling Libra. That means anyone with Libra has a high degree of assurance they can convert their digital currency into local fiat currency based on an exchange rate, just like exchanging one currency for another when travelling. This approach is similar to how other currencies were introduced in the past: to help instil trust in a new currency and gain widespread adoption during its infancy, it was guaranteed that a country’s notes could be traded in for real assets, such as gold. Instead of backing Libra with gold, though, it will be backed by a collection of low-volatility assets, such as bank deposits and short-term government securities in currencies from stable and reputable central banks.

The subtle inference is that Libra is better than the Fed's or the IMF's SDR, because its liability units promise to be redeemable at any cost. But there's a reason why the conversion window was suspended by Nixon in 1971. The transfer of assets couldn't keep up with demand or the growth of the economy in general.

At the time of the SDR’s creation, the Bretton Woods system of fixed exchange rates was alive and well. Central banks around the world pegged their currencies to the value of the greenback, which in turn was pegged to the price of gold. The resulting shortfall of gold and US dollars borne out of this dynamic created the need for additional liquidity, to which the IMF responded with SDRs. One SDR was equivalent to one US dollar, which at the time was equivalent to 0.888671 grammes of fine gold.

Since the collapse of the Bretton Woods system in the early 1970s — with President Nixon slamming shut the gold window — and the untethering of the exchange rates of major developed countries from the dollar, SDRs have changed their use-case. The SDR has become a funding of last resort mechanism only, to be used by the IMF to rebalance economies when debt or liquidity crises strike.

This is why the IMF specifies in its definition that an SDR is only a potential claim on the freely usable currencies of IMF members. Nothing is locked-in on purpose. This is to avoid shocks or runs on the reserves of nations — a lesson learnt from history.

Libra's commitment to redemption at any cost, however, introduces a new type of “breaking the buck” risk into the global payments system — something regulators must immediately turn their attention to. (To be frank, it's unclear why Facebook thinks it can operate Libra as an effective bank with only the money transmitter licenses its subsidiary Calibra is allegedly applying for. Money transmitters are not allowed to invest in securities for a reason.)

Then there's the fact that Libra issuance is open-ended. Unlike the SDR system, which is capped by design, the only limit to how much Libra currency can be issued is the amount of available pledgable assets (bank deposits or high quality securities not yet specified by Facebook) in the global system.

Post the Global Financial Crisis, George Soros campaigned successfully to have the global cap on SDRs pumped up to $300bn to alleviate some of the pressure from that cap. But even the new extended allocation is tiny compared to the relative amount of foreign exchange held in global reserves, and thus the potentially monolithic size of a Libra fund.

On that basis, the Libra system — much like China — has the capacity to gobble up a huge swath of global spare foreign exchange liquidity while setting up its float. It seems logical that due to the liquidity implications on the global economy (again the reason why the SDR system does not require prepaid funds) that float will eventually have to be transformed from fiat cash deposits at banks into something more durable, like short-dated government securities.

The more people that use Libra, the greater the shortage of safe assets in the global system and the greater the negative pressure on interest rates.

That's ironic when you consider the Libra Reserve plans to pay its management and operating costs (and dividends to founding members) through seized interest from customer deposits.

Alarmingly, the notion that there might not be enough safe securities to make the model work without exposing the system to the risk of negative interest rates seems not to have crossed the minds of the founders.

We know the tech giant aims to link Libra’s value to a basket of highly liquid fiat currencies but we don't know which currencies yet make the cut. As Facebook’s paper on the Libra reserve notes:

. . . the above basket has been structured with capital preservation and liquidity in mind. On the capital preservation point, the association will only invest in debt from stable governments with low default probability that are unlikely to experience high inflation. In addition, the reserve has been diversified by selecting multiple governments, rather than just one, to further reduce the potential impact of such events.

The problems here are obvious. Debt from stable governments with low default probability is already pushing the zero bound, while any diversification into riskier realms introduces default exposure and makes it harder to match value in the basket with actual commercial flows.

The chances of the Libra system breaking the proverbial zuck buck are concerningly high — especially if you consider that nobody onboard seems to have any direct experience managing assets.

And what about the name itself? The seventh sign of the zodiac, Libra, is depicted by a pair of scales held by Themis, the Greek goddess of divine law and order. From the Latin libra, it means “a balance” and in ancient Rome — libra pondo — “a pound by weight.” In fact, it's where the British pound came from and why it's abbreviated £.

We get the reference. Libra is word play: a balance of payments with a double-sided ledger that intends (finally!) to bring harmony to the international financial force.

But cast your attention all the way back to ancient Egypt, and you will find that Libra also implies something more fundamental: the notion of Ma'at.

This is the concept of cosmic order and balance as personified by the Egyptian deity whose job it was to weigh the hearts of the deceased against a feather. It is the opposite of the chaos and imbalance embodied by the god Isfet.

In the Ma'at mythology, if a human heart weighed the same or less than the feather, they were considered in balance and thus just and worthy of entering into everlasting life. If the heart was heavier, they were considered unbalanced, and the deceased was refused an afterlife.

The irony of Libra being represented by a balance is that its structure — unlike the SDR which actually does strive to rebalance the system — is more than likely to worsen global imbalances rather than improve them.

Add to the mix Libra's light-touch approach to Know-Your-Customer and Anti-Money-Laundering regulation, and you realise it's light on the judgment component which filters out bad actors as well.

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