On June 18th, Facebook released a white paper and additional documentation that describe a new cryptocurrency, called Libra, which will be governed by the twenty-eight member Libra Association (the “Association”). Shortly thereafter, the Senate Banking Committee and the House Financial Services Committee announced they would hold hearings to look into Libra and Facebook’s involvement; these hearings are scheduled for July 16th and 17th respectively. The following post contains a number of questions that policymakers should consider asking during these hearings. I have grouped the questions into the following broad categories: strategy; privacy and security; Libra’s reserve; law and regulation; and technology and governance. I provide additional color after each question to help inform the debate. These questions are by no means exhaustive, but in my view, they reflect the most pertinent issues that policymakers should focus on.
Strategy
What’s in it for Facebook?
Facebook and the Association justify Libra’s existence by relying on the empty altruism we’ve come to expect from Silicon Valley:
- We believe that many more people should have access to financial services and to cheap capital.
- We believe that people have an inherent right to control the fruit of their legal labor.
- We believe that global, open, instant, and low-cost movement of money will create immense economic opportunity and more commerce across the world.
- We believe that people will increasingly trust decentralized forms of governance.
- We believe that a global currency and financial infrastructure should be designed and governed as a public good.
- We believe that we all have a responsibility to help advance financial inclusion, support ethical actors, and continuously uphold the integrity of the ecosystem.
This language isn’t fooling anybody. Facebook is a publicly traded company, and their past actions reveal they are driven by the modern capitalist’s imperative to maximize shareholder value. However, Libra is not unlike other cryptocurrencies whose circulation in and of itself does not generate revenue for its founders.[1] Nor does it appear that Facebook will play an outsized role in Libra’s development and governance; from the white paper:
“Once the Libra network launches, Facebook, and its affiliates, will have the same commitments, privileges, and financial obligations as any other Founding Member. As one member among many, Facebook’s role in governance of the Association will be equal to that of its peers.”[2]
Libra’s true profit potential for Facebook lies in the development of ancillary services that will allow users to send and receive Libra. In effect, if Libra becomes a truly global currency, native to the internet, Facebook stands to profit by providing utilities that run on Libra. To this end, Facebook is launching Calibra, “a newly formed Facebook subsidiary whose goal is to provide financial services that will let people access and participate in the Libra network.”[3]
How will Calibra make money?
Calibra is a digital wallet that will allow users to save, spend, and send Libra. Like most digital wallets, users will be charged a fee for every transaction. For example, one of the more well-known digital wallets in the U.S., Apple Pay, charges merchants approximately 0.15 percent of each purchase.[4] Because Apple Pay is linked to your existing credit card, the merchant will have to pay this fee on top of the traditional fee charged by the card network. But because Libra is a cryptocurrency that will settle on a permissioned blockchain, Calibra should be able to charge lower fees because it can avoid the interbank settlement process that plagues legacy payment systems. However, Calibra has yet to disclose what these fees will be and who will pay them (the payor or payee) other than saying they will be “low cost and transparent.”
Which exchanges will support Libra and will Calibra ever become an Exchange?
Popular U.S. cryptocurrency exchanges, Coinbase and Gemini, also provide wallet services. This means that users can exchange dollars for bitcoin on the Coinbase website or app, and then hold and spend their bitcoin on the same website or app. In their Customer Commitment statement, Calibra notes that they “may integrate with cryptocurrency exchanges, but will not act as an exchange.”[5]
Calibra’s website states that:
“[Y]ou can convert your local currency into Libra to add money to your wallet, and convert it back when you want to withdraw. When converting your local currency to or from Libra, the app will show you the exchange rate so you know exactly what you’ll get.”[6]
Furthermore, the white paper notes that Libra will be “supported by a competitive network of exchanges buying and selling Libra.”[7]
Therefore, getting Libra into the Calibra wallet will require users to obtain their Libra elsewhere. This seems like a lost opportunity – from a revenue perspective – for Calibra, and may have been done to assuage other cryptocurrency exchanges and incentivize them to offer Libra on their platforms. The largest U.S.-based cryptocurrency exchange, Coinbase, is a founding member of the Association, so presumably, they are committed to supporting Libra upon its launch. But Facebook and the Association make no mention of other exchanges that will offer Libra. If Libra is not offered on a sufficient number of exchanges, Calibra may decide to also become an exchange. This would provide an additional revenue stream for Calibra and perhaps crowd out other Libra service providers. Indeed, I would be surprised if Calibra did not become an exchange at some point.
Do Facebook and Calibra have plans to offer additional financial services?
In many respects, Calibra resembles a bank. One primary function of banks is accepting deposits. Banks make loans with these deposits and profit off the interest rate spread between what they pay depositors and receive on loans. This process of making loans from deposits has the added effect of creating new money, and is known as fractional-reserve banking. As a digital wallet, Calibra is effectively serving as a depository for users’ Libra. In the future, Calibra may decide to pursue additional revenue opportunities by lending Libra to companies and consumers. Given the volume and specificity of data that Facebook has access to, they can assess credit risk as well as, or better than, traditional financial institutions. Facebook’s ability to provide Libra loans will be restricted by Libra’s full reserve requirement (more on this below) but the Association has the power to relax this requirement in the future.
Will Calibra exchange funds with accounts that don’t use Calibra?
Most cryptocurrency wallets permit users to send funds to anyone that has a public address associated with the given cryptocurrency. It is unclear if Calibra users will be able to send Libra to non-Calibra (or WhatsApp or Messenger) users. Libra is an open source protocol, so there is nothing stopping third-party developers from building their own Libra wallets or existing wallet providers from adding Libra functionality. While Calibra claims they will follow applicable laws and regulations, there are no guarantees that other wallet providers will do the same. If Libra is being exchanged through third parties that are not following know your customer [KYC] requirements, regulators will surely take notice and intervene in ways that hinder the broader adoption of Libra.
How will Libra be used across the Facebook suite of products?
Facebook’s ambitions are clearly broader than just operating a digital wallet that allows users to send yet another cryptocurrency back and forth. This is evident in the fact that Calibra will be integrated into WhatsApp and Messenger so “you can send and receive money as easily as you message friends, family, and businesses.”[8] This approach resembles that of Chinese payment giants, WeChat Pay and Alipay. For the 2014 Chinese New Year, Tencent’s WeChat service, which started as a WhatsApp-like instant-messaging app, introduced a feature for distributing virtual red envelopes, modelled after the Chinese tradition of exchanging packets of money among friends and family members during holidays. This propelled WeChat Pay’s rapid adoption, to the point where last year, WeChat Pay processed over 460 billion transactions.[9]
It is unclear if WeChat Pay generates a profit for parent company TenCent, but that is largely beside the point. The ease and simplicity of sending money through WeChat Pay attracted ever more users to the WeChat platform, and these users are targeted with ads and additional services, like games.[10] Similarly, should Libra gain widespread adoption, Facebook can leverage this engagement to promote additional products and services. Libra could also become Facebook’s native currency, whereby advertisers on Facebook remit payment in Libra. This set-up would incentivize advertisers, who are mostly selling consumer goods and services, to accept payment in Libra. Eventually, Facebook could create an environment where commerce on the internet was conducted in Libra and mostly through the Facebook suite of products.
Explain the decision-making process to launch Libra while under antitrust scrutiny?
Last month, the House Judiciary’s subcommittee on antitrust announced they were launching an investigation into anti-competitive behavior by Google, Apple, Facebook, and Amazon.[11] At the same time, it was revealed that the Federal Trade Commission was launching an antitrust investigation into Facebook.[12] Standard public relations practice dictates that you should not announce plans to launch a new currency that will compete with the U.S. dollar while being investigated by the government for antitrust violations. By doing so, Facebook is thumbing their nose at Congress and the public, and revealing that they have truly learned nothing from their past scandals.
Privacy and Security
How will Facebook and Calibra protect user data and privacy?
The fundamental concern, amongst the public and policymakers, is that Facebook will utilize Libra and Calibra customer data in ways that are unauthorized and harmful. This concern was articulated in a statement by House Financial Services Committee Chairwoman Maxine Waters the day Libra was announced:
“Facebook has data on billions of people and has repeatedly shown a disregard for the protection and careful use of this data. It has also exposed Americans to malicious and fake accounts from bad actors, including Russian intelligence and transnational traffickers. Facebook has also been fined large sums and remains under a Federal Trade Commission consent order for deceiving consumers and failing to keep consumer data private, and has also been sued by the government for violating fair housing laws on its advertising platform.”[13]
To address these predictable concerns, Calibra released a separate “Customer Commitment”[14] document that highlights their approach to consumer data privacy (this document will be replaced by a comprehensive data policy prior to the launch of Calibra). Calibra attempts to assuage the public’s concerns by first noting that Calibra is a separate, regulated, subsidiary of Facebook and that this structure will facilitate “keeping Calibra’s financial data separate from Facebook’s social data.”[15] Calibra goes on to assure us that they “will not share account information or financial data with Facebook, Inc. or any third party without customer consent” and that “customers’ account information and financial data will not be used to improve ad targeting on the Facebook, Inc. family of products.”[16]
Given Facebook’s history, only a fool would believe their promise to keep Calibra data separate from Facebook data. In 2011, Facebook settled charges with the Federal Trade Commission (FTC) that they “deceived consumers by telling them they could keep their information on Facebook private, and then repeatedly allowing it to be shared and made public.”[17] Read anew, the FTC’s list of complaints point the way for what could go wrong with Calibra and Libra:
- In December 2009, Facebook changed its website so certain information that users may have designated as private – such as their Friends List – was made public. They didn’t warn users that this change was coming, or get their approval in advance.
- Facebook represented that third-party apps that users’ installed would have access only to user information that they needed to operate. In fact, the apps could access nearly all of users’ personal data – data the apps didn’t need.
- Facebook told users they could restrict sharing of data to limited audiences – for example with “Friends Only.” In fact, selecting “Friends Only” did not prevent their information from being shared with third-party applications their friends used.
- Facebook had a “Verified Apps” program & claimed it certified the security of participating apps. It didn’t.
- Facebook promised users that it would not share their personal information with advertisers. It did.
- Facebook claimed that when users deactivated or deleted their accounts, their photos and videos would be inaccessible. But Facebook allowed access to the content, even after users had deactivated or deleted their accounts.
- Facebook claimed that it complied with the U.S.- EU Safe Harbor Framework that governs data transfer between the U.S. and the European Union. It didn’t.
The FTC settlement did little to change Facebook’s ways because the firm repeated essentially the same behavior after its 2014 acquisition of WhatsApp. At the time of the acquisition, Facebook told the European Commission that they “would be unable to establish reliable automated matching between Facebook users’ accounts and WhatsApp users’ accounts.”[18] However, after WhatsApp changed their terms of service and privacy policy in 2016 to include “the possibility of linking WhatsApp users’ phone numbers with Facebook users’ identities”[19] the Commission launched an investigation that ultimately found that “contrary to Facebook’s statements in the 2014 merger review process, the technical possibility of automatically matching Facebook and WhatsApp users’ identities already existed in 2014, and that Facebook staff were aware of such a possibility.”[20] In short, Facebook lied. How do we know they’re not lying now?
Even in their Customer Commitment document, Facebook leaves open the possibility for data to flow between Calibra and other Facebook products. They note there are limited cases where Calibra customer data may be shared “to keep people safe, comply with the law, and provide basic functionality to the people who use Calibra.” Calibra notes that they will share “customer data with managed vendors and service providers” that is necessary for “completing the defined activity or service.” Calibra also admits they may share “aggregated data to Facebook, Inc. or third parties relating to the performance of its products and services.” But don’t worry, Calibra will employ techniques “to prevent the aggregated data from being connected back to an individual.”
Facebook also leaves open the potential for data to flow the other way, from Facebook to Calibra. For instance, “people may choose to import their Facebook friend list into Calibra to make sending money easier,” but only after customers consent to do so.
Taken as a whole, Calibra wants you to believe that any information that is shared between Calibra and other Facebook products is solely for the purpose of improving the “product experience” or complying with laws and regulations. However, given Facebook’s history, it is inevitable that Calibra customer data will be blended with data from other Facebook products for use in targeted advertising, which is Facebook’s primary revenue source. In the words of Mark Zuckerberg: “Senator, we run ads.”[21]
Our financial data, in particular our payments data, is the last honeypot for technology companies to collect before they have total insights, and control, into all aspects of our lives. When combined with the data culled from our social media profiles, our browsing history, and increasingly our offline activity – think of internet of things devices – our payments data will allow Facebook to know us better than we know ourselves. In fact, the imperatives of surveillance capitalism demand that Facebook extract this new data source for use in behavioral prediction markets. In her excellent book, “The Age of Surveillance Capitalism” Shoshana Zuboff notes that:
“Surveillance capitalism unilaterally claims human experience as free raw material for translation into behavioral data. Although some of these data are applied to product or service improvement, the rest are declared as a proprietary behavioral surplus, fed into advanced manufacturing processes known as “machine intelligence,” and fabricated into prediction products that anticipate what you will do now, soon, and later. Finally, these prediction products are traded in a new kind of marketplace for behavioral predictions that I call behavioral futures markets. Surveillance capitalists have grown immensely wealthy from these trading operations, for many companies are eager to lay bets on our future behavior.”[22]
Libra is not Facebook’s first attempt to capture the behavioral surplus from our transactions data. In 2009, the company launched Facebook Credits, a virtual currency that enabled users to purchase items in games and non-gaming apps on Facebook.[23] Facebook discontinued Credits in 2012 due to low adoption,[24] but other tech companies have since launched their own payment services. However, these services, like Apple Pay; Google Pay; PayPal; Samsung Pay; and Amazon Pay, still rely on existing third party infrastructure, such as credit card or retail payment systems, to process and settle payments.[25] Because these services run atop existing payment rails, they are only incremental improvements from an efficiency and user experience standpoint. It also means that these tech companies have to share the behavioral surplus generated from consumer transactions with the infrastructure providers, like Visa, MasterCard, and card issuing banks. Libra and Calibra provide Facebook with an opportunity to make seamless, instant, online transactions a reality. But more importantly, from Facebook’s standpoint, it provides an opportunity to be the sole beneficiary of the behavioral surplus that comes from our transactions data.
How will Calibra safeguard users’ Libra?
Libra, like bitcoin, relies on public key cryptography, whereby transactions are executed when the payor signs a message to the payee with their private key. Thus, if a malicious actor gains access to your private key, they have unfettered access to your Libra. Therefore, it is essential that digital wallets, like Calibra, have strong security procedures to keep their users’ private keys secure.
Libra’s Reserve
How will Libra’s reserve be managed?
Libra is a stablecoin. Stablecoins are cryptocurrencies that maintain a stable value against a target price.[26] In Libra’s case, it will be fully backed by a basket of bank deposits and short-term government securities. In this sense, Libra resembles a currency board, whereby the management of the exchange rate and money supply are given to a monetary authority that makes decisions about the valuation of a nation’s currency, specifically whether to peg the exchange rate of the local currency to a foreign currency, an equal amount of which is held in reserves.[27]
The Libra Association claims there will be no Libra monetary policy, nor will Libra be actively managed. Instead, Libra can only be created by growing the reserve. Basing Libra’s reserve on a basket of national currencies supports Libra’s ambition to be a global currency. As the Association notes:
“[F]rom the point of view of any specific currency, there will be fluctuations in the value of Libra.”[28]
However, because the reserve will be backed by multiple currencies, the overall volatility in Libra will be dampened as the volatility between various currency pairs within the reserve should average out. Should Libra gain widespread adoption, the volatility between Libra and fiat currency will be irrelevant to Libra users. As Bloomberg columnist Matt Levine notes:
“If you buy most things online, and if everything online is priced in Libras, then you’ll end up living your life denominated in Libras, and only converting your Libras into dollars on your occasional touristic visits to the physical world.”[29]
The value of any asset, including Libra, is determined by what people are willing to pay for it. While people should theoretically pay no more, or less, for Libra than the value of the reserves backing it, the cryptocurrency market defies traditional pricing logic. Once Libra is freely tradable, its value may fluctuate wildly. Provided most consumers continue to transact in fiat currency, which I expect will be the case for a while, Libra’s volatility will hinder its use as a medium of exchange. In this case, would Libra Association members intervene to stabilize Libra’s value?
Does the SEC have jurisdiction over the creation of Libra’s reserve?
One problem associated with fully collateralized stablecoins, is that in order to issue one dollar’s worth of the stablecoin, the issuer must attract one dollar of investment capital from you or me and place it in a bank account. As Barry Eichengreen points out, the challenge with this is that it requires one of us to trade “a perfectly liquid dollar, supported by the full faith and credit of the U.S. government, for a cryptocurrency with questionable backing that is awkward to use.”[30] Libra overcomes the initial challenge of creating reserves by issuing separate “Investment Tokens” to the twenty-eight founding Association members, who each signed a nonbinding agreement to invest at least $10 million to join the Association.[31] In return for this fiat investment, members will receive an Investment Token that entitles the token holder to interest earned on the Libra Reserve.[32] The Investment Tokens are clearly securities, and the Association notes that the funds will be raised through a “private placement to investors.”[33] However, the Association provides no further details on the nature of this private placement.
Reserves will also be created when users demand new Libra coins. This requires the “purchase of Libra for fiat and transfer of that fiat to the reserve.”[34] If Libra begins to gain traction as a payment mechanism, users will demand additional Libra, and this additional Libra can only be created by transferring fiat currency to the reserve. But this transfer will not be done by users. Instead, there will be:
“[A]uthorized resellers who will be the only entities authorized by the Association to transact large amounts of fiat and Libra in and out of the reserve. These authorized resellers will integrate with exchanges and other institutions that buy and sell cryptocurrencies to users, and will provide these entities with liquidity for users who wish to convert from cash to Libra and back again.”[35]
As others have pointed out, this sounds a lot like creation and redemption in an exchange-traded fund (ETF) and indeed, Libra conceptually resembles an ETF.[36] An ETF is a collection of securities that track an underlying index and is traded on an exchange just like stocks. Libra resembles an actively managed ETF that will invest in a basket of currencies and government securities based on a set of investment objectives that will be determined by the Association. The SEC regulates ETFs under the Investment Company Act of 1940 but the Libra white paper and reserve document make no mention of the SEC’s jurisdiction over Libra. Facebook, and other Association members, will likely claim that Libra is not a security[37] – and thus not an ETF – because buyers of Libra will have no expectation of profit, which is one prong under the four-prong Howey Test to determine if an investment contract (a type of security) exists. This is why it is important that returns from the reserve go to Investment Token holders and not holders of Libra. If they did, Libra holders would have a reasonable expectation of profit, and as long as the Association members are the only nodes validating the Libra blockchain, this profit would come from the efforts of others, which is another prong in the Howey Test.
Who will be the authorized resellers, where will they trade, and how will they be monitored?
The Libra Reserve document[38] states that new reserves can only be created by “authorized resellers” but it makes no mention of which firms will fulfill this role or the necessary qualifications to become an authorized reseller. Resellers will play a critical role in the Libra ecosystem by arbitraging away differences between the value of Libra and the value of the reserves. Should Libra’s value in the open market exceed the value of Libra reserves, resellers will pay fiat into the reserve and receive Libra, which they will then sell in the open market for a profit. By selling Libra, resellers will push the price down until it is aligned with the value of reserves. Thus, resellers are essential to maintaining a stable value for Libra and the Association should provide more details about who will fulfill this role.
The arbitrage process described above will only work if there are exchanges that offer Libra in sufficient volume. While the largest U.S. cryptocurrency exchange, Coinbase, is a founding Association member, additional exchanges will need to list Libra if the arbitrage process is to function smoothly. The Association needs to explain how they plan on convincing other cryptocurrency exchanges to offer Libra.
What assets back the reserve, where will these assets be held, and how will the public know there are sufficient reserves?
The Association provides scant detail on the assets that will back Libra, other than stating: “[A]ssets will be a collection of low-volatility assets, including bank deposits and government securities in currencies from stable and reputable central banks.” The stability of Libra will ultimately depend on the stability of the assets in the reserve, therefore Facebook and the Association should provide additional details on reserve eligible assets and the proportion in which they will be held. They should also provide detail on who will be holding the reserves and the nature of that relationship. For instance, will reserve custodians be bankruptcy remote trusts?
Currently, no financial institution (bank, broker-dealer, etc.) belongs to the Association, but these institutions will be necessary for the custody of reserve assets. What makes the Association think financial institutions will be willing to serve as reserve asset custodians? Also, Facebook and the Association should indicate if they plan on opening accounts at central banks, including the Bank of England, who recently announced they plan on offering non-bank payment companies access to interest-bearing accounts.[39] Finally, a stable Libra depends on the public’s belief that sufficient assets are held in reserve. Maintaining this belief will require more than verbal assurances from the Association. Facebook and the Association need to explain how reserve assets will be audited and the results of these audits should be made public.
What impact will Libra have on global interest rates and monetary policy?
The Association claims the government securities in Libra’s reserve will only come “from stable governments with low default probability that are unlikely to experience high inflation.” However, the yield on sovereign debt from developed countries – who are the most likely to meet this criteria – is already close to zero, and is negative in several European countries. If Libra were to grow in popularity, additional sovereign debt would be added to its reserve. This sovereign debt would be purchased in the open market, which would push the price of such debt up and the yield down. At a time when central bankers are already worried about their ability to stimulate the economy by pushing interest rates down – because they are already at or below zero – a vibrant Libra would only make this problem worse. Libra could further reduce the efficacy of monetary policy by reducing the available supply of sovereign debt and neutralizing the role of banks in money creation.
Law and Regulation
Is Facebook willing to comply with the laws and regulations currently in place?
Whether cryptocurrency advocates like or not, there is an established regulatory framework that governs the development, use, and exchange of cryptocurrency in the United States. This framework is fragmented across multiple agencies, and confusing to those with little regulatory experience. But Facebook is one of the largest companies in the world, with near unlimited resources to comply with the myriad laws and regulations that apply to its operations around the world. However, Facebook appears unwilling to accept cryptocurrency regulations as they are. In the Commitment to Compliance and Consumer Protection document, the Libra Association notes that:
“Founding Members are committed to working with authorities to shape a regulatory environment that encourages technological innovation while maintaining the highest standards of consumer protection.”[40]
Facebook is making it clear that it doesn’t intend to passively accept the current regulations governing cryptocurrency. Instead, it wants to “shape” these regulations, presumably to suit Facebook’s needs.
Does Facebook anticipate the development of Libra derivatives and will Libra be classified as a commodity?
In 2015, the Commodities Futures Trading Commission (CFTC) classified Bitcoin, and by extension other virtual currencies, as a commodity in an order against Coinflip Incorporated.[41] This order stated that Bitcoin and other virtual currencies fall under the definition of a commodity according to the Commodity Exchange Act (CEA) of 1936. As a result of this order, virtual currencies are now considered “exempt commodities,” which is the same category that the CFTC places metals and energies commodities, including: gold, silver, oil, and natural gas. The CFTC has jurisdiction over futures and other derivatives involving these exempt commodities but the cash markets, also referred to as the spot markets, for these commodities do not fall under the jurisdiction of the CFTC. However, the CFTC does have fraud and manipulation enforcement jurisdiction over these markets and market participants.
Because the CFTC considers cryptocurrency to be a commodity and they do not regulate commodity spot markets, online exchanges like Coinbase do not need to register with the CFTC. However, any business involved in virtual currency derivatives— including foreign businesses that solicit or provide services to U.S. customers—will most likely have to register with the CFTC. In addition, if any entity offers a commodity, such as Bitcoin, for sale to a retail customer on a margined, leveraged, or financed basis – in other words, with borrowed funds – then the agreement is regulated as if it were a futures transaction unless the commodity is actually delivered to the buyer within 28 days.[42]
The CFTC will likely classify Libra a commodity, as its technical characteristics are similar to bitcoin. This means that Libra trading will be unregulated and Calibra will be unsupervised at the federal level. Given the potential for Libra adoption to grow quickly – due to Facebook’s two billion customers – regulators may worry about such a large market going unregulated. Because the CFTC has the authority to police the Libra market for fraud and manipulation, they may rightly wonder how they will do so without insights into the market. The CFTC may then lean on Facebook and Calibra to supply the agency with Libra trading data and to report any suspicious activity in the Libra market. Will Facebook comply with these requests?
Additional regulatory scrutiny will come when the first attempt to list a Libra derivative or exchange-traded product is made. Given that bitcoin futures contracts exist, it is safe to assume that one or more futures exchanges will attempt to list Libra futures. In December 2017, the Chicago Mercantile Exchange Inc. (“CME”) and the CBOE Futures Exchange (“CFE”) self-certified new contracts for cash-settled bitcoin futures products.[43] The self-certification process allows designated contract markets (“DCMs”) to list new derivative products one day after submitting in writing to the Commodity Futures Trading Commission (“CFTC”) that the product complies with the Commodity Exchange Act (“CEA”) and CFTC regulations.[44] While the CFE contact has been delisted due to lack of interest, CME’s bitcoin futures contract lives on.
Because the CFTC classifies virtual currency as a commodity, this means that it cannot also be a security subject to SEC rules and regulations. However, any sort of investment vehicle that holds virtual currency and offers ownership interests in the vehicle will be considered a security subject to SEC registration unless it meets SEC exemption requirements. This is why the SEC must sign off before any sort of Bitcoin, or other virtual currency, exchange-traded product can enter the market. Exchange-traded products (ETPs) are simply marketable securities that track an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETP trades like a common stock on a stock exchange. In 2017, the SEC rejected a bid by Bitcoin investors Cameron and Tyler Winklevoss to list an ETP tied to the price of Bitcoin.[45] The SEC’s main concern was the unregulated nature of Bitcoin spot markets made the ETP susceptible to fraud and manipulation. After Bitcoin futures came to market, the SEC received a flood of new ETP applications that all proposed to track the price of Bitcoin futures. Once again, the SEC rejected these proposals due to concerns over the potential for fraud and manipulation in the Bitcoin spot market.
Given that Facebook has two billion users, Libra has the potential to be exchanged in volumes that vastly exceed that of bitcoin and that one day rival the dollar. Were that to happen, the SEC would find it difficult to resist demands for a Libra ETP and other Libra investment vehicles. Policymakers should look beyond the immediate rollout of Libra and consider the impact Libra-related financial products will have on the heath and resilience of our financial system.
How will Libra be regulated by the states?
The act of transferring money or value from one person to another also brings into play the state statutes licensing money transmitters. State licensing requirements vary from state to state, but typically include some form of minimum net worth, maintenance of a bond, annual audits, examinations by regulators, record-keeping, anti-money laundering programs, and a list of permissible investments for funds received and held. State money transmission statutes are clearly triggered when a money transmitter maintains an office or an agent in a state, but a physical presence is not necessary to invoke the statute and merely having an internet website that does not block access to a resident in a state may be enough to implicate a state’s licensing requirements. States are taking different approaches on the regulation of cryptocurrency, with some clarifying that the use of cryptocurrency to transfer funds from one person to another is within the statute, while others are taking the opposite position.
Therefore, any entity that exchanges Libra, or facilitates Libra transactions, must obtain a state license in those states that treat cryptocurrency as money. Calibra claims they have obtained licenses in those states that treat cryptocurrency as the equivalent of money in their regulation of money transmission. According to the Conference of State Bank Supervisors, Facebook currently is licensed as a money transmitter in 42 states plus the District of Columbia and Puerto Rico.[46] However, it does not appear as though Facebook or Calibra have obtained the New York state BitLicense, which was introduced in 2015 to govern “virtual currency business activity” in or involving the state of New York.[47] The BitLicense can be described as “money transmitter plus,” because, in addition to imposing requirements similar to those imposed by money transmitter regulations, the BitLicense also imposes requirements tailored to the unique nature of the virtual currency business, such as cybersecurity and special suspicious activity reports.
Calibra will be unable to serve New York customers without the BitLicense, and an ongoing state investigation into Facebook’s privacy practices may hinder Calibra’s ability to obtain the license. In February of this year, New York governor Andrew Cuomo directed the New York Department of State, in partnership with the Department of Financial Services and other state agencies, to investigate allegations that a wide range of apps are sending highly personal data to Facebook without users’ consent and when users are not logged in through Facebook.[48]
Facebook should provide Congress with additional details on their conversations with state regulators and the licenses they hold. Because most states restrict money transmitters from investing in anything but the most liquid assets, Facebook should also disclose if state restrictions on permissible investments interferes with the Association’s ability to manage the Libra reserve. Finally, Facebook should detail how they plan on complying with the regulations governing money transmission in other countries.
How will Facebook comply with Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) regulations and U.S. Sanctions?
The Financial Crimes Enforcement Network (FinCEN) is a bureau of the United States Department of the Treasury that collects and analyzes information about financial transactions in order to combat domestic and international money laundering, terrorist financing, and other financial crimes. FinCEN is responsible for enforcing the Bank Secrecy Act, the nation’s first and most comprehensive Federal anti-money laundering and counter-terrorism financing statute. In 2011 and again in 2013, FinCEN issued guidance clarifying the applicability of the regulations implementing the Bank Secrecy Act to persons creating, obtaining, distributing, exchanging, accepting, or transmitting virtual currencies.[49] FinCEN’s guidance makes clear that the definition of a money transmitter does not differentiate between real currencies and convertible virtual currencies and the guidance states that “administrators and exchangers,” of convertible virtual currencies are subject to FinCEN regulations governing money transmitters; while users of virtual currencies are exempt.
Calibra has registered as a Money Service Business with FinCEN and claims they “will implement a robust Anti-Money Laundering and Countering the Financing of Terrorism (AML/CFT) program on its platform wherever the product is available, irrespective of whether local regulations have applied AML laws to cryptocurrency wallets.” In addition, Calibra will “administer and enforce applicable sanctions programs including, for example, U.S., EU, and U.N. sanctions program.”
Complying with these regulations is easier said than done. Many large, established, financial institutions have run afoul of AML/CFT laws and regulations. Calibra claims they will ensure compliance with AML/CFT requirements by requiring ID verification, both “documentary and non-documentary”. It is uncertain what they mean by “non-documentary” but I imagine it includes cross-referencing user data with Facebook or Instagram profiles.
Facebook’s compliance with U.S. sanctions may create tensions with other jurisdictions in which the firm is pushing for Libra adoption. For instance, after the Trump administration imposed additional sanctions on Iran after pulling out of the Iranian nuclear deal, several European countries expressed concern about the impact these sanctions would have on their companies and some even tried to establish a new system that would allow their companies to trade with Iran.[50] It is easy to imagine a scenario in which a foreign country bans Libra in retaliation for Facebook’s decision to comply with U.S. sanctions. If this country was China, would Facebook be willing forgo over one billion people using Libra?
Cryptocurrency is designed to facilitate pseudonymous transactions. This is one reason why it has become the currency of choice for criminals. In July of 2018, special counsel Robert Mueller indicted twelve Russian intelligence officials for allegedly attempting to influence U.S. elections in 2016.[51] The indictment notes that the conspirators used bitcoin to fund the purchase of servers, register domains, and make other payments “in furtherance of hacking activity.”[52] According to the indictment, the “use of bitcoin allowed the Conspirators to avoid direct relationships with traditional financial institutions, allowing them to evade greater scrutiny of their identities and sources of funds.”[53]
Libra will share many of the same properties that has made bitcoin so attractive to criminals. As the Libra Association acknowledges:
“Individuals or organizations will operate on the Libra Blockchain through user accounts, which are dissociated from their real-world identity. Authentication occurs through public keys used on the network, which does not give any information regarding the user’s personal data. Only data relevant to each transaction, such as the public address of the sender and receiver, the timestamp, and the transaction amount, are recorded and publicly visible.”[54]
While digital wallets and online exchanges can verify customer identity by requiring ID verification, once a broader ecosystem is built out, it will be relatively easy to send Libra to anyone, anywhere (this will be especially true if Libra transitions to a permissionless blockchain as planned).
Because of the pseudonymity provided by the Libra blockchain, effective AML/CFT compliance can only occur at the access points where customers are engaging with a third-party to exchange or send Libra. As the Association notes:
“While the network is open and accessible to everyone with internet access, the network’s main endpoints, in the form of exchanges and wallets, will need to follow applicable laws and regulations and collaborate with law enforcement.”[55]
Facebook and the Association cannot guarantee that exchanges and wallets will follow applicable laws and regulations, just like no entity can guarantee that bitcoin exchanges and wallets will follow applicable rules and regulations. If Libra gains widespread adoption, there is nothing to stop it from becoming the new currency of choice for bad actors.
Technology and Governance
How will the Libra blockchain transition from permissioned to permissionless?
Libra will begin as a permissioned blockchain with the goal of transitioning to a permissionless blockchain within five years of launch. In a permissioned blockchain, only a defined set of entities, referred to as validators, can shape consensus and governance. Initially, Libra’s validators will be the twenty-eight founding members of the Libra Association and any additional members that are added to the Association based upon defined member evaluation criteria.[56] This means that Libra will begin as a centralized system that is governed by the founding members of the Libra Association who will all work to maintain the Libra blockchain.
There are several benefits to being centralized. First, it allows Association members to maintain tight control over the development of the Libra software and quickly work out any bugs that are sure to arise. It also provides Association members an incentive to promote the adoption of Libra as they will receive interest on the Libra reserve. And finally, permissioned blockchains can process higher transaction volumes than permissionless blockchains.
Compared to permissionless blockchains, permissioned blockchains can process transactions quickly because only a select group of validators – Association members in Libra’s case – need to obtain consensus (as opposed to every node in the network for permissionless blockchains). In a permissionless blockchain, like bitcoin, the validators don’t know or trust one another, so there needs to be a mathematical mechanism that allows all validators to agree on the current state of the ledger. With bitcoin, this consensus mechanism is called “proof of work.” The problem with proof of work is that it takes more time to achieve consensus than it does in centralized systems, which leads to lower network throughput.
If Libra is to become a global medium of exchange, it will need to process transactions at a rate much higher than what is currently possible with permissionless blockchains. The Libra white paper acknowledges this challenge:
“[A]s of today we do not believe that there is a proven solution that can deliver the scale, stability, and security needed to support billions of people and transactions across the globe through a permissionless network.”
But, there are downsides to permissioned blockchains; the biggest being that users have to trust the validator nodes to behave honestly and ethically. In their document detailing how they will move toward permissionless consensus,[57] the Association expounds on the benefits of permissionless systems:
“[P]ermissionless systems have low barriers to entry and innovation, are resistant to censorship attacks, and encourage healthy competition among infrastructure providers (e.g., who can participate in consensus) as well as the developers of applications on top of the network. Since nobody can exclude others from the market or censor their transactions, permissionless systems provide stronger guarantees to participants that no single party will be able to unilaterally change the rules of the network to their advantage at a future date. At their core, permissionless systems make irreversible commitments to operating as open networks where changes can only be implemented if they are democratically supported by a majority of constituents.”[58]
The problem for Libra is that no distributed network has ever transitioned from permissioned to permissionless.[59] There are multiple reasons for this, but the biggest is that no one has been able to figure out how to adequately scale permissionless systems. As the Association notes:
“As the validator node set grows, that will lead to a decline in performance. The Association needs to understand how to maintain acceptable performance while expanding participation and increasing the number of validators.”
Libra has the added challenge of being fully reserved, with this reserve managed by the Association. If Libra were to become truly permissionless, who would manage the reserve? The Association recognizes this challenge, but they do not have an explanation for how to decentralize the reserve management function.
The commitment to transition to a permissionless system within five years may placate cryptocurrency enthusiasts who are naturally distrustful of any kind of central authority. It may also allay concerns regulators and policymakers have about Facebook exerting too much influence over a new monetary system. But this commitment is likely a charade, and I question whether Facebook truly believes it is possible to convert Libra to a permissionless blockchain. If Libra gains mass adoption and fulfills its stated promises, most people won’t care if it is permissionless or permissioned. Facebook is betting five years is enough time to make this a reality.
What will happen when there is a dispute on the Libra blockchain?
Libra is about so much more than just a new cryptocurrency. In fact, the Libra blockchain will use a new programming language, created by Facebook employees, called Move, which will allow for the implementation of “custom transaction logic and “smart contracts.””[60] A smart contract is a computer protocol intended to digitally facilitate, verify, or enforce the negotiation or performance of a contract without the need for a trusted third party. For example, it can easily be programmed in a smart contract that “IF on 1 August 2020, Bank A does not receive USD 1,000 from Alice, transfer USD 1,000 from Alice’s account to Bank A’s account.”
The first well-known use of a smart contract came with the launch of the Decentralized Autonomous Organization (DAO) in 2016.[61] Between April 30th and May 28th of 2016, the DAO offered and sold approximately 1.15 billion digital tokens in exchange for a total of approximately 12 million ether, which had a value of $150 million at the time. All of this was done on the Ethereum blockchain. After the funding period, the DAO began to operate, whereby various people made proposals to the DAO on how to spend the funds raised and the members who bought the tokens voted to approve these proposals. If these proposals were profitable, DAO token holders were entitled a proportional share of the reward.
The DAO never became operational because shortly after its launch, hackers exploited a flaw in the smart contract’s code and gained access to 3.6 million ether, worth about $50 million at the time. A vigorous debate then erupted within the Ethereum community about what, if anything, should be done about the hack. Many argued that there should be a hard fork in the Ethereum blockchain that would create a new version of Ethereum software and return the stolen ether to the previous owners.[62] Other argued that while it was unfortunate the hack occurred, the Ethereum blockchain should not be altered because immutability is a founding principle of Ethereum, and cryptocurrency more broadly. A vote was put to ether holders, who decided to execute the hard fork. This led to the creation of a new cryptocurrency called Ethereum classic.
The DAO anecdote highlights how contentious governance decisions can be on the blockchain. While the Libra white paper argues that Move “creates a language that makes it inherently easier to write code that fulfills the author’s intent, thereby lessening the risk of unintended bugs or security incidents,” disagreements are all but inevitable. How these disagreements are handled will influence the development and adoption of Libra. Initially, any decisions regarding the Libra blockchain will be made by the Libra Association council, which is comprised of one representative per validator node (validator nodes are the same as Association members). According to the white paper: “[M]ajor policy or technical decisions require the consent of two-thirds of the votes,” of the council. How will disagreements be adjudicated if, and when, Libra transitions to a permissionless blockchain?
Why are developing countries not represented in the Libra Association?
Developed countries benefit from having established banking systems that intermediate consumer payments. This is why developed countries have yet to see major changes in how consumers pay for goods and services and why Libra’s adoption may be slow going in the U.S. and Europe. But in developing countries that lack established banking systems and have high mobile penetration, Libra has the potential to become the payment of choice. As Michael Kimani notes:
“[F]or many emerging ‘mobile first’ consumers from East Africa the internet is indistinguishable from Facebook and the internet does not exist outside of this singular social network.”[63]
Given the potential for Libra to transform payments in Africa and other developing countries, it is worrisome that Libra Association membership is limited to twenty-eight American and European companies. As Kimani notes:
“I find it hard to reconcile a group of American corporations, far removed from the realities of Africans, machinating a grand plan on how to save the unbanked women of Africa. Especially when you consider their recent history of data privacy breaches (Facebook) and worker exploitation (uber).”
Libra may also neuter central banks in developing countries because the Libra reserve will be invested in currencies and bonds from “stable and reputable central banks.” This means that sovereign debt from developing countries will likely be excluded from the Libra reserve. If Libra becomes the currency of choice in developing countries, the traditional tools available to central banks would become useless.
[1] Provided they retain some of the currency, founders will benefit from an increase in the currency’s value. In addition, nodes that update the cryptocurrency’s distributed ledger – often referred to as “miners” – may receive a reward of a certain amount of the currency.
[2] https://libra.org/en-U.S./white-paper/
[3] https://newsroom.fb.com/news/2019/06/coming-in-2020-calibra/
[4] https://www.macrumors.com/roundup/apple-pay/
[5] https://scontent-iad3-1.xx.fbcdn.net/v/t39.2365-6/65083631_355528488499253_8415273665234468864_n.pdf?_nc_cat=106&_nc_oc=AQnswExdtQ-hs7uLGM2C54D6kCfstY6WMy6vnj2TGFNq2hgfKM3iO3-jAI0ZyKGYCAQ&_nc_ht=scontent-iad3-1.xx&oh=233e1e2ab94fca4be1a375f901f2aba2&oe=5DBFB7C3
[6] https://calibra.com/
[7] https://libra.org/en-US/white-paper/
[8] https://calibra.com/
[9] https://walkthechat.com/the-cross-border-payment-war-of-wechat-pay-and-alipay/
[10] https://www.bbc.com/news/business-44149371
[11] https://www.nytimes.com/2019/06/03/technology/facebook-ftc-antitrust.html
[12] https://www.wsj.com/articles/ftc-to-examine-how-facebook-s-practices-affect-digital-competition-11559576731?mod=e2tw
[13] https://financialservices.house.gov/news/documentsingle.aspx?DocumentID=403943
[14] https://scontent-iad3-1.xx.fbcdn.net/v/t39.2365-6/65083631_355528488499253_8415273665234468864_n.pdf?_nc_cat=106&_nc_oc=AQnswExdtQ-hs7uLGM2C54D6kCfstY6WMy6vnj2TGFNq2hgfKM3iO3-jAI0ZyKGYCAQ&_nc_ht=scontent-iad3-1.xx&oh=233e1e2ab94fca4be1a375f901f2aba2&oe=5DBFB7C3
[15] Id.
[16] Id.
[17] https://www.ftc.gov/news-events/press-releases/2011/11/facebook-settles-ftc-charges-it-deceived-consumers-failing-keep
[18] http://europa.eu/rapid/press-release_IP-17-1369_en.htm
[19] Id.
[20] Id.
[21] https://www.thewrap.com/senator-orrin-hatch-facebook-biz-model-zuckerberg/
[22] Zuboff, S. (2018). The age of surveillance capitalism: The fight for the future at the new frontier of power. London: Profile Books. Pg. 8.
[23] https://www.lifewire.com/why-buy-facebook-credits-2654744
[24] https://techcrunch.com/2012/10/13/3-lessons-that-startups-can-learn-from-facebooks-failed-credits-experiment/
[25] https://www.bis.org/publ/arpdf/ar2019e3.htm
[26] Nathan Sexer, State of Stablecoins, 2018, MEDIUM (Jun. 24, 2018), https://media.consensys.net/the-state-of-stablecoins-2018-79ccb9988e63.
[27] https://www.investopedia.com/terms/c/currency_board.asp
[28] https://libra.org/en-U.S./about-currency-reserve/#the_reserve
[29] https://www.bloomberg.com/opinion/articles/2019-06-18/facebook-will-make-the-money-now
[30] https://www.fa-mag.com/news/the-stable-coin-myth-40803.html?section=3&page=2
[31] https://www.nytimes.com/2019/06/25/technology/facebook-libra-cryptocurrency.html?emc=rss&partner=rss
[32] This return will conceivably be remitted in Libra. I say conceivably because the White Paper and The Libra Reserve paper do not explicitly say how the reserve returns will be distributed other than to say the “Association will pay out incentives in Libra coin to Founding Members to encourage adoption by users, merchants, and developers.”
[33] https://libra.org/en-US/about-currency-reserve/#the_reserve
[34] Id.
[35] Id.
[36] https://www.etf.com/sections/blog/most-interesting-etf-filing-ever-libra?nopaging=1
[37] You can avoid becoming a registered investment company if you stay underneath a specific threshold of owning securities; if Libra aggressively limits its exposure to bonds and other assets, and mostly holds currencies, it could avoid (at least) the ’40 Act (although it would limit the income earned for the foundation).
[38] https://libra.org/en-US/about-currency-reserve/#the_reserve
[39] https://www.ft.com/content/148c3724-9376-11e9-b7ea-60e35ef678d2?utm_campaign=morning%20scan%20plus-jun%2021%202019&utm_medium=email&utm_source=newsletter&eid=%7Bmd5%28email%29
[40] https://libra.org/en-U.S./compliance-consumer-protection/#overview
[41] UNITED STATES OF AMERICA Before the COMMODITY FUTURES TRADING COMMISSION. The Commodity Futures Trading Commission, 17 Sept. 2015, www.cftc.gov/sites/default/files/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfcoinfliprorder09172015.pdf.
[42] “CFTC Issues Proposed Interpretation on Virtual Currency ‘Actual Delivery’ in Retail Transactions.” U.S. COMMODITY FUTURES TRADING COMMISSION, www.cftc.gov/PressRoom/PressReleases/7664-17.
[42] SECURITIES AND EXCHANGE COMMISSION. Bats BZX Exchange , 10 Mar. 2017, www.sec.gov/rules/sro/batsbzx/2017/34-80206.pdf.
[43] See U.S. Commodity Futures Trading Comm’n, CFTC Backgrounder on Self-Certified Contracts for Bitcoin Products (2017), https://www.cftc.gov/sites/default/files/idc/groups/public/@newsroom/documents/file/bitcoin_factsheet120117.pdf.
[44] 17 C.F.R. § 40.2 (2018).
[45] See Order Disapproving a Proposed Rule Change to BZX Rule 14.11(e)(4), Exchange Act Release No. 34-80206, 116 S.E.C. Dockets 2746 (Mar. 10, 2017), https://www.sec.gov/rules/sro/batsbzx/2017/34-80206.pdf
[46] https://www.americanbanker.com/news/why-washington-mobilized-so-quickly-against-facebooks-crypto-plans
[47] BitLicense Regulatory Framework, New York State. www.dfs.ny.gov/legal/regulations/bitlicense_reg_framework.htm.
[48] https://www.dfs.ny.gov/search/site?search=Facebook
[49] “FinCEN Issues Guidance on Virtual Currencies and Regulatory Responsibilities.” USA PATRIOT Act | FinCEN.gov, www.fincen.gov/news/news-releases/fincen-issues-guidance-virtual-currencies-and-regulatory-responsibilities.
[50] https://www.nytimes.com/2019/05/08/world/europe/eu-iran-nuclear-sanctions.html
[51] Indictment, United State v. Netyksho, No. 1:18-cr-00215-ABJ (July 13, 2018), https://www.justice.gov/file/1080281/download.
[52] Id. at 21.
[53] Id. at 22.
[54] https://libra.org/en-U.S./compliance-consumer-protection/#overview
[55] https://libra.org/en-U.S./compliance-consumer-protection/#overview
[56] https://libra.org/en-U.S./becoming-founding-member/#member_evaluation_criteria
[57] https://libra.org/en-U.S./permissionless-blockchain/#overview
[58] Id.
[59] https://onezero.medium.com/thoughts-on-libra-blockchain-49b8f6c26372
[60] Libra white paper
[61] “Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO.” Securities and Exchange Commission, United States Securities and Exchange Commission, 25 July 2017, www.sec.gov/litigation/investreport/34-81207.pdf.
[62] https://www.cryptocompare.com/coins/guides/the-dao-the-hack-the-soft-fork-and-the-hard-fork/
[63] https://kioneki.com/2019/06/28/5-reasons-why-facebooks-new-cryptocurrency-libra-is-bad-news-for-africa/
