Payments Views

Bryan Derman

In Zuck We Trust?          

We got the first real details this week on the Facebook-sponsored Libra cryptocurrency. Opinions are still taking shape around Glenbrook, but it’s fair to say that the team is deeply intrigued by the possibilities and sees it as both a novel and potentially very practical application of blockchain technology. We think the consortium-based governance, open source roots, scalability, and openness to overlay services give the payment system a solid chance of adapting itself to serve real-world transaction needs, especially for cross-border applications.

Choices and Design Features

Let’s start with a brief rundown of what, for us, are the key design choices and features of Libra:

Consortium Governance

While created at Facebook, Libra will be overseen by a nonprofit association established in Switzerland. An initial list of 28 “Founding Members” was announced, but membership appears relatively open to anyone capable of acting as a “validation node” on the Libra blockchain, and the stated hope is to have about 100 members in the Libra Association when the system launches in the first half of 2020.

Ensuring that neither Facebook, nor any individual member would dominate the new system was an important decision on many, many levels. Nevertheless, Libra is unavoidably a Facebook idea, and because of that, we believe, it is generating regulatory scrutiny that goes beyond what a scheme launched by another entity might face. Think of this as a regulatory stone that will burden the concept. On the other hand, of course, there are all those hundreds of millions of users….

Examining the founding membership list is very interesting. It contains many of the marquee names in technology but, notably, does not include any banks, legacy or challenger. We wonder if the implicit endorsement of a few highly regarded global financial institutions would have served to calm regulatory concerns and move the consortium further from the mantra of “move fast and break things”.

Based on Fiat Currency, Aiming for Stable Valuation

The Libra design comes quite close to the promise of global, digital cash. Libra will be based on, and backed by, a reference basket of major, stable fiat currencies. While it won’t be pegged to the value of the basket, the hope is that its value will remain relatively stable over time. The composition of the reference currency basket may even be adjusted periodically in pursuit of this goal. It has been suggested that the initial valuation of the Libra will be geared to be in the range of three of the basket currencies – the Euro, the U.S. Dollar, and the British Pound – whose value in U.S. dollar terms is currently about $1.00-$1.27.  This should work, we think, and is a critical factor to enable adoption by consumers and businesses.

We suspect that Facebook’s earlier experiment with an abstract, virtual currency known as Facebook Credits (which was used mainly to accomplish game-related purchases on the Facebook site) has taught it that a currency-denominated medium of exchange will be easier for users to grasp, particularly if the cryptocurrency’s value bears some close relationship to a familiar fiat currency.

Medium of Exchange

The supply of Libra will not be predetermined by an intentional system design or algorithmic process like bitcoin; rather, because it will be 100% backed by a reserve of fiat currencies, the supply of Libra will be determined solely by users’ desire to convert their fiat currency into the cryptocurrency. Thus, the Libra “money supply” should be mainly a function of its utility as a medium of exchange. Unlike bitcoin, there is no a priori reason to believe the Libra will be inherently inflationary, which can cause investors to hoard a cryptocurrency (like a commodity) rather than transact with it.

The fact that the basket of reference currencies will help make the valuation more stable also makes Libra more suitable as a medium of exchange. The volatility of bitcoin has frequently been cited as a limitation on its value as a purchasing system. The ideal, of course, is that Libra would become a highly liquid, readily convertible currency traded by a wide range of currency dealers around the world; this would allow Libra to be used for its instantaneous transfer capability and then changed into fiat currency at a predictable rate for traditional spending needs. If and when that goal is achieved, we would find that a growing number of people and companies will accept Libra directly, confident in the knowledge that they could either re-spend it or easily convert it when necessary.

This brings us to a concept that you might think of as “Libra Liquidity”.  What if re-spending became easy? People might then choose to leave their funds as Libra in their wallet, making the system a place to store funds as well as to transact. This would be more likely in the developing world, where access to bank accounts is constrained by economic factors. But for now, the far more likely scenario in the developing world is that transferred funds will continue to be “cashed out”. Solving this problem in an economically acceptable manner to all involved continues to be the dominant problem in moving people away from cash in these countries. There is nothing about Libra that creates any particular advantage in solving this.

Pseudonymity

Libra says that users will be able to hold multiple addresses on the blockchain and these addresses will not be linked to real world identity. This is an area where Libra will need to “thread the needle” between privacy, security, and compliance. Facebook’s historical problems in helping users maintain privacy are likely to be a regulatory focus, but at the same time, it seems likely that financial regulators and law enforcement agencies will want to be able to track illicit activity and identify criminals. To them, what makes digital cash better than physical cash is its digital footprints. We will need to watch the details of how “pseudonymous” gets defined in the protocol.

Some industry participants we have spoken with in recent days think that Libra—or at least some Libra wallets—will have to evolve towards identity-linked wallets that have met international “Know Your Customer” (KYC) standards. A “KYC’d Libra Wallet” might have controls, for example, that limit its ability to transact with non-KYC’d wallets. The trade-off here is between privacy and the ability to control or limit money laundering or other nefarious uses of funds. We’re betting that regulators come down heavily on the latter side.

Scalability, Open Source, Open Platform

The Libra Association will begin by operating as a “permissioned” blockchain in which only members of the consortium can act as validation nodes. While there are requirements to be met, Libra hopes to expand membership to around 100 in the next year and professes a desire to move to a permissionless state beginning in five years, if the Association can find a scalable and secure way to do so.

Use of the Libra blockchain will be open to all parties wishing to build applications on it. This will be facilitated by the use of the open source Move programming language. The validator nodes will process the Byzantine Fault Tolerant (BFT) consensus protocol to allow validation to occur even if up to one-third of the nodes fail or are compromised, while maintaining high throughput, low latency, and better energy efficiency than “proof of work” consensus models, like that used for the bitcoin blockchain.

Connection to Social Networking and Messaging

The most powerful assets that Facebook brings to this enterprise are its social and messaging applications, with roughly 2.5 billion users on the Messenger and Whatsapp platforms. The power of such platforms to act in the payments space (both online and offline) has already been proven by WeChat, with the 800 million users of its WeChat Pay service. Other existing services from eCommerce platforms (Alibaba-Alipay, eBay-PayPal, Amazon Pay) to ride sharing (GrabPay, Uber-PayPal) are also showing interest and could even become members of Libra (Uber already is).

This seems to be a main path through which Libra use could propagate and catalyze its use for person-to-person transfers (see below).

On the whole, we believe these design features bode well for the potential success of Libra. They clearly reflect an understanding of factors that have hampered the existing digital currency initiatives.

But building a new payment system is always a daunting challenge. As we say in our Glenbrook Payments Boot Camps, payments is a “chicken AND egg” business, a networked model that requires attracting two kinds of customers: one that wants to send value and another willing to receive value in that same form.

Analyzing Libra’s Role in the Payments Ecosystem

This, in turn, leads us to analyze where Libra can add value in the payments ecosystem as it applies to the following payments domains:

Point of Sale Purchases

This domain is very well served in developed economies and probably offers limited opportunity, but it is open to innovation in emerging economies where card acceptance is not yet ubiquitous and its hardware and networking requirements can be a barrier to card deployment. Think Alipay and WeChat Pay in China, PayTM in India, and GrabPay in Southeast Asia. A stable and readily-convertible cryptocurrency that, for example, could be rendered in stores as a QR code would bring significant utility to many markets where cash is still the predominant tender type.

Remote Commerce Purchases

The global, instant, point-to-point transmission of cryptocurrency has always seemed attractive in this domain. However, the fact fulfillment is usually delayed or can become disrupted has also made eCommerce problematic for push payment systems. Who do I call when I’ve sent some Libra to an online seller but the goods never arrive?

A system of rules for mediating disputes between buyers and sellers is needed to compete against this core advantage employed by the card systems, PayPal, and Alipay. Perhaps the Libra Association will develop such a dispute resolution system, but we doubt that this will rise to the top of their list in the near term. In the meantime, Libra could play a role in some “hybrid transactions” where purchases made in the physical world are paid for with a remote commerce payment system. The presence of Uber and Lyft in the Libra Association are notable in this regard.

Consumer (C2B) Bill Payment

Practices here vary widely around the world and there may be specific opportunities, but bill payment is mainly a domestic transaction space, so it may be difficult for a cryptocurrency not directly denominated in the national currency to find traction. However, cash is still surprisingly prevalent for bill payment, particularly among unbanked populations, so billers could come to view Libra as a way to electronify payments, especially in less developed economies.

At best, we would imagine that this use case will become viable later in the evolution of Libra, not taking shape until very liquid and stable exchange markets are in place between Libra and the national currency in question.

Person-to-Person (P2P) Transfers

P2P certainly seems to be the early target for Libra, especially for cross-border transactions. The early plans for the Calibra wallet on Facebook’s Messenger and Whatsapp services seems to create a readymade P2P user base. While domestic P2P payments are increasingly well served by Faster Payments systems (like Zelle, in the U.S.) and fintech services (Venmo, Square’s Cash app), cross-border remittances have long been known for high fees and unfavorable currency exchange rates. There is an obvious appeal in a system that offers instantaneous, low cost, global transfers of a cryptocurrency based on a stable, readily convertible, value.

The big hurdle in this use case can often be the last mile. How will Libra transfer recipients, who are often unbanked individuals living in less developed countries, use the Libra they receive to buy everyday necessities? Perhaps in time they will be able to spend their Libra directly—as WeChat Pay has done for Chinese consumers—but in the near term, they will need access to a network of local agents able to convert Libra into local currency notes at a reasonable exchange rate. As the Libra Association expands its membership, it will be interesting to see whether any traditional remittance players (Western Union, MoneyGram) join the consortium.

Business-to-Business (B2B) Payments

While B2B have become a focus of payments innovation, we do not see this domain being an early focus for Libra development. The users of these payments tend to be oriented to bank transfers and are often tied to legacy messaging systems like SWIFT. They also have complicated needs for the exchange of remittance data (information that describes what their payments are for), which have not been needed on consumer messaging systems and social networks. Still, a stable currency based on a basket of fiat currencies should have some appeal in the B2B space. Over time, the combination of Libra transfer with a rich data standard like ISO 20022 could produce a useful B2B payment system.

Income (B2C) Payments

This domain, dominated by wage payments and government transfers, is mainly domestic in nature and well serves the banked population. While cash is still used to a surprising degree, it is unclear whether a pseudonymous cryptocurrency would be viewed as an acceptable alternative to senders and receivers. The space also includes government transfers and is highly regulated, so Libra will likely have to survive extensive regulatory scrutiny before gaining traction in this domain.

Climbing Mount Compliance

On first analysis, we see Libra as a thoughtful design that has learned important lessons from the blockchain initiatives that came before it. It will spring to life with important technical assets and influential backing. But it also comes at a controversial time for many of its founding members, especially Facebook. In contrast to the way many other technology-based services have been built, we think Libra must demonstrate a healthy respect for compliance and security, and it must do so across a wide range of jurisdictions, since the most attractive use cases involve cross-border funds transfers.

Libra’s founders will need to be incredibly vigilant about the potential for their system to facilitate money laundering, terrorist financing, illicit drug trade, and other criminal activities. Such compliance is difficult in such a highly decentralized ecosystem. Given the sharp global reaction to Libra’s goals, the consortium will have to be as innovative in its compliance activities as it is in its commercial endeavors.

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