LIBRA IS ALMOST CERTAINLY NOT WHAT YOU THINK IT IS.
Dr. Avtar Sehra, Chief Executive Officer at Nivaura.
Jannah Patchay, Director, Regulatory & Market Structure SME at Markets Evolution
[Part One of Two]
In Part One of a two-part analysis, Dr Avtar Sehra, Chief Executive Officer at Nivaura, and Jannah Patchay of Best Execution take an in-depth look at the market structure and regulatory challenges around Facebook’s proposed Libra cryptocurrency.
Facebook’s announcement of its new Libra coin project, on the 18th June 2019, was greeted with much fevered excitement and speculation from all quarters. Bitcoin’s value soared in light of the perceived vote of confidence this bestowed on cryptocurrency as an asset class. There was much discussion of the potential benefits to the unbanked, who would now be able to make and receive payments as easily as sending an instant message.
The founding members of the Libra Association include an illustrious set of the big names in payments – Visa, MasterCard, Paypal – plus luminaries of the tech world such as Uber, Lyft, Spotify and eBay. Most of all, Libra’s single biggest advantage is perceived to be Facebook’s 2.4 billion-strong user base, combined with the social media giant’s well-known ability to burrow into every aspect of their lives. In the intervening weeks, the noise has certainly not died down; however, as lawyers, regulators, economists and central bankers have subjected the Libra White Paper to greater scrutiny, a number of questions arise. What exactly is Libra, when you look at its structure up close? How should it be regulated? What systemic risks will it pose? And where is it going?
First of all, Libra is, in almost every major financial jurisdiction, a security of some description. Libra is backed by a basket of fiat currency deposits and short term government debt. Each Libra coin represents a unit of value of the underlying assets, held in the Libra Reserve. To this extent, Libra most closely resembles a collective investment scheme in the EU and UK, or a mutual fund in the US. These structures are typically regulated in jurisdictions globally, particularly when distributed to retail investors (i.e. the Libra user base).
Given the ultimate intention is that Libra will be exchange-traded, it’s clear that the Libra coin operating model has been designed to replicate a currency basket ETF structure, which is a security. In this instance, the structure is even more complex than a standard ETF, as it seems in the case of Libra it will more closely resemble an “actively-managed” fund. Active management will be necessary in order to drive its objectives of managing the funds in a relatively liquid manner, to generate returns for its Investment Token holders (the Validators), but more importantly to provide a capital preservation strategy for the Libra Coin holders i.e. minimise volatility and potentially provide the retail Coin holders access to the underlying basket of funds at any time on redemption of their Libra Coin.
The Libra market structure is rather complex, and in order to understand the potential regulatory and economic treatment and challenges, it’s necessary not only to examine the Libra coin as a construct but also each activity taking place in the Libra marketplace.
These can be broken down as:
1. Minting new Libra coins – subscription and redemption processes – and the role of the Libra Reserve and the Authorized Resellers (distributors) in this process.
2. The initial sale of Libra coins to end users, by Authorized Resellers, in exchange for fiat or crypto currency.
3. The on-going market making capability provided by Authorized Resellers to end users, on the secondary market.
4. Trading of Libra coins on exchanges and trading venues.
5. The use of Libra as a medium of exchange by end users, and the payments service provided by the Calibra wallet system in facilitating this.
6. The role of the Libra Reserve in managing Libra as an actively managed fund structure, in undertaking regular valuations and in rebalancing the underlying basket’s composition so that it remains extremely stable in value (at its face value at least).
All of these activities and services, were they considered in the context of traditional financial markets, would be captured within the regulatory perimeter of the overwhelming majority (if not all) of the jurisdictions in which the Libra Association seeks to provide services (certainly for the EU, US, Singapore, Hong Kong and Japan). It is quite clear, therefore, that the expected regulatory treatment of Libra as a security creates a number of challenges for its proposed usage.
Typically, shares in ETFs /mutual funds / unit trusts are valued by an independent fund administrator on a regular basis, with the valuation methodology and net asset value being fairly transparent (as demanded by both regulators and investors). Holders of the fund units are also entitled to the profits attached to and generated by the underlying basket of assets. Market makers in ETFs also apply a spread when making two-way prices (this is how they derive their profit from the transaction), and this means that the bid and offer prices are primarily dependent on the value of the underlying assets, plus the spread applied. Libra, however, is different.
The White Paper envisages Libra’s value being purely driven by market forces. The assets underpinning Libra (fiat deposits and short term notes) will still generate an income, but this income will effectively be stripped from Libra coins and attributed, instead, to the investment token that is held by the members of the Libra Association. The Authorized Resellers and end users will also be exposed to all the credit and market risk associated with the underlying basket, but will gain none of the upside. This is quite unlike any other asset, to say the least.
So, then, Libra is worth whatever the market determines it to be worth. Which may be the same as the value of its underlying assets, or may deviate – the authors of the White Paper do not appear to be too concerned as to the extent to which deviation may occur. In the case of Libra, its pricing and volatility is derived from two factors – the value of the underliers and their own volatility in the market, and the value attributed to Libra itself by the market and by demand for Libra coins by their end users as a means of exchange for goods and services, or by speculators (and there will be plenty of speculative trading).
Going back to traditional markets, typically where the value of an ETF or a derivative contract starts to deviate significantly from the value of the underlying assets, certain market participants will see opportunities for arbitrage, and the prices of both will naturally start to come back into alignment again as those opportunities are exploited. Nobody is using ETFs as a means of exchange, so there is no additional concern around the speculative value of an ETF outside of the inherent value created by the underlying assets. Libra, on the other hand, is intended for use as a currency.