Facebook’s Libra project to create a digital currency has had a difficult start, with criticism from authorities, and the departure of some founding members. Libra's critics have mostly focused on risks associated with money laundering, financial stability and data privacy. But the project also raises questions about monetary management.
Libra’s promotors present it as a payment system innovation. It is, however, also a new monetary system, because it implies the creation of a new currency—at least in the project’s initial form—and because the Libra Association itself has characterised its approach as “similar to the way in which currency boards (eg of Hong Kong) have operated”.
Currency boards are a type of monetary system in which the issuer balances its liabilities with assets in the form of foreign currency. For example, the Hong Kong Monetary Authority issues its own currency—the Hong Kong dollar—and holds US dollars on its asset side. Similarly, Libra would hold a basket of high quality and liquid assets, such as bank deposits and government securities, against Libra issuance.
Libra is thus analogous to a currency-board regime. And yet, Libra’s proponents have so far overlooked the problems of monetary management that a currency board raises.
Destabilising shocks threaten all monetary systems and Libra would be no exception. To ensure their stability, successful currency boards like Hong Kong’s require active management and discretionary interventions. But unlike a traditional currency board, the Libra issuer would be a private association, not a legally-mandated monetary authority. And Libra is a profit-making endeavour, without the tools that can assure stability. Such differences have significant implications for the Libra currency, which the Libra Association has so far glossed over.
In currency boards – and Libra – the issuing entity holds different items on the two sides of its balance sheet and must ensure consistency between them (eg Libra coins on one side, a basket of high-quality assets on the other). But shocks will inevitably hit both the asset and liability sides of the Libra issuer’s balance sheet, potentially disrupting this consistency.
Shocks to Libra would not have this destabilising effect should the issuer allow shocks to fully affect the value of its liabilities, ie if it lets its currency float freely. But letting the currency float would contradict Libra’s stated aim of stability, where ‘stability’ is explicitly understood in terms of purchasing power in relation to real goods. Libra is “designed to be a currency where any user will know that the value of a Libra today will be close to its value tomorrow and in the future”.
Shocks would also not have this destabilising effect if the shocks affecting the two sides of the balance sheet are always small or, if large, are very closely correlated. However, financial history shows it would be very imprudent to base the entire construction on this unwarranted assumption. In fact, experience with currency boards (and metallic monetary systems) shows that the maintenance of a peg (to reserve assets) requires very active protection.
On the liability side, in particular, changing expectations can generate significant destabilising shocks. In national currency boards, conflicting government interests might drive fears that the government will abandon its commitment to maintaining the peg in order to pursue some macroeconomic goal, as Argentina did in 2002. In private currency boards, the profit motive plays the role that macroeconomic interests play for national currency boards. Libra holders might fear that, when opportunities for profit arise, the Libra Association will violate its commitments, eg that it issues liabilities in excess of its assets, that it suspends convertibility or even that it debases Libra. There are many historical examples of such cases, for instance in metallic monetary systems.
One Libra-specific vulnerability would be the issuer’s right to change the composition of reserves. Such changes would, according to the project, be exceptional and subject to strict decision-making. This feature, however, might drive speculative activities: if Libra holders expect a composition change that could imply a jump in value on the asset side of the balance sheet, speculation could drive demand for Libra up or down for fairly long periods.
The very low yield that could be earned, now and in the foreseeable future, from holding highly liquid and high-quality reserves, might drive deviations from Libra’s commitment to maintaining the peg. Holders might fear that Libra will succumb to the temptation to chase yield, for example by changing the composition of Libra reserves to enhance the meagre return on its assets – ie giving more weight to less liquid and less creditworthy, but higher-returning, assets.
The temptation to look for yield could be aggravated by two distinctive features of Libra:
- Interest on the reserves will be used to pay dividends to the currency’s first investors. These first investors, however, also happen to be Libra board members whose financial interests might conflict with the stability of the system. Libra’s incentive structure thus has a tendency to encourage instability.
- Libra Association members will be subject to limited liability, undermining the credibility of the association in satisfying fully the claims of Libra holders.
As we have seen, asymmetric shocks threaten the stability of currency boards and Libra would be no exception. Nevertheless, some currency-board systems, such as Hong Kong’s, have proved resilient. To ensure sustained maintenance of the peg to reserves, successful currency boards include strong stabilising mechanisms. These amount to: (i) an organisational set-up that allows for intervention in case of shocks, and (ii) operational tools to implement such decisions. One solution for Libra could be to adopt its own stabilising mechanisms. To assess whether this might be possible, Libra can be compared to the currency board of Hong Kong.
Hong Kong’s currency board, introduced in 1983, has proved long-lasting. This success most certainly drives Libra’s explicit comparison of itself with the territory’s monetary system. However, Hong Kong’s success rides on a complex framework.
Firstly, the Hong Kong Monetary Authority (HKMA) maintains a greater than 100% reserve. The equity buffer represents insurance for the HKMA’s ability to defend the currency peg, enhancing the system’s credibility.
Secondly, the HKMA has high transparency standards and commits to public outreach. HKMA market operations are announced immediately, and relevant data is published daily. Prior to any major reform of the system, HKMA officials inform market participants about the changes, and research is published to provide background information and explain the rationale. Furthermore, the HKMA releases the minutes of the meetings of the currency board governing committee, and currency board accounts data and other statistics are published every month.
Most importantly, the success of Hong Kong’s currency board depends on active management – both mechanical and discretionary interventions:
- The mechanical stabiliser involves automatic intervention by the HKMA to sell or buy the Hong Kong dollar when capital inflows or outflows push the exchange rate outside a narrow These interventions cause the monetary base to expand or contract, putting downward or upward pressure on interbank interest rates, which counteract the original capital flows and ensure that the exchange rate remains stable. In other words, interest rates offset, at least partially, the effects on exchange rates of capital inflows and outflows.
- The HKMA has powers of discretionary intervention, which have been used twice since a reform in 2005 to address rising demand for the Hong Kong dollar ahead of large stock market launches (see here, for example). Furthermore, the HKMA intervenes intermittently in the money markets to stabilise interest rate differentials with the US. The interventions rein in differentials, when needed, by selling exchange fund bills and notes, thus soaking up excess cash, or vice versa.
Lessons for Libra
Hong Kong shows that a complex framework with demanding features, including active management, is needed to maintain consistency between the currency on the liability side and a foreign currency on the asset side in the face of potentially offsetting flows. Can the Libra association adopt the tools used in Hong Kong to guarantee the stability of its currency? Will a mechanism, provided by profit-motivated ‘authorised resellers’, arbitraging between the value of libra and that of reserves, be robust under all circumstances, like that provided by the HKMA?
As we have discussed, the possibly disruptive effect of expectations is particularly challenging. When the market has doubts about the maintenance of the dollar peg of the Hong Kong currency, in either direction, the central bank intervenes to reassure the market (ie it indirectly adjusts interest rates and carries out quantitative interventions).
With Libra, no entity has clear responsibility to respond to shocks (such as those generated by changes in expectations). Who will stand ready to defend Libra in the event of a crisis? Even if an entity was given responsibility for managing Libra, it might lack the tools necessary to discharge this task. Four tools missing so far from Libra are: (i) equity buffers, (ii) interest rates, (iii) transparency and proactive communication and education, and (iv) a legal mandate.
First, it is difficult to see how Libra will accumulate the equity necessary to intervene and offset potential imbalances between its assets and its liabilities (ie accumulate a greater than 100% reserve). Libra is supposed to invest in liquid and high-credit securities. But these are exactly the securities that have very low and even negative yields now and, looking at forward rates, in the future. For instance, a composite security made up of GDP-weighted US, German, French, Japanese and UK Treasury bills would have a yield of 0.88% – hardly likely to lead to the accumulation of a protective buffer. Most probably, Libra will rather have problems in breaking even.
Second, the Libra board will not have interest rates as an important stabilising tool. HKMA interventions work by affecting the demand for (or supply of) the Hong Kong dollar through interest rates. But Libra is stuck with a 0% rate, meaning its board would be unequipped to similarly affect the demand for (or supply of) its currency to counter destabilising flows.
Third, stable expectations around currency boards are built on transparency and proactive communication. The extent to which we can expect a profit-driven enterprise to meet the standards of a legally-mandated public institution is very much an open question.
Finally, in the absence of a legal mandate, it is not clear that the necessary stabilisation tools would be effective in the hands of the Libra Association. Availability of the tools could stabilise expectations, but in the face of enticing profit opportunities (or major losses), might holders not rightly question the Libra Association’s commitment to use the stabilising tools?
Regulation might overcome some of the challenges we have discussed, for example, if there were an obligation to create an equity buffer. However, regulating a global currency such as Libra will require deep cross-border coordination and a genuine acceptance of regulation. Creating a new monetary system, such as Libra, seems a disproportionate and potentially ineffective approach to achieving a safe, stable, cheap, simple and instantaneous global payment system. Developing and internationalising instant payment systems, such as the European Central Bank’s Target Instant Payment Settlement, seems a more fruitful option.