Imagine a world where cross-border money transfer and payment is instantaneous, involving only one click of a button and with funds arriving immediately after the click. Now imagine a world where anyone that has a smartphone could access banking and financial services, all through the phone that sits comfortably in their palm. “But how is this possible,” you ask? I do not have the answer, but cryptocurrency advocates certainly think they do. One such advocate is Facebook.
It took me a long time to get around to reading the second version of Facebook’s Libra’s whitepaper (if you don’t know what Libra is, it is Facebook’s proposed cryptocurrency. Check out my previous article for an introduction). It is an understatement to say I am disappointed by the changes the Libra Association is proposing, and I realised the problems that necessitate those changes are inherent to all cryptocurrencies. These problems are so serious that they render the very concept of cryptocurrency futile in that cryptocurrency could never fulfil its promises. Let me explain.
The first major change in Libra is the introduction of single-currency stablecoins. The Libra payment system will include multiple stablecoins, each matched to a fiat currency, for example a USD stablecoin or a EUR stablecoin. According to the whitepaper, “each single-currency stablecoin will be backed 1:1 by the Reserve, which will consist of cash or cash equivalents and very short-term government securities denominated in the relevant [fiat] currency” (Libra Association, 2020, p. 5). The single-currency stablecoins will exist alongside a multi-currency coin called Libra Coins. Each Libra Coin is “a composite of 1:1-backed single-currency stablecoins” (Libra Association, 2020, p. 5), aggregated with fixed nominal weights (e.g. 0.5 USD stablecoins, 0.18 EUR stablecoins and so on). Single-currency stablecoins are intended for within-border use in countries whose fiat currency has a corresponding stablecoin, while the multi-currency coin is intended to be used in all other countries and for cross-border transactions.
The Libra Association claims the purpose of this change is to prevent undermining countries’ monetary sovereignty and monetary policy. This problem may manifest in the form of interest rates losing monetary policy impact, currency substitution, reduction in domestic currency deposits, and exchange rates distortion in global trade (see the report by the G7 Working Group for a detailed description). The hope is that, since each single-currency stablecoin is backed by assets denominated in a single fiat currency, this gives the central bank which prints the fiat money control over the cryptocurrency. Such hope is misguided. Even if we only consider countries whose fiat currency has a corresponding single-currency stablecoin, the control that central banks have over the stablecoins are limited, let alone countries whose fiat currency is not included in the Reserve basket. Policymakers and central bank officials should be gravely concerned if their residents use a currency over which the authority does not have control. Such weakening of monetary control is not limited to Libra; it is an unavoidable effect of every cryptocurrency. This means governments will not only place strict restrictions on the use of Libra in their country; they will restrict the use of all cryptocurrencies.
Let us contemplate a hypothetical scenario. Country A and country B agree to let Libra enter their markets on the condition that Libra will comply with their sanction rules and requests. One day, country A is unhappy with something that country B has done, and A announces sanctions on individuals and businesses from B and asks Libra to execute the sanctions. In retaliation, country B sanctions individuals and businesses from A and asks Libra to comply. Country A now threatens they will ban Libra in their country if their sanctions are not carried out or if Libra listens to country B. What should the Libra Association do? In recent years, similar situations have been witnessed in the World Trade Organisation and the World Health Organisation, and it would not be unreasonable to assume this would happen to any cryptocurrency that reaches global scale.
You may point to the Euro as a counter-argument in which governments have no full control over their fiat currency. But Euro is not a cryptocurrency and it is controlled by a central authority, the European Central Bank, in which all euro area countries have a stake and decision-making power. If countries wanted to come together and establish a common currency, they would inevitably establish a central authority in whose decisions they all have a say. This means there will not be any distributed ledger or blockchain where nodes or validators are private actors. And it certainly means money will not be printed or burned by private entities. So yes, countries may be willing to give up complete control of their fiat currency, but this will not take the form of cryptocurrency.
Another change in Libra is the abandonment of permissionless blockchain, where anyone could become a validating node. Instead, the Libra ledger or database (notice my reluctance to call it a blockchain) will be maintained by a select group of private companies. This was basically predictable from the first version of the Libra whitepaper. The Libra Association wants to maintain governance of both the network and the Reserve to the highest standard, and this, by definition, rules out the possibility of a permissionless blockchain. They cited “the need to guard against unknown participants taking control of the system and removing key compliance provisions” (Libra Association, 2020, p. 3) and “that it would be challenging for the Association to guarantee that the compliance provisions of the network would be maintained if it were to transition to a permissionless network where, for example, no due diligence is performed on validators” (Libra Association, 2020, p. 22), which is totally fair. The problem is Libra could no longer call their database a blockchain. In fact, given their intensions, a blockchain would be contrary to what they want. However, the very purpose of a cryptocurrency on a blockchain is to eliminate middlemen and authorities in the financial process to make it more fair and transparent. But if cryptocurrency cannot be successful without appropriate regulations, and satisfying regulations means a blockchain is not feasible, then there really is no point in creating a new digital currency, and other solutions should be explored to solve the world’s financial problems.
To be fair, there are stablecoins which are hosted on blockchains, such as Tether, which is claimed to be backed by US dollars and utilises both the Bitcoin blockchain and the Ethereum blockchain. However, as explained earlier, governments will never allow money printed by a private company, in this case Tether Limited, to be the dominant currency of their country. In fact, since its inauguration, Tether has been immersed in controversies. There have been allegations of improper printing of coins without the associated backing fiat money, among other questionable conduct (see this study for an example). This illustrates that the risks of letting a private company or a group of private entities to print and burn money are too high for any government’s appetite.
In short, stablecoins, by their nature, require a central authority to mint coins and govern the rules for asset management. This goes completely against the purpose of blockchain technology, rendering it obsolete, which in turn means the ‘coins’ cannot be called cryptocurrency. Moreover, if such authority comprises private actors, the cryptocurrency would never be trusted by governments, who will not permit the cryptocurrency becoming the dominant currency.
At this point, it is clear that mass adoption of stablecoins as a medium of payment for daily consumptions, in other words, as ‘money’ in the ordinary sense, is near impossible. There are, however, reasonable use cases in small-scale settings, such as JPM coin which is backed 1:1 by US dollars and will be used by only JP Morgan’s institutional clients to facilitate payment transfers. However, their ‘blockchain’ is controlled by JP Morgan and a select few of JP Morgan’s partners, thus the database cannot be called a blockchain, and JPM coin should be simply classified as ‘digital token’, instead of cryptocurrency. In fact, blockchain technology is completely unnecessary in this use case; any traditional database technology would suffice.
If cryptocurrencies developed by the private sector cannot work, could governments create cryptocurrencies? In theory, yes. But in practice, this is senseless. Governments already have their fiat currencies which are all digitised, and transactions already take place online. Creating another domestic currency serves no purpose because a true blockchain cannot be allowed, so any new domestic cryptocurrency would be no different from the existing domestic currency. Additionally, collaborating with other countries to create a common currency can work effectively without the complexities and risks of a blockchain, just like the Euro. Instead of getting hyped up about cryptocurrency, policymakers should be thinking about smarter and more efficient ways of improving their financial systems. Many simpler solutions, such as WeChat Pay, AliPay, M-Pesa, and Square have achieved incredible advances in financial inclusion and payment facilitation.
In conclusion, traditional cryptocurrencies, like Bitcoin and Ether, have failed their mission to replace fiat currencies due to the high volatility in their prices. On the other hand, stablecoins, which are meant to address this volatility issue by having each coin backed by concrete assets such as cash, still face serious regulatory challenges that threaten the very idea of cryptocurrency. At present, it is not conceivable that any cryptocurrency could achieve mass adoption and serve as money.
When I first heard of Bitcoin, I was so excited by the utopia depicted by its founder, Satoshi Nakamoto, where the world is rid of greedy banks that caused the 2008-2009 financial crisis. I was wrong. If only I could be wrong this time around …
References
Libra Association. (2020). Libra white paper v2.0. Retrieved from https://libra.org/en-US/wp-content/uploads/sites/23/2020/04/Libra_WhitePaperV2_April2020.pdf
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