Libra and the Challenges Ahead for the Financial System’s “Skype Moment”

June 21, 2019

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In 2003, a tech startup launched a service to allow users to make voice calls over the Internet. Until then, making international long-distance calls was expensive, with intermediary phone companies taking a sizeable share of the cost. But when Skype burst on to the scene, and intermediaries faced a new source of competition, prices went down, access increased, and the global economy became more connected.

The financial system has yet to have its “Skype moment,” where expensive, dedicated, single-purpose networks and systems are shed in favor of cheaper, general-purpose ones. As a result, it is often expensive—in terms of both time and money—to send funds around the world, making it impractical to send small transfers and limiting digital trade. Furthermore, the traditional financial system has not served everyone, with bloated costs and lack of access to financial services leading to large populations of unbanked or underbanked people all over the world. And while many startups and traditional financial companies have attempted to improve this system through new technologies, business models, and innovative uses of financial data, many gaps remain.

Facebook recently announced that it is partnering with 27 other organizations to create an open financial network build on blockchain technology that would enable instant, low-cost movement of money anywhere in the world. This project, called Libra, could be a significant push towards a general-purpose financial network. Importantly, Facebook is not the only system striving for this future, with open blockchain systems like Ethereum and others offered by competing open financial services. Only time will tell if general purpose financial networks like these can succeed in lowering costs and improving access for all.

What Is Libra?

The proposed Libra system is made up of three parts: a blockchain, a cryptocurrency, and smart contract platform.

First, the project outlines the Libra blockchain. Blockchains are digital ledgers that record information that is distributed among a network of computers that ensure each computer has identical records. The Libra blockchain is permissioned, yet open. Unlike public blockchains like Bitcoin and Ethereum, only members of the Libra Association, the nonprofit organization setup to govern the system, will be able to validate transactions. For the moment, the association is made up of payment companies like Visa, technology companies like Uber and Facebook, blockchain companies, nonprofits, academic institutions, and more. This list will likely expand before the project’s launch in 2020. However, the system will enable anyone to operate on top of it and offer their own apps and services.

Second, the project introduces the Libra cryptocurrency. Cryptocurrencies are digital units of exchange that rely on cryptographic techniques to regulate and decentralize the creation of units of currency and verify the transfer of funds. While other cryptocurrencies, like Bitcoin, are known for their volatility, Libra will be stabilized by its operators who will back each unit of cryptocurrency with real-world assets. This type of cryptocurrency, often called a stable coin, will have a relatively consistent value over time. Libra will be pegged to many different types of assets, from various fiat currencies to bank deposits and store-term government securities. Each time someone converts a token to real assets, that token is destroyed.

Finally, the Libra system will be programmable, enabling users to automate actions or functions. This application is often referred to as a “smart contract,” a computer protocol that can facilitate, verify, and enforce the performance of an action or contract on a blockchain. This aspect of Libra will be used by developers to provide added efficiencies in their applications.

In essence, this system is designed to allow anyone to participate and send funds for little to no cost. Users will accrue these benefits no matter where they are located, as the network drives down costs for those sending money domestically and internationally. Developers can also offer their own services on top of the system for users, opening up new financial applications for individuals that are currently cost prohibitive, such as remittances. Moreover, this open system would enable individuals to pick which services they want: No one would be forced to use Facebook or any other service to participate, and users could select competing firms or developers offering their services over the platform.

The Questions Ahead

There are a number of policy and technical challenges policymakers and organizations must address before users can capture the benefits of an open financial network like Libra or its competitors. These challenges are not unique to Libra. Chiefly, there are complex and duplicative regulations, outstanding tax questions for cryptocurrencies, and the underlying technological challenges of making better blockchains.

The first challenge is the burden of complying with all the regulations that come with creating a platform to send money globally. Take, for example, U.S. money-sending laws. Because money-transmission laws are often based on the location of the customer rather than the business, payment and digital currency businesses must get a state-issued money-sender or transmitter license in every state in which they have customers. These frameworks are often different, and this problem compounds even more when a service launches internationally. While some companies operating on the Libra system have the scale, money, and manpower to abide by every mismatched regulatory jurisdiction in which Libra operates, a startup offering its services on the Libra blockchain may not have the capacity to even understand what rules it needs to comply with, let alone comply with them.

Fortunately, there are some efforts to harmonize financial regulations across borders. From an international perspective, for example, the Global Financial Innovation Network is a network of 35 financial regulators and related organizations that was formed in January 2019 to test cross-border fintech projects. And to their credit, some states are starting to standardize licensing practices for payment systems.

Second, there are many outstanding questions about taxation of cryptocurrencies. For example, owners of Libra tokens would face the same tax questions as those of other cryptocurrencies. While the IRS treats cryptocurrency as a commodity, the agency does not have a de minimis exemption for cryptocurrencies. This means that, if the value of a cryptocurrency increases before a transaction, then it is subject to capital gains. This creates a substantial burden for users adopting the cryptocurrencies like Libra that owners of fiat currencies avoid. In the United States, the IRS and several lawmakers are striving to address these gaps.

Finally, there are still several major underlying technological challenges associated with blockchain systems, such as creating scalable blockchains that can handle the volume of transactions of a global system, identifying security threats, improving cryptography, and more. Indeed, while Libra will start as a permissioned blockchain, where access to enable validation of transactions on the network is granted by the association, the goal will be to become permissionless—where anyone can participate and validate transactions. This future will only come with additional research to help achieve the scalability improvements necessary to realize it. Government investment, which played a key role in developing technologies like smartphones or the Internet, can play an important role in developing better blockchain applications.

While there is a lot of misinformation circling about the Libra system, the goals of an open, general-purpose financial system are admirable. Policymakers should support these systems, whether they are facilitated by tech companies like Facebook, cryptocurrency businesses, banks, or any other organization.