In this interview about Facebook´s planned digital currency Libra, Maik Schmeling looks at its possible implications for monetary policy and the banking system. A professor at Goethe University since 2018, Schmeling holds the chair for Finance. The focus of his research lies on empirical asset pricing, international finance, and monetary policy.
Facebook is planning to introduce a global digital currency in 2020. How does Libra differ from other blockchain-based payment methods, such as Bitcoin?
As a stablecoin version of a blockchain currency, Libra is intended to hold the value of a coin stable in relation to a benchmark: Libra would be an electronic means of payment whose value would be kept stable against a basket of currencies, although we do not yet know exactly how the basket will be structured. The other difference is that Bitcoin is decentralized while Libra will be managed by a group of big companies. There are already other stablecoins such as Tether, for example: the idea is that for every Tether created, one dollar is held in a reserve to back it; this should serve to keep the price of one Tether equal to one dollar. Where the idea behind Libra diverges is that the currency will be stable against a basket of various currencies – i.e. one Libra will be equivalent to the value of these other currencies.
In SAFE Policy Letter No. 76, you compare Libra with a currency board. What are the similarities and differences?
Similar to a central bank, a currency board issues domestic currencies; where it differs from a central bank, however, is that for each unit of domestic currency, a certain amount of another currency is put into a reserve and can be paid out if necessary. Hong Kong is a good example: If the Hong Kong Monetary Authority creates 7.8 Hong Kong dollars (HKD), one US dollar is put in the reserve. Thus, a currency board can guarantee that the exchange rate between the US dollar and the Hong Kong dollar always remains 7.8. If the value of the HKD falls below the fixed exchange rate, you can buy HKD and exchange them for US dollars at the higher rate and make a profit. The Libra idea is similar. The biggest difference would be that there is a currency basket. The reserve contains several currencies – but this does not guarantee a fixed exchange rate to any particular currency. At this point, it is also not clear whether the composition of the reserve can change over time.
Would Libra’s stability also depend on Facebook’s reputation?
According to the proposals, the Libra Foundation will be independent of Facebook; many companies support the project and are part of the foundation, and the Libra reserve is not subject to access by Facebook. A run on the currency by Libra investors as a result of Facebook encountering difficulties would probably be more the result of a psychological effect than of anything else. However, the details of the system are not yet clear, so it is hard to say how influential Facebook will be.
What opportunities does the project offer?
I expect Libra to be attractive for users in certain countries, especially those with unstable currencies. In these countries, it might be attractive to switch to Libra and thereby hold a basket of foreign, stable currencies. Holding a share of one’s assets in safe currencies, such as US dollars or Swiss francs, for example, is not uncommon nowadays and Libra would be a relatively easy way to hold such foreign currencies, especially for smaller investors – and use these assets as a means of payment, too.
What would Libra mean for banks?
If Libra is used extensively, banks’ payment transaction business would diminish. For example, a bank that grants consumer credits and manages customer accounts learns a lot about its customers from observing payments. Banks would lose this source of information and, in addition, parts of their cheapest funding. If customers withdraw money from banks and convert it to Libra, banks would have to rely more on other sources of funding, which tend to be more expensive. Inside the Libra ecosystem, other financial products could arise. If many end-users rely on Libra for payments, for instance, consumer or supplier credits will likely become important as a way of avoiding exchange rate risks. Credit products such as loans are also needed to construct derivatives against exchange rate risks; in short, if Libra were adopted to a significant extent, there would be a great demand for (credit) products not yet planned. Problems would arise, however, because no one would be responsible for those products: as it will be a global currency, which is only subject to varying national sets of regulation, there is no single natural regulator – no central bank to provide liquidity in the event of a crisis, for example.
In your assessment, how severe are the potential risks to the financial system?
Libra could become an extremely large cash pool that contains a lot of short-term government securities and be able to negotiate the terms of investments with large banks on equal terms. This would put pressure on banks’ margins, yet if there were a run on Libra, large sums could then be withdrawn at short notice. This state of affairs would, of course, have implications for the financial markets. There would be a whole array of unregulated credit products, for instance, because, even if there were tight regulation in place, these areas often migrate into shadow systems – to countries with fewer regulations, for instance. It was a similar development which lead to the creation of the Eurodollar market, so if Libra were adopted on a large scale, a kind of shadow Libra system might form.
How should financial supervision react? And what does Libra mean for central banks and the effectiveness of the monetary policy?
Depending on which legislation is applied, its use as a means of payment can be prohibited. How Libra is classified seems to depend very much on the country: is it considered an electronic currency, a means of payment, or a type of security? The latter would be subject to different regulations, so it is hard to say at the moment how Libra will be regulated. A fast and cheap global payment system would have advantages, of course, but a key question is who would be responsible for regulating this system. Central banks would no longer have a direct influence on a key part of the payment system, leading to a weakening of their control over the financial system. If a high volume of transactions takes place in a currency that is not controlled, this can become a problem for the transmission and the conduct of monetary policy.
Lettau, M. and A. Madhavan (2018), “Exchange-traded funds 101 for economists”, Journal of Economic Perspectives, Vol. 32, pp. 135-154.
The paper “What is Libra? Understanding Facebook’s Currency” was published as SAFE Policy Letter No. 76 and is available here.