Could Facebook’s Crypto Break the Financial System? Congress Airs Fears

Xconomy San Francisco — 

In late 2017, a federal watchdog unit assigned a working group to keep an eye on cryptocurrencies such as Bitcoin, and to sound an alert if those alternate currencies showed signs of becoming a risk to the stability of the US financial system. Soaring prices of Bitcoin and other so-called digital tokens were attracting investments from speculators hoping to get rich quick—but these virtual coin values were also known to drop just as suddenly, the US Treasury Department’s Financial Stability Oversight Council noted.

But when the financial oversight council published its 2018 annual report, it concluded that volatility in the cryptocurrency realm could not yet cause broad ripples affecting the health of other US financial institutions. The total value of cryptocurrencies still made up a small fraction of US financial assets, and the coins had “limited use in the real economy or financial transactions,’’ the council wrote.

That was before Facebook (NASDAQ: FB), in June, publicly unveiled details about the new digital currency it’s proposing to launch by the first half of 2020 in partnership with at least 27 well-established business partners, including Visa (NYSE: V), Mastercard (NYSE: MA), Uber (NYSE: UBER), Lyft (NASDAQ: LYFT), PayPal (NASDAQ: PYPL), Spotify (NYSE: SPOT), Vodafone (NASDAQ: VOD), and venture capital firms including Andreessen Horowitz.

Facebook’s plans to make the novel currency, Libra, a global medium of exchange have raised alarms not only from US regulators, but also from lawmakers and guardians of the international financial system. Federal Reserve Chair Jerome Powell, a member of the Financial Stability Oversight Council, told members of Congress last week that Libra could pose a risk to US financial stability, and to the role of the US dollar in international finance, according to The Washington Post as well as lawmakers’ comments.

Two committees of Congress this week gave a public airing to that concern—and many others—as a Facebook executive endured hours of often testy questioning. Democrats called for a moratorium on the Libra project. Republicans—though many said they were loath to stifle business innovation with regulation—also joined Democrats in reviewing a litany of past user abuses laid at Facebook’s door, from making its privacy policies hard to navigate, and allowing member profiles to fall into the hands of third party developers without their consent, to failing to stop Russian government agents from manipulating the 2016 US presidential election through its social media platform.

“Facebook now wants to control the money supply,’’ Sen. John Kennedy (R-LA) said Tuesday during a Senate Banking Committee hearing on Libra. “What could possibly go wrong?’’

Lawmakers from both parties said they feared that Facebook, with more than 2 billion users and global dominance in social media platforms, could also dominate digital payments with Libra and mine user financial data from transactions with the currency, for profit. In its core social media business, the company earns money by offering advertisers the ability to target ads to groups of users based on information they share on the Facebook site.

Leaving Facebook’s checkered track record on data privacy aside, however, some lawmakers focused their questions on the finance elements of the company’s plan for Libra, which might have raised urgent questions no matter who was leading the charge. For the first time, a digital currency could be adopted at a large scale for worldwide use to buy and sell things.

“This is a complete overhaul of the circulatory system of the global economy,’’ said U.S. Rep. Jim Himes, (D-CT) at a hearing before the House Committee on Financial Services Wednesday.

Facebook has no plan to disrupt the financial system, and will make sure the concerns of all international regulatory bodies are addressed before the Libra currency is launched, according to hearing testimony by David Marcus. He heads up Calibra, the digital wallet that Facebook created so users can conduct transactions using Libra.

Marcus would not commit, however, to starting the Libra endeavor as a limited pilot project involving no more than a million users, and under supervision by the Federal Reserve and the Securities and Exchange Commission—a request from US Rep. Carolyn Maloney (D-NY). Nor did Marcus volunteer to change the planned timeline of the Libra rollout.

Ironically, Facebook’s digital currency initiative is drawing fire for eliminating many of the weaknesses that have confined earlier, volatile cryptocurrencies to the narrow backwaters of the financial world. While most digital coins have no intrinsic value, Libra would be backed by a reserve fund comprised in part of government-backed currencies including US dollars, euros, British pounds, and Japanese yen. Users would be able to change their Libra back into conventional currency, and the reserve fund is expected to maintain a stable exchange value for the digital coin, according to Marcus.

In his testimony before Congress, Marcus conceded that Facebook needs to earn back the public trust due to its much-maligned performance on data privacy issues. For that reason, he said, the company had decided to share the governance of the new digital currency with at least 27 other businesses and organizations, which he said have already established relationships of trust with consumers.

The digital currency, and its reserve fund, would be administered by the Libra Association, a private, nonprofit member organization set up in Geneva, Switzerland. Facebook and the other members would each have only one vote, and the membership of the association could eventually grow to 100 partners from a variety of nations.

Marcus told members of Congress that Facebook’s original 27 partners had been chosen because they had the ability to “accelerate the acceptance and utility of Libra’’ as a payment method for goods and services, as well as a tool to transfer money across international borders.

The Libra Association would keep transaction records through a blockchain—an online, distributed ledger, whose “nodes’’ would be operated by members of the Libra Association. This varies from the blockchain designs of some other cryptocurrencies, but the differences are of little consequence compared to Libra’s possible macroeconomic consequences and impact on international finance, said Claudia Biancotti, a visiting fellow at the Peterson Institute for International Economics in Washington, DC.

“What matters is that 28 private businesses, mostly from the United States, aim at introducing a global means of payment,’’ Biancotti said in an interview. “They actually have the numbers to succeed in this enterprise. This could get very big, very quick.’’

If Facebook’s more than 2 billion users decided to use Libra to make purchases and move money around, “it could become one of the world’s biggest financial entities,’’ according to a report in The Economist. Other partners in the Libra Association could also draw millions of their own customers into the digital currency.

“The crux of the matter is that the private sector is introducing a global currency,’’ Biancotti said. “This never happened before.’’

The creation of a currency is normally the exclusive sphere of the central banks of sovereign nations, Biancotti said. Safeguards should be put in place to prevent the Libra system from interfering with the rights of countries to control their monetary policy, she argues.

A nation’s monetary policy consists of actions such as setting interest rates in order to control inflation and influence the amount of currency in circulation—a major element of the money supply.

At the House Financial Services Committee hearing, both Democrat Maloney and Republican Andy Barr of Kentucky said they were concerned about Libra’s potential to interfere with central banks and monetary policy.

Maloney said the Libra Association’s reserve fund could end up “managing too much money,’’ posing a systemic risk to US financial stability by pulling an outsized amount of cash out of banks.

With depleted reserves, banks would need to reduce lending, The Economist predicted. If every bank customer in the West shifted a tenth of their savings deposits to Libra accounts, the Libra reserve could reach a value of more than $2 trillion, the publication estimated.

That potentially vast amount of money would be invested in a portfolio of assets, making the Libra Association an influential new investor in the financial markets. The reserve fund’s currency holdings would be lodged in custodial accounts at banks, but Libra’s managers could also invest in securities such as short-term government bonds.

Biancotti said the Libra Association’s investment bets could boost demand for financial assets such as bonds. “This could have repercussions for prices [of bonds],’’ she said. For that reason, the Libra project might be wise to phase in the process of selling the currency, to avoid swelling the fund and investing it over a short period of time, she said.

Members of Congress, as well as US and international regulatory agencies, are trying to figure out whether the Libra project can be controlled by their current framework of regulations. It’s not yet clear how the Libra Association would be classified—whether as a bank, a purveyor of securities such as exchange-traded funds, or some new kind of entity.

Marcus maintained that Libra is a payment tool, and will never grow large enough to supplant another currency.

The Libra Association will accept government-backed currency as payment for units of Libra, but it won’t pay interest to the buyers, such as consumers and businesses that want to use Libra for transactions.

If the assets in Libra’s reserve fund rise in value, the profit would be used to pay the operating expenses to maintain the currency. Beyond that, some of the profit would be distributed to Facebook and any other organizations that funded the Libra project. Marcus said part of the profits will be used for a pool of incentives to spur merchants and consumers to use Libra.

Facebook’s Calibra wallet is the first for-profit business created on top of the Libra currency, though the plan calls for many independent developers, from any country in the world, to build other wallets and financial services based on Libra. Calibra would compete in the digital payments field by offering users and merchants quick transactions at fees that could be substantially lower than the current average for credit card purchases and international money transfers, Marcus testified.

Facebook would profit from the Libra system because it would help establish ecommerce on the company’s social media platforms, including its WhatsApp and Messenger apps, Marcus said. That activity would lead to more revenue from advertising. Users could choose to use competing digital wallets through their Calibra accounts, but Calibra will be the only wallet embedded in WhatsApp and Messenger, Marcus revealed under questioning by Sen. Mark Warner (D-VA) at a Senate committee hearing Wednesday.

Marcus also claimed a benevolent mission for the Libra ecosystem—it would serve the poor and people in developing nations who lack access to banking services or can’t afford the fees. With a $40 smartphone and a basic data plan, he said, workers could tap into the global economy, or send money to family members in their home countries instantly while avoiding money transfer charges of 7 percent or more.

The success of the global Libra system would depend on a network of for-profit businesses and currency exchanges in many countries, where monetary policies vary widely. Marcus said US-based Calibra would not be able to operate in some developing countries that impose currency controls. Certain countries bar the use of foreign currencies, regulate exchange rates, or forbid the export of the national currency, for example, as a means of stabilizing the local economy.

Biancotti said the Libra project could pose a danger to developing countries, which often have high inflation rates that lead to a devaluation of the local currency. Citizens of these countries might sell assets to buy Libra to avoid the erosion of their wealth or to participate in the global economy, she said. This could cause the local currency to devalue against the dollar, the yen, or other government-backed currencies. Some residents—such as those without Internet access—could be stuck with the national currency, dividing commercial activity between two forms of money. The nation’s central bank would be unable to fully mitigate the disruptive effects through its monetary policy, she said.

“They can only reach those using the national currency,’’ Biancotti said. “It’s an extreme case, but it could happen.’’

The United States uses its control of the national currency (dollars), its jurisdiction over banks, and its monetary policy not only to regulate the economy, but also to prevent crimes like money laundering and the financing of terrorist plots. In addition, it can enforce sanctions on other nations or individuals by freezing their bank accounts.

Members of Congress asked Marcus how that could change with Libra in use. “The currencies represented in the Libra Reserve will be subject to their respective government’s monetary policies—policies those governments will continue to control,’’ Marcus said in testimony prepared for the Senate Banking Committee. As for US-based Calibra, it would comply with US laws, he said. Competing wallets and other Libra-related services based in other countries would follow local laws there, Marcus said.

If it does nothing else, the Libra project has created a boatload of new homework for US legislators and regulatory agencies. Members of Congress are now preparing written questions to send to Facebook, and the company’s meetings continue with agencies belonging to the Financial Stability Oversight Council.

Concerns over Libra are confronting lawmakers while Congress is still grappling with a larger quandary—have tech companies such as Facebook, Amazon (NASDAQ: AMZN), and Google (NASDAQ: GOOGL) become so large that they have outsized influence on everything from social media and entertainment to commerce and politics? And if so, should US lawmakers look to break them up under the nation’s antitrust laws?

Facebook appears to be facing some strong headwinds before it can gain US approval for Libra. The Federal Reserve chair, the Treasury secretary, and President Donald Trump have all expressed reservations about the cryptocurrency project. But Facebook also has a cultural hurdle to overcome, because some Republican lawmakers see the company as a liberal Silicon Valley communications powerhouse that has allegedly tilted its content curation to discriminate against conservative messages and businesses such as gun manufacturers.

At the Senate Banking Committee hearing, Louisiana Congressmember Kennedy wondered whether Facebook could use its leadership position in the Libra network to set its own political or cultural agenda by controlling access to the digital currency it created.

“Facebook is really not a company anymore—it’s a country,’’ Kennedy said.