February 26, 2020
Hilary J. Allen, American University Washington College of Law
Money serves three important functions. It acts as a unit of account (meaning that it can be used to measure the value of goods and services); a store of value for the future; and a medium of exchange enabling a transfer of value from one person to another. Money does not necessarily need to be issued by a sovereign government: these functions can be fulfilled by something that does not satisfy any legal definition of “money” or “currency”, so long as there is an implicit agreement amongst a group of actors to use that thing as a unit of account, store of value and medium of exchange. However, in the absence of institutional support from a central bank and government, confidence in the ability of such privately-issued money to continue fulfilling these functions is fragile, and thus the tenure of privately-issued money is often limited. This essay will consider the extent to which cryptocurrencies, and in particular, Facebook’s proposed Libra currency, can serve as privately-issued moneys, and explain why their money status (if achieved) will be fragile, and potentially dangerous.
Panic can quickly erode the money status of any privately-issued money. If confidence in that money begins to fray for any reason, payments will no longer be able to be reliably effected in that money at a rate that matches the expectations of the community that adopted it. Because private issuers of money are unable to levy taxes, they are limited in their ability to muster resources to back their money in the event of a panic. The inverse is also true: because privately-issued money cannot be used to pay taxes, there is no baseline public demand for that money, which means that it is less likely than sovereign-issued money to continue to function as a means of exchange and reliable store of value during and after a panic. Sovereign currencies also benefit from other measures of support that privately-issued money lacks. Central banks often commit to price stability mandates that can ensure that sovereign currencies continue to match expectations about their continued functioning as a unit of account and store of value. If confidence in a sovereign currency is undermined for some reason, central bank statements regarding prospective monetary policy can calm those concerns. During a panic, users of privately-issued money are therefore likely to exchange that money for sovereign currencies, depressing the value of the privately-issued money (thus damaging its functions as a unit of account and store of value) while at the same time reducing the pool of people with whom privately-issued money can be used as a means of exchange. Even more users of the privately-issued money will then be incentivized to exchange for sovereign currencies, creating a vicious cycle.
The possibility of such dire outcomes does not always dissuade users from adopting a privately-issued form of money, though. Just as other assets (ranging from immovable stone discs to squirrel pelts to cigarettes) have temporarily served as money within certain communities, a cryptocurrency could serve as money if there were agreement within a community to use it in that fashion. However, even when compared to historical examples of privately-issued money, the “money” status of cryptocurrencies like bitcoin seems particularly fragile because such cryptocurrencies are not backed by any revenue stream and lack any tangible value as a commodity. As a result, a panic could easily deprive the cryptocurrency of its ability to serve as a means of exchange or a store of value. Furthermore, panic is not the only means by which cryptocurrency could be stripped of its money functions. As the technologies by which money is created, documented and conveyed become increasingly sophisticated, it becomes increasingly possible that operational failures could cripple its functionality. For example, if the distributed ledger on which ownership of a cryptocurrency is recorded became significantly corrupted, then the cryptocurrency would no longer act as a reliable store of value (the existence of a unit of cryptocurrency is entirely determined by its recordation on a distributed ledger). Furthermore, because transactions in cryptocurrencies can only be effected by updating the distributed ledger to reflect the transfer of the unit to the new owner, a corrupted ledger would also prevent the cryptocurrency from serving as a means of exchange.
Distributed ledgers can be difficult to fix. Many such ledgers are decentralized, in the sense that there is no one “in charge”, and so fixes cannot take effect unless and until they are adopted by the majority of the users in the network. If majority approval cannot be achieved, the gridlock can be addressed by a “hard fork” that splits the distributed ledger in two, but given the network effects of distributed ledgers, hard forks are undesirable. Admittedly, not all distributed ledgers are decentralized: some are designed to have hierarchies of control or established coordination mechanisms that make such impasses less likely. However, if these ledgers are designed to be interoperable with other ledgers, or are accessed through APIs developed by third-parties, those in charge of the ledger may still be limited in their ability to address operational failures. In sum, because of the technological complexity of cryptocurrencies, there are yet-to-be-appreciated operational risks that could impair a cryptocurrency’s ability to function as a unit of account, store of value and means of exchange.
Of course, in order for a privately-issued money to lose its money status, it has to attain that status in the first place. The volatility of cryptocurrencies has so far inhibited their ability to function as a unit of account, means of exchange or store of value, (although cryptocurrencies have arguably come closer to achieving that status in jurisdictions like Argentina, where the sovereign-issued money is also plagued by uncertainty and volatility). The latest iteration of cryptocurrencies, the “stablecoins”, are designed to better achieve money status by moderating fluctuations in value – either by backing the cryptocurrency with some form of asset collateral, or by using algorithms to manage the supply of the cryptocurrency (or by combining both mechanisms). The Libra currency that has been proposed by the Libra Association (a not-for-profit organization that was pioneered by, and is currently led by, Facebook) has been classified as a “global stablecoin” or “GSC”. The white paper setting out the Association’s proposal explains that the Libra currency will be backed by a basket of bank deposits and short-term government securities in a variety of currencies (referred to as the “reserve”), in order to assuage concerns about Libra’s reliability as a store of value and unit of account. Since the Libra Association published its white paper, it has received significant (and seemingly unanticipated) pushback from national governments. This concern is justified by the proposed scope and scale of Libra – the white paper states that it seeks to be a global currency that will facilitate cross-border exchanges amongst billions of people.
The value of a Libra will fluctuate depending on the composition and valuation of the underlying reserve of assets, but the Libra Association has stated that the Libra currency has an intrinsic value. This assurance could quite possibly create unwarranted confidence in Libra that could easily be disrupted by a panic. If holders of Libra came to doubt that Libra could retain a stable value against their preferred sovereign currency, then they would exchange their Libra for that currency. It is unclear from the White Paper whether Libra holders would be able to require the Libra Association to buy Libras back from them, or if holders would be entirely reliant on third parties to exchange their Libras for sovereign currencies (if the latter, the reserve seemingly contributes little to Libra’s reliability as a store of value). If the former, during a panic the Libra Association would have to start exchanging or selling the most liquid assets from the reserve in order to meet the redemption requests, flooding the market with such assets and depressing their values. Remaining Libra holders who feared that the value of their Libra would plummet against sovereign currencies as the reserve is depleted would be incentivized to redeem their Libra for sovereign currencies as early as possible, creating a vicious cycle. If, on the other hand, holders had no right to redeem their Libras from the Libra Association, the reserve assets themselves would be less affected by a panic. However, asset prices would be dragged down in other ways. Confidence in Libra would be even more fragile if the reserve were inaccessible to Libra holders, and so financial institutions with significant exposure to Libra could swiftly find their holdings to be worthless in a panic – given how highly leveraged financial institutions tend to be, they would likely have to rapidly sell other assets in order to meet their obligations, depressing their values.
A panic with regard to Libra could therefore result in a fire sale of assets, crippling the financial markets. Given Libra’s proposed scale, the impact of such a panic would likely be global, and to avoid such an eventuality, there would be pressure on national authorities to bail out Libra (although given the international reach of Libra, working out the terms of such national intervention would be a messy process, with the panic only worsening as the details were hashed out). Furthermore, even in the absence of panic, Libra could generate negative externalities worldwide. Implicit in the Libra Association proposal is that user confidence will be derivative of the efforts that national governments and central banks expend on maintaining the sovereign currencies that make up the Libra reserve. The Libra Association intends to profit from producing and distributing Libra, and these profits (known as seignorage) free-ride on the efforts of national governments, central banks and regulatory authorities to preserve stability in their own sovereign currencies. At the same time, Libra intends to cannibalize the market for sovereign currencies and thus erode the ability of national authorities to earn their own seignorage. A more limited supply of national currency also limits the ability of national authorities to carry out monetary policy for the benefit of the broader economy. In sum, a widely-adopted Libra could undermine national monetary policy and profit at the expense of national governments, as well as create global financial crises. While Libra has been proposed as a solution to real problems like financial inclusion and cross-border payment inefficiencies, the significant perils associated with treating it as privately-issued money militate for finding other solutions to these problems.
There is some controversy about whether Libra should be classified as a cryptocurrency, because the Libra White Paper does not contemplate using any cryptographic proofs to verify Libra transactions (at least at first). However, Libra shares many other attributes with existing cryptocurrencies which are pertinent to determining the “money” status of Libra. ↑