Will Libra affect the Chinese version of digital currency?

Note: This article was first published on FT Chinese on December 25, 2019.

Libra has claimed since its creation that it will be committed to promoting inclusive finance. This reason seems to resonate easily in today's world. In addition, it is pegged to a basket of sovereign currencies, has no monetary policy, complies with the regulatory requirements of various countries, and has a decentralized management form, all of which are trying to show goodwill to all parties. However, can Libra really be as inclusive and harmless as it claims?

1. Discussions in the early stages of development: Questions about the inclusiveness of Libra

The Libra white paper describes three types of problems in today's financial system: complicated fees, high loan interest rates, and low availability of bank accounts. Libra is also committed to solving these problems. However, a little analysis will reveal that there are many logical doubts.

First of all, how can Libra services cover customers without bank accounts? For users with low bank account availability, although they can quickly open a Libra account online, the Libra coins in the account need to be obtained through exchange or transfer from others. In the absence of a bank account, the exchange of national currency and Libra can only be done through cash transactions. Libra operates in a binary model of "Libra Association-Distributor". How can dealers build such a strong network to meet the demand for cash transactions? Will unofficial Libra regional agents emerge, or even evolve into a black market in essence?

Second, the white paper uses several cases to illustrate that traditional financial loan interest rates are high. Does this mean that Libra will introduce low-cost micro-loan services in the future? As we all know, as a payment system and as a lending institution, the two are significantly different in terms of licenses, management models, and impact on the financial system. If the current plan includes a loan function, the depth and breadth of its evaluation should be greatly enhanced.

Third, whether the comprehensive use cost of Libra is lower than that of banks remains to be discussed. The blockchain system does not involve high transfer and wire transfer fees, but other fees still exist. For example, the Libra reserve is composed of a basket of currencies, which means that "subscription/redemption" with any currency requires buying or selling the reserve currency basket, thereby facing exchange fees, including handling fees and exchange losses caused by exchange rate fluctuations. Although the exchange work is likely to be completed by dealers, the fees incurred will not disappear out of thin air, but will be implicit in the exchange rate between Libra and various currencies. This fee may be more obvious for users whose national currency is not a Libra reserve currency. In addition, Libra does not generate interest, so users holding Libra will bear the opportunity cost of generating interest, and the lost interest income also needs to be included in the comprehensive use cost of Libra.

2. Discussion after reaching a certain scale: Libra’s potential impact on the existing economic system

If Libra can successfully become the mainstream digital currency of many countries, the existing order of the world economy will most likely be broken. First, Libra will introduce a non-nationalized currency board system for small economies; second, for large economies, it is more likely to manifest as inflationary pressure brought about by Libra's money multiplier; third, the design similar to ETF funds will generate a large number of intermediate asset forms, which will bring new uncertainties to the global market for Libra's liquidity management; fourth, if Libra conducts credit business, it will make the problem more complicated.

1. Denationalized Currency Board System

There are many cases of currency board system around the world, but Libra is the first cross-border currency board system arrangement. For sovereign states, adopting two currencies at the same time in their country will cause many problems. Libra does not have an independent monetary policy, but it does not mean that there is no monetary policy: the interest rate and exchange rate level of the anchor currency will greatly affect Libra itself. Although Libra claims that it will not pay dividends to currency holders, there is no need to worry about interest rates. But its exchange rate with other currencies will always be in dynamic change, that is, Libra's "exchange rate" problem cannot be avoided for the time being. From a practical point of view, the currency board system is only suitable for a certain type of small open economy. Will Libra's indiscriminate forced introduction of it into various countries have beneficial consequences?

For small economies, the problem may be more serious. In order to maintain currency stability, Libra currently chooses a basket of reserve currencies of five relatively strong currencies (50% US dollar, 18% euro, 14% Japanese yen, 11% British pound, and 7% Singapore dollar). According to the exchange rate formation mechanism, the exchange rate between Libra and a country's sovereign currency will depend on the monetary policy, balance of payments, and medium- and long-term economic development of the country where Libra is anchored. Therefore, a country's sovereign currency may form a relatively stable exchange rate with Libra, or it may diverge. Under the condition of a single currency, even if a country's currency is weak, it still has a certain degree of isolation mechanism between foreign currencies and the domestic economy. However, if Libra is introduced, strong currencies will be directly introduced into the domestic circulation market. This approach may lead to three problems:

First, the domestic pricing system adopts double standards, which is easy to cause price chaos in the commodity market. Unlike the IMF's Special Drawing Rights (SDR), Libra directly faces producers and consumers. Therefore, most raw materials, semi-finished products and finished products can be settled in Libra and local currency at the same time. If these two currencies cannot maintain a relatively stable exchange rate, it will cause chaos in the commodity market, causing price failure, which will then be transmitted to the upstream of the production chain, causing a more serious impact on the country's circulation and production links.

Second, Libra may have a crowding-out effect on the local currency. This effect will not only fail to benefit the general public, but will also cause social instability and wealth transfer. Libra's underlying assets are the reserve currencies of large countries, which have obvious stability and liquidity advantages over the currencies of small countries. When two currencies can be used at the same time, residents will naturally choose the more convenient and stable currency, which is the so-called "good money drives out bad money". The exchange process corresponds to the country's local currency selling and buying reserve currencies in the foreign exchange market, which will lead to depreciation pressure on the country's currency. The depreciation of the local currency will make its exchange rate with Libra lower, thereby further encouraging the country's residents to exchange for Libra in order to seek asset preservation. As a result, the country will form such an embarrassing situation: the sooner the local currency in hand is exchanged for Libra, the relatively high exchange rate can be enjoyed; the later the exchange, the lower the exchange rate. Once such a situation is formed, on the one hand, it will cause panic selling of the local currency, and on the other hand, it will actually lead to the redistribution of social wealth, from late exchangers (the general public) to early exchangers (the wealthy people who are foresighted).

Third, small economies may lose their monetary policy independence. When two currencies are used at the same time, the exchange rate needs to be kept as stable as possible to ensure the smooth operation of the market. However, Libra corresponds to the currencies of several major countries. To keep consistent with them, the monetary policy of the country must be as subordinate to the monetary policy of the major countries as possible. This is undoubtedly equivalent to Libra forcibly introducing the currency board system into these small countries. However, due to the obvious differences in economic cycles, economic structures and external environments between countries, following the policies of major countries may bring immeasurable problems to these small countries.

2. Libra’s multiplier effect

For large economies, a larger economic size may avoid the above-mentioned problems of small countries to a considerable extent. However, the operation mode of Libra will also bring new challenges. The author believes that the "multiplier effect" of the Libra currency may be the most worthy of discussion. This issue was first raised by Alex Lipton and others from the Massachusetts Institute of Technology, but it was not called the "multiplier effect". In the traditional monetary system, the multiplier effect is generated by commercial banks through continuous credit activities. The final money supply in the market will be several times the base currency issued by the central bank. Does the lack of credit activities in Libra mean that there is no multiplier effect? ​​For large countries (especially reserve currency countries), Libra will use the corresponding reserve currency to purchase high-grade bonds and other securities while releasing digital currency to the market. In other words, this part of the reserve currency is not stored, but returned to the financial markets of these countries and entered the circulation link. This move is equivalent to doubling the local currency used to purchase Libra in the market: half circulates in the form of Libra and the other half circulates in the form of local currency, which will bring certain inflationary pressure to the above-mentioned countries.

3. Libra’s liquidity management

The white paper emphasizes that Libra will not pay interest to users, so users face two practical problems: the balance may not be enough when they need to use it; and a large number of Libras idle in the account is a waste. Therefore, how to convert Libra into an interest-bearing asset as soon as possible when it is idle, but how to quickly convert it into cash when it is needed, is the basic requirement of users for Libra. Cash also has this problem. But cash can be deposited and withdrawn on demand in banks, and behind it is the highly developed liquidity management system of the banking system. In order to achieve a balance between risk and return, the banking system has strong constraints on liquidity management from the regulatory level, and each bank also has a complete set of mature management systems to meet the liquidity needs of all parties.

In terms of liquidity management, Libra faces a more complicated situation. The entire system involves four asset forms: a combination of national currencies, reserve currencies, financial assets invested by reserve currencies, and Libra currency. The first three are real assets, and their conversion requires real connections with the global financial market. When its volume is large enough, it will have a significant impact on the financial market. Banks' liquidity management mainly considers the proportion of different asset types and the mutual matching with the liability side. Although the management work is more complicated, it is mainly based on the same currency, so matching can be completed by relying on several domestic market transactions. The above three real asset forms of Libra determine that it must be operated simultaneously in the financial markets of multiple countries and the global foreign exchange market. Not only does it involve the ratio of different types of assets in different countries on the asset side, but it also involves the comprehensive control of liquidity between different currencies on the liability side. Its complexity can be seen.

When the scale is large enough, Libra's liquidity management will have at least three impacts on the global market:

First, the volatility of the foreign exchange market will increase. The exchange between the local currencies of various countries and the reserve currency combination will be more frequent, and a force will be formed to enhance the consistency of the trend of each reserve currency. However, there are large differences in the economic development stage, monetary policy and other aspects of the countries that serve as reserve currencies, and the exchange rate trends may not necessarily converge. The convergence force brought by Libra will disrupt the original pricing logic of the foreign exchange market and aggravate market volatility.

Second, it affects the pricing logic of the financial market. Although it may not chase the rise and fall, Libra's reserve currency will still participate in cross-border capital flows as part of international "hot money". When the reserve currency portfolio is converted into a financial asset portfolio, it will prefer low-risk assets with high credit ratings, which will lead to a decline in the yields of these assets. Since high-credit-rating products are often the "anchor" for the pricing of other products (such as US bonds), in terms of effect, the expansion of Libra's scale will drive the yields of low-risk financial products downward and credit expansion; while the contraction of its scale will lead to a large number of sales, which will increase yields and shrink credit. This will bring new variables to the monetary policy transmission of reserve currency countries and increase market uncertainty.

Third, financial disintermediation. As a means of payment, Libra essentially directs the value circulating in the banking system to the Libra network. As mentioned above, the multiplier effect of Libra doubles the value of legal currency: half is placed on the Libra network, and the other half continues to exist in the traditional financial system in the form of reserve assets. This model disintermediates the currency that should have participated in bank credit creation to Libra, forming an "off-balance sheet asset" in the financial system. This move will undoubtedly make Libra compete with commercial banks to a certain extent, reduce the role of banks in the financial system, and thus pose a greater challenge to the traditional financial regulatory model.

Although at the U.S. House of Representatives hearing, project leader Marcus tried his best to deny that Libra is an ETF fund, its currently announced operating model does have too many similarities with ETFs, especially that both require subscription and ultimately purchase of asset portfolios. Similar to ETFs, there are theoretically two ways to obtain Libra: subscribe for new shares or purchase transfer shares from the secondary market. The white paper currently does not mention the secondary market transfer method, but from an efficiency perspective, the subscription/redemption method requires repeated exchange and asset trading, which incurs a lot of costs; it is better to establish a secondary market trading mechanism to make fine adjustments on the liability side without involving repeated adjustments of the underlying assets, which is beneficial to the liquidity management of the entire system. However, whether the establishment of a secondary market is conducive to maintaining the stability of the Libra currency value is also a question to be discussed.

4. Potential credit creation capability

Although Libra currently claims to be used only for payment, if its scale expands, we cannot prevent it from providing some service modules with credit creation functions, such as small consumer credit business similar to "WeChat Loan" or "Huabei". Its model for carrying out such business can be very flexible, and it can provide loans to users at the dealer level without the Libra Association. We might even boldly speculate that credit business is the only way for Libra to develop in the future, because as mentioned earlier, it clearly states in its white paper that the high loan interest rates in some regions are a problem it hopes to solve.

If Libra creates credit, it will undoubtedly have a significant impact on the global financial system. In the traditional financial system, credit creation and currency issuance are completed through the cooperation of the two-tier structure of "central bank-commercial bank". The central bank is responsible for issuing base currency and assumes the role of the lender of last resort. Commercial banks directly face end customers and complete a series of specific tasks such as credit creation and deposit absorption. In the Libra system, the relationship between the association and dealers may also evolve into the relationship between the central bank and commercial banks. Once credit creation is carried out, it first means that the Libra system has the willingness and ability to add new assets without surrendering reserve currencies, that is, Libra is no longer strictly linked to reserve currencies, and its value basis has undergone a fundamental change: from a stable currency to a quasi-sovereign currency. The Libra Association will actually become a supranational central bank.

So, will this super-sovereign central bank succeed? Currency is the liability of the central bank. The reason why the central bank can issue currency is that it has state-owned assets and future taxes as value support. The reason why the Bretton Woods system eventually collapsed (the dollar was decoupled from gold) was that people believed that the amount of gold held by the United States could no longer support its currency issuance. But once Libra is separated from the reserve assets, there is no other value basis at the bottom. Even if it is widely used around the world and can be regarded as a value basis, Libra will evolve into a typical Ponzi scheme and will ultimately fail.

Therefore, if Libra wants to solve the problems of low loan availability and high interest rates, the way of creating credit by itself may not bring good results. The author believes that there are two other ways that can be tried: First, Libra cooperates with commercial banks to serve as a payment tool and a medium for information collection, so that banks can expand their services to areas where financial services are underdeveloped. Second, dealers first pay 100% of the reserve funds, obtain a certain amount of Libra currency, and then transfer it to users who need loan services with a certain interest or handling fee. Users repay the principal to dealers in the form of Libra or local currency within the prescribed period. In this way, the Libra system does not involve the problem of credit creation. The so-called loan is just the dealer lending out the stock Libra he holds, which avoids the problem of Libra being decoupled from reserve assets.

3. Comparison between Libra and China’s central bank digital currency

While Libra is controversial, the People's Bank of China's proposed central bank digital currency DCEP (Digital Currency Electronic Payment) is in full swing and will soon enter the actual issuance stage. Although both are digital currency attempts, the models and ultimate goals chosen by Libra and DCEP are completely different.

From the surface design, there are many differences between the two: on the basis of credit, the value of the reserve currency pool is behind Libra, while the sovereign currency credit of the RMB is behind DCEP. In terms of scope of use, DCEP only replaces M0, that is, cash in circulation; while Libra also involves M1 and even part of M2. In terms of usage, DCEP can realize "dual offline payment" and does not force account binding; but Libra must be authenticated online and is based on a clear account concept. In terms of organizational form, the core part of Libra operates in the form of an association, and it is time-consuming and laborious to coordinate major matters among members; while the core part of DCEP is completely managed by the central bank, and the decision-making process is simple and efficient. In terms of regulatory adaptation, although Libra has tried its best to please central banks of various countries, including the Federal Reserve, the current mainstream regulatory agencies around the world are still skeptical about it, and the road to hearings and demonstrations is endless; DCEP is led by the People's Bank of China and has a natural "regulatory license" in China, so it can focus on rapid advancement.

Through logical deduction, the possible consequences of the two are also very different: in terms of management methods, Libra currency will gradually break away from the traditional financial system, that is, "financial disintermediation"; but DCEP will gradually include cash transactions that cannot be tracked by the traditional banking system into the management scope, which we might as well call "cash re-intermediation". In terms of the impact on the market, Libra will complicate the financial market, aggravate market volatility, and reduce the effectiveness of monetary policy; while DCEP will help the central bank to achieve its monetary policy goals to a large extent due to its enhanced unified management of M0. In terms of international impact, Libra's reserve assets are likely to be mainly US dollars, which will enhance the dominant position of the US dollar in the world and may form a certain suppression on the sovereign currencies of non-reserve currency countries; DCEP is completely used to replace the RMB's M0, so theoretically it has no significant impact on the foreign exchange market. On the premise of not having an adverse impact on other countries' currencies, it can create favorable conditions for the in-depth implementation of the internationalization of the RMB and play a positive role in enhancing my country's international status and enhancing its voice.

In summary, although Libra and the central bank's digital currency DCEP are both attempts to expand currency into the digital field to make daily payments more convenient, in fact, no matter from the perspective of technology, model, results, etc., the two have completely parted ways and are moving in opposite directions. Of course, neither of them has been officially launched yet, and we can only conduct theoretical analysis and logical deduction based on existing public materials. Before the product is actually launched, a large number of technical adjustments are inevitable.

4. Sober Thoughts on Digital Currency and Blockchain

Digital currency and blockchain are like twin brothers, inseparable and mutually beneficial. With the promotion of digital currency, blockchain technology has received great attention at the core level, and has derived many potential application scenarios under the repeated fermentation of the market. However, blockchain technology has been invented for more than ten years. So far, it is not that the market has not paid enough attention or invested enough resources, but there are still few actual applications combined with the industry. The author believes that this contrast has its deep reason, that is, the boundaries of technology are not as boundless as the market advocates.

The essence of blockchain is to enable parties who do not trust each other to trust each other through a consensus mechanism. But just like accounting, clear and accurate accounts do not mean that the underlying business can stand the test. From the author's microscopic observation, the main application scenario of blockchain at present is to ensure the security of information after "on the chain" so that it cannot be tampered with. This security is indeed important, but it may not be the key issue facing the current industry. Take financial fraud as an example. Several years ago, the fraud method was mainly to modify accounts or "two books". However, with the increasing intensity of audit work, it has become increasingly difficult to modify accounts. Therefore, in recent years, the fraud method has been upgraded: the account and various documents are strictly consistent, and the underlying business level is directly manipulated. For example, inflated business, cash flow, goods outbound and inbound orders can all be real, but the goods shipped can be different from the ones in the order, or even empty boxes, which is the so-called "brushing orders". Such behavior is difficult to reflect on the books. The author uses this example not to specifically say that this type of fraud cannot be prevented, but it has indeed exceeded the field of blockchain technology. Now that the fairness of the "bookkeeping" work itself is no longer a bottleneck for the development of the real economy, how great is the value of blockchain technology generated by bookkeeping, and how to better serve the real economy are indeed issues worth rethinking.

The success of blockchain in the field of digital currency mainly stems from the fact that the exchange of currency is mainly reflected in the accounting level, and does not involve more basic business, so it happens to be covered by the advantages of blockchain. But from another perspective, the relatively complicated consensus process of blockchain also affects the real-time and concurrency of transactions to a certain extent. The author suggests that the ability boundary of blockchain should be viewed rationally and dialectically, and its advantages in the field of digital currency are not suitable for unlimited extension, so as to avoid ineffective investment of social resources. Of course, blockchain technology itself is also constantly innovating, and its ability boundary will inevitably expand. Digital technology is ultimately just a tool. The author sincerely hopes that the only direction after the large-scale promotion of digital currency is to make life better. But whether it can be achieved in the end, we will wait and see.

This article is from the "Chief Economist Forum".