libra

Understanding Facebook's Libra

May 21, 2020

Money is a social construct. Societies around the world have agreed that money would be the primary mechanism to use for transferring value between people. If it weren’t for that agreement, cash would just be paper, a credit card a piece of plastic, a bank account a useless number. 

Because money is a social construct, we’ve been able to abstract it away. The dollar hasn’t been tied to gold for decades and digitization means we’re moving to cashless societies. Money now moves digitally, invisibly. When the US government says they’ll print $2 trillion, they won’t actually print $2 trillion physical dollar bills. Someone in the Federal Reserve will just increase the number on their balance sheets. Poof, money.

Those who can print the money have the power. So, when Facebook came out with plans to launch its own cryptocurrency in June 2019, governments and central banks around the world reacted with horror, terror, and Senate hearings. This is Facebook’s attempt to take even more, we heard. Facebook is trying something that will destabilize society, we heard. This is dangerous and should be stopped, we heard.

But sensationalist headlines only ever scratch the surface of a topic. I wanted to understand what Libra actually is. What is its mission, how does it work, and how is Facebook involved in the project? I dug deep into the official Libra white paper, Libra’s developer documentation, and other, more critical sources to figure this all out. Here’s what I found.

Why Does Libra Exist?

Libra wants to “enable a global payment system & financial infrastructure to empower billions of people." They particularly focus on those who either don’t have access to financial services (the unbanked) or those who have limited access to financial services (the underbanked). 

Today’s banking system is expensive for the poor. While a $5 remittance fee might mean nothing to someone sending across $1 million, it’s incredibly painful for the factory worker sending across $20 to his family abroad.

Additionally, billions of people simply don’t live in an area where they have physical access to a bank. A Berber in the Sahara desert or a sheepherder in the Himalayas is unlikely to ever come across the regional equivalent of an HSBC.

the Sahara desert and a single palm tree
Follow your nose to the closest bank

However, there’s a good chance that these people have a phone connected to the Internet. A financial system built with blockchain technology means, theoretically, that anyone with an Internet connection can participate. Libra wants to be that financial system. It wants to combine blockchain technology with accepted, regulatory financial frameworks to reduce the cost of the banking system and make it more inclusive.

Who’s in Charge?

Contrary to popular opinion, Facebook is not in charge of Libra. They came up with the idea and built a large chunk of the technology behind Libra, so they definitely want to see the project succeed, but they have no disproportionate voting power to account for this. I only chose the title “Understanding Facebook’s Libra” because Libra in itself doesn’t have enough brand power yet for everyone to immediately understand what the article was about. But there is no such thing as a “Facebook Libra”. Instead, Libra is owned by the Libra Association.

The Libra Association is a not-for-profit membership organization based in Geneva, Switzerland. It’s responsible for the development of the Libra project and for providing decision-making frameworks for the Libra Network and Reserve (more on them later). Members of the Association include Shopify, Farfetch, Coinbase, Spotify, Uber, etc. It’s a growing list of companies from a wide variety of industries.

It’s not easy to become a Libra Association member. If you’re a for-profit company, you need to invest at least $10 million, have a market cap of more than $1 billion, reach more than 20 million people a year, and be recognized as an established top-100 industry leader. You also need to run a validator node to process transactions on the Libra blockchain, which can cost a few hundred thousand dollars a year.

In exchange, you get one vote or 1% of the vote (whichever is larger) in the Association’s Council and the equivalent of the money you’ve invested in Libra Investment Tokens. Your share of the tokens will translate into the proportion of the dividend you’ll receive from the interest of the assets in the Libra Reserve. So the more you invest, the higher your proportion of the dividend and the more money you’ll earn if Libra succeeds.

How Does it Work?

Now that we know who’s in charge, let’s examine how Libra works. The Libra Association owns Libra Networks, which is responsible for minting and burning Libra Coins, administering the Libra Reserve, and for operating the Libra payment system that runs on the Libra Blockchain. Let’s go over each of these elements in turn.

Understanding Libra Coins

When Facebook launched the Libra project in June 2019, they intended to run only one cryptocurrency on the Libra blockchain: the Libra Coin (abbreviated as ≋LBR). It was meant to be a cryptocurrency with low volatility that people can use to settle transactions across borders. 

Sending 20 ≋LBR to your family abroad across the Libra Blockchain would be fast and very cheap, and your family could then convert it to their local currency to spend on goods and services.

One of the reasons why Libra faced such strong opposition is because countries were afraid Libra could interfere with their monetary sovereignty. They were afraid of a scenario where a majority of people would only use ≋LBR for everything instead of their local currency. So, after many months of deliberation, Libra backed down. As announced in the second edition of their white paper, ≋LBR will no longer be the only cryptocurrency on the Libra Blockchain. Instead, they will also include single-currency stablecoins, starting with LibraUSD, LibraEUR, LibraGBP, and LibraSGD. 

Brief explainer: stablecoins are cryptocurrencies that are pegged to the currency they represent. For example, LibraUSD is a stablecoin of the US dollar. 1 LibraUSD can be converted to almost exactly $1. Stablecoins are one of the fastest-growing areas of the cryptocurrency industry.

All the cryptocurrencies on the Libra Blockchain are called Libra Coins. Libra Networks is responsible for minting and burning them, which will happen in response to the market demand of that particular coin. 

While Libra will still control the single-currency stablecoins running on their blockchain , they say in their white paper that they want countries to directly integrate their Central Bank Digital Currencies (CBDCs) into the Libra network. If the US created its own CBDC and wanted to integrate that into the Libra Blockchain, Libra would remove the LibraUSD in exchange for that currency. 

So all Libra Coins are stablecoins. Their price will not fluctuate like the price of Bitcoin or Ethereum, which makes a Libra Coin a much more trustworthy currency to use as money. But how will Libra keep the prices of its coins relatively stable? That’s where the Libra Reserve comes in.

Understanding the Libra Reserve

The Libra Reserve must hold an amount of money at least equal to the face value of each Libra Coin in circulation, either in cash or cash equivalents. Compare that to traditional banks, which only need to hold a fractional reserve (or nothing at all, as per recent developments in the US). 80% of Libra’s Reserve will consist of short-term government securities with low credit risk while 20% will be held in cash.

If those assets yield a negative return, the Reserve will make up for it through other revenue streams, such as the transaction fees of the Libra Blockchain. It will use positive returns to pay for its operating expenses and to return a dividend to the members of the Libra Association (remember those Libra Investment Tokens? That’s what they’re for). 

To further spread the risks of shocks to the system, the assets of the Reserve will be held by a geographically distributed network of well-capitalized banks. There will also be an additional capital buffer to absorb unexpected losses. All this to make sure that 1 ≋LBR (or any other Libra Coin) keeps its value over time and doesn’t fluctuate as crazily as regular cryptocurrencies do.

Understanding the Libra Blockchain

One of the biggest problems of today’s cryptocurrencies is speed. Bitcoin, for example, can only process about 7 transactions per second (TPS). Compare that to traditional payment provider Visa, which can handle 24,000 TPS on their network. 

If you want to build a cryptocurrency that billions of people can use without friction, it needs to be fast, efficient, secure, and flexible. That’s why the Libra Blockchain runs on an entirely new programming language called Move. Developers can use Move to implement transaction logic and smart contracts on the Libra Blockchain, although, at first, only Association-approved and -published smart contracts will be able to interact directly with the Libra payment system.

The Libra Blockchain is built in such a way that it can process approximately 1,000 TPS. This is in part because of its consensus mechanism. Libra does not rely on Proof of Work, like Bitcoin does, because it’s slow and bad for the climate (it consumes lots of electricity). Instead, it relies on the validator nodes of Association members to confirm transactions.

Without going into too much technical detail, the actual consensus mechanism is called LibraBFT and is based on the HotStuff consensus protocol. Contrary to a “traditional” blockchain, the Libra Blockchain is not separated into blocks of transactions. Instead, it’s an ever-growing Merkle tree where each newly executed transaction is a new leaf on the tree.

Permissioned vs Permissionless

Blockchain purists reading this article will by now be seething with rage. After all, transactions on the Libra Blockchain are approved by validator nodes of Libra Association Members, an exclusive club of wealthy companies. It is a permissioned blockchain. This goes directly against one of the central tenets of blockchain technology: removing the middleman and returning power to the people.

Unfortunately, as of right now, no blockchain exists that is both permissionless and fast enough to confirm hundreds, if not thousands of transactions per second. This being said, Libra intends to eventually allow new entrants to run independent validator nodes that will increase the security and the reliability of the network. 

They will also eventually allow new entrants to build payments and financial services on the Libra blockchain for businesses and consumers, as well as allow them to actively participate in the governance and evolution of the Libra project. But they want the right technology and the right frameworks before allowing this, to make sure that every new member is compliant with the necessary regulatory frameworks (no one wants ISIL as a member).

Where’s Facebook in All This?

So we already know that Facebook created Libra and that they have one vote as a member of the Libra Association. They also probably have a good bunch of Libra Investment Tokens that will generate nice money if Libra Coins are used by millions, if not billions of people, and the Reserve has positive yields on their cash-like assets.

But that’s not where the story ends and of course it’s not. Zuckerberg is smart. He wants to position Facebook as a leader in the financial industry, because he believes things can be done better. And they definitely can be. Contrary to most other people’s opinions, I don’t believe Zuckerberg has bad intentions. However, it’s entirely possible for Libra to accidentally take a turn for the worse, which is why all governments around the world are so cautious about this initiative.

Mark Zuckerberg tweet
Oops

Facebook is involved in the Libra project in two other main ways. Firstly, it’s working on a cryptocurrency wallet called Calibra. All those people who want to use Libra Coins will need a place to store it. That place can be Calibra, a custodial wallet designed with user experience and privacy in mind. This means that Facebook won’t be able to use their data for ad targeting through Calibra. They also won’t be able to figure out who someone is based on their publicly visible transactions.

The Calibra wallet will be built into WhatsApp, Messenger, and Facebook itself, which leads me to the second big way Facebook is involved. It’s the only company in the Association (and indeed the only company in the world) that has access to 2.6 billion people. No other company comes close.

So anything that Facebook builds will reach an enormous number of people almost automatically. This gives them a ton of soft power. Although other people will eventually be able to build their own Libra wallet, it’s unlikely that they’ll ever be able to compete with Facebook’s Calibra.

Similarly, while Facebook might only have one vote in the association, their access to billions of people gives them enough soft power that other members of the Association might follow whatever Facebook decides to vote on. After all, without access to those billions, Libra won’t succeed, and every Association member wants to see a positive return on their investment.

In Conclusion

Everything considered, I lean in favor of Libra. It seems to be built in such a way that it can provide a fundamental layer for financial innovation that benefits the unbanked and underbanked. There also seems to be enough government scrutiny to keep Facebook in check and to make sure it doesn’t accumulate too much power too rapidly through Libra.

It’s hard to say whether the project will succeed though, as countries might find the whole endeavor too risky altogether. France and Germany have already agreed to block Libra, for example. But even if the Libra project doesn’t succeed, it has made countries and banks anxious enough to work hard on making their financial service cheaper, faster, and more accessible.

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