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Wednesday, June 26, 2019

Brief Comments On Libra And Online Commerce

Facebook has led a consortium which has unveiled a white paper on a proposed Libra cryptocurrency. It is described as being backed by a multi-currency portfolio of government bonds, and so it might be looked at as a currency basket. I am not an expert on Libra, but I just wanted to comment on the pros and cons of such a basket for small online commerce players (such as BondEconomics.com). I also conclude with a short discussion of systemic risk posed by this platform.

(I normally avoid discussing particular corporations. As a disclaimer, I do not own any shares in any of the consortia behind Libra directly, but they are probably represented in equity index funds that I own. I use Facebook very little; I have an account that I use to announce my books, and to allow any potential readers find me.)

It's a Govvie ETF

The Financial Times Alphaville site has run a series "Breaking the Zuck Buck," which as the title suggests, is slightly skeptical. This article is the first of the series. I assume that the reader will have seen other descriptions by this point. One may note that this is only a White Paper, and it is running into regulators, so the final product might end up quite different.

The idea is that there is a pool of high quality, multi-currency bonds/bank deposits backing Libra, and Libra will created destroyed to match collateral entering/leaving the pool.

From my perspective, this has the economic exposure like a high-quality multi-currency bond fund, with an extremely vague investment mandate. It turns into an exchange-traded fund (ETF) once we realise that the White Paper is about building a digital trading protocol for these fund units.

In other words, they wish to market an unregistered investment fund that is traded on a completely unregulated exchange that is open to anyone on the internet. I am not an expert on retail securities law, but writing the previous sentence caused my eyes to water. As such, I am unsure how close any implementation would end up to the White Paper vision.

For the purposes of my article, I will assume it somehow flies with a multi-currency basket in place. (A model where each retail user only sees a domestic currency balance would presumably make it easier to get through regulations, since it is closer to a standard payments system.)

Wildly Uninformed Comments On The User Side

Although I recognise that Facebook is a massive player in social media, I am somewhat unsure about the use case. It may be that the Libra infrastructure would just be a backbone for more traditional single-currency digital payments systems, and so it will be fighting for market share with other payments systems. If so, it is purely a market share story, and not particularly interesting from my perspective.

The use of Libra itself seems like a hard sell in a place like Canada. I was a late adopter, but the use of emails and SMS to transfer funds from banks is already entrenched; there is also the various no-swipe cards and other payment apps. Adding an exchange rate to a fictional "currency" is a definite competitive disadvantage. The only country I am aware of where it might be innovative is in the United States, which is far behind in offering consumer payments services. Obviously, the United States is a large market, but other competitors will step into any legal openings that Libra creates.

The obvious way to generate interest in Libra is have products that are exclusively available for sale in that currency. Although that is the modus operandi of the tech sector, it is unclear how viable that strategy is for a firm that is already facing calls for antitrust actions.

What's In It For Small Vendors?

Although I cannot see myself using Libra as a consumer, I would be perfectly happy to sell my electronic books in that format. Although my publishing business is not exactly a major economic player, I am facing the same forces as any small or mid-sized firm.

For a small player, getting another venue to sell your product is always a good thing. If it were possible to directly sell products from within the Facebook app, there is an obvious synergy with social network marketing. (For example, I might even log into my Facebook account and post things.)

For digital products, the marginal cost of production is close to zero. Since I sell via retailers (for reasons discussed below), there can be a download charge. However, this is a percentage of the selling currency price, and so the net royalty is always positive. Therefore, any sales increase increases total profits. For someone in my position, the only concern is the possibility of arbitraging yourself by setting a Libra price that is much lower than in real currencies. Given this potential friction, it would be very awkward setting a Libra price that is not pegged to a reference currency.

Note that it is not only e-books that are sold via digital retailers; other electronic media like music are in roughly the same position.

A vendor that is selling things like video games might have only a single sales platform, and so this cross-currency arbitrage would be less of a concern. The only concern is whether Libra sales can meet fixed costs in domestic currency.

Why Sell E-books via Retailers?

One of the things that might not be obvious: why would I sell my books via online bookstores? They are specialty publications that could very easily be sold as PDF's. The answer: the government, or more accurately, the multiplicity of governments.

If one wants to be a law-abiding retailer in 2019, you need to comply with VAT/sales taxes in each jurisdiction. And if you are looking at Canada, that's at least 10 provincial jurisdictions. Although my books alone might not generate enough revenue to catch tax authorities eyes, my consulting fees are covered by the Canadian value-added taxes. As such, I am already on the VAT radar. When I did my research, there was no platform that handled both transactions and taxes for electronic sales.

This is on top of the issue of the greater difficulty of selling products to people online from unfamiliar sales platforms -- particularly if I tried building the platform myself. Meanwhile, there is the advantage of getting potential sales by building up a presence on retailers' websites.

So unless I got a major boost in revenues, it is uneconomic to set up a server and go it alone -- even though that is technologically feasible. In my view, the concentration of internet sales platforms is no big surprise, even though the technology suggests that small players should flourish.

I will now give a quick rundown of publishing economics. I own the ISBN of my books, and that puts me in the role of a manufacturer. I set the recommended retail sales price, and sell the rights to the electronic book at a discount to that price the retailer; they can sell at whatever price they wish. Each sale gives me a fixed royalty, even if the retailer sells at a discount (presumably on the theory that lower prices will raise sales).

As such, I would not care about small fluctuations in the value of Libra; that is the retailers' problem. However, come of the retailers are concerned about competing against a suggested price that is lower than what I am basing my royalties on for them, so I need to keep suggested retail prices in line within a country. (If someone could shop for ebooks in any currency, they could get them much cheaper in most jurisdictions, but online book retailers lock the currency of their clients.) Having a fixed Libra price across all countries would mess up my pricing strategy. However, since everyone else using self-publishing platforms would face the same issue, it is extremely likely that Libra pricing indexed to domestic currency would have to be offered by book retailers that adopt Libra.

An alternative way to avoid the price arbitrage issue is to make sales exclusive to a platform that sells only in Libra. This might work for some products (video games?), it would be quite difficult for digital media like books and music. Do you really want to try building a presence on a new sales platform, and cut off existing customers? The only way this will work is if a major existing retailer moved to Libra exclusively.

Paperbacks - Not Really

As soon as we get to goods with a fixed domestic currency cost, Libra pricing is unlikely. For my paperbacks, they are print-on-demand, sold to retailers at a fixed discount to the suggested retail price. Those retail prices are denominated in the currency of the printing plant -- currently, USD, EUR, and GBP. As soon as the books leave the printer, it is ka-ching! for me, the retailer can sell them for Yap stones for all I care.

I cannot really offer a price in Libra, since all I could do is arb myself: buyers are going to the same printing plant, and will pay the cheaper of the two prices. Given that the print-on-demand industry is highly concentrated, even the Libra consortium is unlikely to have the market power to convince them to take the new currency as an alternative (unless it is so successful that their clients want to be paid in Libra).

Any physical good has a cost of production in some domestic currency. It might be possible to hedge into Libra, but prices will not be sticky in Libra terms: they would have to be reset as hedges expire. Stickiness would require Libra-denominated input costs, and/or really large profit margins.

What About Big Vendors?

The logic around Libra is different for large digital product vendors that have some market power. They have a large existing customer base, and they might be able to push that customer base to Libra. Given the fascination for novelty (and/or an ideological dislike of fiat currencies) by many consumers of digital services, they might be very happy to be pushed in that direction.

If the Libra platform is going to succeed, it will need those big vendors. So long as regulatory hurdles are cleared, that is really what will matter in the short run, not the technological capability of the platform (so long as it is minimally functional). Given the entities involved with Libra, my working assumption is that some significant entities are lined up for that role. From my perspective, the main point of interest is whether that includes an e-book retailer.

Appendix: Libra and Systemic Risk

I have seen some concerns about the systemic risk posed by Libra. I do not see any plausible risks for quite some time. The system might blow up and affect any businesses exclusively using it, but that is only company-specific risk. It is unlikely that Libra will have enough market share in payments that its disruption would cause anything other than a hiccup over reasonable horizons. There are plenty of other electronic payment options (outside the United States) to fill the gap.

Could the "govvie ETF" cause problems? Basic arithmetic says that they cannot peg the Libra to any particular currency, unless they only hold that one currency in the fund. Instead, it has to be pegged to the Net Asset Value (NAV) of the reserve fund -- like any other investment fund. So there is no reason for a "run," since there is no peg value (unlike a money market fund, or "stablecoin"). So what? The short-term government bond markets can absorb huge flows without budging. Unless you believe affine term structure models, short-term paper follows rate expectations. In any event, nobody is going to be happy if people started piling into an unregulated government bond fund from within a social media app.

The only way to get an exciting financial crisis is for there to be financial institutions lending and borrowing in Libra. The reason not to get too excited about this is straightforward: you would have to be dumber than a sack of hammers to lend to people in Libra. The exception is that you lend against assets you want to repossess. However, as subprime lenders discovered the hard way in the Financial Crisis, this "loan to own" model of lending does not scale up well.

Very simply, households and firms generally have steady incomes in the domestic currency. If you lend to them in a foreign currency, they need to have some means of hedging that exposure. Businesses can do this by having foreign operations, but this is not really possible for individuals. And in this case, the only businesses for which this is relevant are those that are selling products denominated in Libra. Such firms may exist -- but are these businesses that need to borrow?

(c) Brian Romanchuk 2019

2 comments:

  1. Finally someone who can see Libra as it really is: an overdramatized ETF.

    ReplyDelete
    Replies
    1. Anyone who is a bug on cryptocurrency will definitely not write that, since it gives the game away: it’s an unregistered security offering, and verboten in any developed country (and probably most developing countries). My guess is that if this does fly in any format similar to this white paper, they will need to underline how terrible a financial instrument is, so that it can’t be considered an investment.

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