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Libra will be backed by a basket of currencies
Reuters/Kacper Pempel
Money matters.
TIME TO CHANGE

Currency risk could undermine Facebook’s Libra

By Allison Schrager

I have always been skeptical bitcoin would ever be a viable currency because the ultimate purpose of money is to buy stuff. In order to be useful, money has to fill three functions: It needs to be a unit of account, so prices can be measured against each other (for example, prices in the US quoted in dollars); a medium of exchange (so you can buy stuff with dollars or transfer them to others); and a store of value.

Each of these functions is equally important. But the problem with bitcoin, or any cryptocurrency, is they are not a great medium of exchange because so few merchants—from your landlord to the government—will accept it. They are also lousy stores of value because they’re so volatile. When I wrote about the dark web in 2015,  I spent a fair amount of time on Reddit, where drug dealers complained endlessly about bitcoin. They had no choice but to use it, since it is the primary currency on the dark web. But many of them didn’t like it because the rest of their lives occurred off the dark web; they still had to pay rent or their mortgage in dollars. Bitcoin prices were so volatile they could see their profits wiped out while waiting for their transactions to clear. This currency risk was unhedgeable (there was no market for bitcoin futures at that time) and a constant threat to their business model.

It’s not clear if Facebook’s new currency, Libra, will overcome this challenge either. Libra, set to debut next year, is being touted as a global cryptocurrency  that is backed by a basket of global low-risk currencies and securities, but many details are unclear. It sounds as though it is sort of like a money market fund (although one that pays no interest), with currency risk and some blockchain thrown in (which raises other risks), used to transfer money and make low-cost transactions. The currencies backing the Libra won’t hyper inflate, so it probably won’t be as volatile as bitcoin, but they still fluctuate against each other. The figure below it the exchange rate between the US and the euro, two of the most stable currencies.

So if you buy a unit of Libra with $1, the next week if probably won’t be worth $1, because of what happened to the other currencies or bond prices in the basket. And that assumes currencies appreciating or depreciating are the only source of fluctuation in the basket. It is still not clear how the reserve fund will be invested exactly; for example, how will the ratio of dollars to euros change over time?  Christian Catalini, chief economist of the Libra Association, says the fund will not be actively managed, which suggests there will be some fixed weighting between different currencies and assets, though he says the investments may change if economic events warrant it (which means it really is kind of active). That just adds to the unpredictability.

Bitcoin and Libra are not safe assets. Libra should be safer, because it is invested in a basket of low-risk, stable currencies instead of varying with market speculation. But because it is not pegged to any one currency, at some point you need to convert Libra to something else if you want to buy groceries or go to the movies. That means you must deal with currency risk and, potentially, fees to make the conversion. If exchange rates swing the wrong way, Libra owners could find themselves losing 10% or more of their initial purchase when they try to cash out.

Of course if you do all your transactions in Libra, you don’t face any currency risk. But eliminating currency risk requires all merchants, as well as your bank (if you have a credit card or mortgage), and government (to pay taxes) to accept Libra—and that’s unlikely, at least for the foreseeable future. If you live in a country prone to hyper inflation, Libra may be less risky than your local currency. But for everyone else, its main value is the ability to transfer money, and there are ways to do that without taking on currency risk.