Of Libras and Zebras, Part Two

cryptocurrency, digital money, monopoly, Libra, financial regulation

What Are the True Financial Risks of the Facebook-Led Digital Currency? (Part II: Monopoly Risk)

cryptocurrency, digital money, monopoly, Libra, financial regulationPolicymakers, in America and around the world, have for the most part responded to the announcement of Libra with skepticism, fear, and not a little bit of loathing. In my last post, I argued that Libra’s association with Facebook and misleading references to it as a cryptocurrency led to an overreaction on the part of the policy elite. Like budding zoologists who think of zebras rather than horses when they hear hoofbeats, government officials are focusing on the memorable (crisis, monopoly, fraud) rather than the probable (an improved payments system) consequences of this innovation.

My previous post showed that warnings about the systemic risk that Libra presents are overblown. In this post, I explore another concern policymakers have expressed about the Facebook-led digital currency project. That is the risk that Libra-based providers, or even Facebook alone, will be able to monopolize payments through the Libra Association. I hope to show that public officials may be letting their imagination run wild, as they have with regard to systemic risk. In fact, Libra appears more likely to increase competition and choice in payments. Such an outcome is not a best-case scenario, but rather what one might expect based on the experience of payment card networks.

Monopoly risk

Facebook is the world’s largest social media network and the fourth most valuable publicly listed firm in the United States. In recent years, it has acquired two of the most promising social media apps, Instagram (2012) and WhatsApp (2014). Facebook’s share of the U.S. digital advertising market, including ads on Instagram, is forecast at 22.1 percent for 2019, nearly triple that of Amazon but well below Google’s 37.2 percent. Yet, unlike Google’s, Facebook’s portion of aggregate online ad spending keeps growing.

Facebook’s dominance of social media has caused some policymakers to worry that its entry into payments might quickly drive out incumbents. Rep. Stephen Lynch, the Democratic Chairman of the U.S. House’s Fintech Task Force, recently expressed concern that Facebook could outcompete banks, particularly small ones, and become a financial-services monopolist.

History suggests that Facebook’s present digital dominance will be fleeting. However, even if Facebook’s dominance were to endure, the firm will not find it easy to become as successful in payments provision on its own  as it has in social media.

Recall that Facebook, even while leading the Libra Association in its early stages, will be just one member among dozens by the time of Libra’s launch in 2020. It is baffling, and has not helped Libra’s reception, that Facebook has so far been much more involved in the development and marketing of Libra than any of its 27 founding partners, but those who see in this a badly crafted attempt to conceal Facebook’s intent to run Libra as a subsidiary should keep in mind that Facebook needs its partners to encourage widespread adoption of Libra.

Why? Payments applications feature network effects: the more users are on the network, the more attractive participation becomes to others. When banks started issuing payment cards in the 1960s and 1970s, they realized their size was too small – especially in the restrictive branching landscape characteristic of those decades – to on its own constitute an attractive network for cardholders and merchants. Banks therefore partnered with their peers to form larger associations within which all payment cards would be interoperable, regardless of the issuer. Visa and Mastercard are now independent public companies, but they started as card associations owned by banks.

Cards within a network had some common features – such as identity verification and the interchange fees that merchants paid – but the issuers (banks) competed in other respects, such as cardholder rewards, interest rates, and annual fees. This mix of cooperation in network management and competition along certain card features has become known as “coopetition.” It is one of the reasons why the payment card market, despite its high concentration, remains highly competitive. Indeed, the “coopetitive” model has remained in place despite banks’ spinoffs of Visa and Mastercard.

The Libra Association resembles payment card networks in their early days. There are 28 founding members, and the Association hopes to raise the membership to over 100 by the first half of 2020. Each member will bring to the network an existing user base that it can hope to entice to use Libra: the total aggregate potential user base among the founding members easily tops 3 billion unique customers.[1] Furthermore, each member will take part in the validation of Libra transactions and their entry into the Libra ledger.

But the members will likely compete along other dimensions. Facebook has already announced its proprietary digital wallet provider, Calibra, which holds money services business (MSB) licenses in eight states and, according to the Treasury’s Financial Crimes Enforcement Network (FinCEN), will conduct money transmission in all U.S. states and territories. There is little doubt that other Libra participants will develop their own Libra-processing services in the coming months. Some Libra Association members, such as Coinbase, Paypal, Mastercard, Stripe, and Visa, already hold money transmitter licenses in most or all states. The other members must either apply for licenses, offer non-custodial wallets,[2] or rely on a third party for their Libra payments.

The members of the Libra Association – among them several online platforms, venture capital firms, and nonprofit organizations in addition to Facebook and the financial services providers listed earlier – have complementarities and different specialties. I therefore would expect a diverse ecosystem to emerge, in which different members do different things. Some will process Libra payments, others will take and make payments, while others may act as market-makers – exchanging Libra into other currencies, and vice versa – or manage the multi-currency basket that will form the Libra Reserve. All members will cooperate in the governance of the Libra Association, but some will compete with others in the provision of Libra-denominated payments.

Card networks have long featured a similar division of labor, with some banks issuing cards, others acquiring transactions on behalf of merchants, and specialist services processing transactions. Some banks perform several of these tasks. And, of course, the networks themselves set some of the terms of transactions and provide for data protection and fraud prevention.

Networks are fragile things. A miscalculated governance change, such as a fee increase or a decrease in processing speed, can rapidly cause users to leave the network in favor of alternatives. This potential for rapid unraveling acts as a spur for networks to remain competitive and refrain from abusing customers. In Libra’s case, many potential rivals are members of the network and would see business flow to them directly if Libra reneged on its promise of cheap payments and transparency. Some of these latent competitors are billion-dollar businesses processing trillions of dollars’ worth of transactions every year, so one should not dismiss out of hand their ability to compete with Libra.

Even if Facebook did manage to gain control over the governance of Libra, Mastercard, Paypal, and Visa will still run their own payments applications. Furthermore, Libra will face different competitors in different markets. For domestic payments, the card networks, Venmo, Paypal, and Zelle (the banks’ Venmo) come to mind. In international payments, Transferwise has quickly become a successful cost-cutter by matching foreign-exchange transactions, whereas Ripple promises to use cryptocurrency technology to cut the cost of cross-border money transfers. To these one must add the incumbent remittance providers, such as Western Union and Ria.

Many people fear that Facebook’s entry into retail payments will reduce competition. But the experience of previous payments innovations suggests that Facebook will have a hard time extending its dominance into this sector without cooperating with others in the Libra project. Even if Facebook did gain an advantage, competition within and without Libra will help to temper its monopolistic impulses.

[1] Customers who patronize several of the Libra Association’s members should not count for more than one.

[2] These are wallets for which the owner does not hand over full control of the assets in the wallet to the wallet provider. According to recent FinCEN guidance, non-custodial wallet providers are not money transmitters.