Quick experiment. Open your phone’s screen-time app. Take a look at the apps that take the most amount of your time. Odds are high at least a large fraction of my readers spend their “digital lives” between Instagram, Whatsapp or Facebook. (You didn’t do what I asked you to, did you?). For many in the world, this is the de-facto definition of what the internet is. Job hunting, dating, gossiping, edutainment, hobbies - you name it. They happen in this walled garden that is owned by Mark Zuckerberg today. Go to nations where internet penetration occurred after Facebook came to prominence, and you will very likely see a generation that believes the internet is “Facebook” or apps owned by them. It is the digital version of seeing KFC as food. Sure you could survive on it, but it is not the only thing you should survive on. Today’s piece explores changes that are happening to Facebook’s blockchain plans, what that means for fintech and my observations and how regulators and open-blockchains will likely compete against all of it.
Sidenote: I am heavily biased against Facebook because of its Internet.org initiative in India. That said, the reason I wrote this piece is that I believe in Facebook’s distribution capability being critical for blockchain adoption.
How it began
Facebook’s plans to launch a blockchain venture was conceived in 2017 and formally announced in June of 2019. The goal was to create a consortium of multiple large names including Andreessen Horrowitz, Uber, Mastercard and Visa to create a payments network that was jointly owned by the firms involved. Each firm was to receive a vote for the $10 million commitments they made to the network. In exchange, they would have access to the interest generated through dollar deposits made for transfers on the network. The consortium’s plan at the time was to focus on banking inclusion for the 1.7 billion people that are currently unbanked globally. Unlike public blockchains like Ethereum or Bitcoin’s, Libra’s consortium was designed to be a permissioned network much in similarity to that of R3.
The association created a separate entity to develop wallets for the blockchain. Why did Facebook have to do this? Clubbing transactional data with personal information could scale Facebook's revenue. In its digital-first format, Facebook knows little about what you buy at a grocery store, although logically, it could track that you visited it using the GPS on your mobile devices. By being a payments enabler, it could see what you were chatting about before visiting the grocer and precisely what you purchased from there. Context and commerce coming together could be a match made in heaven. Facebook quelled these concerns by making it clear that there will be no sharing of data between personal accounts on the platform and transactions made on it. Calibra was explicitly released to set up a firewall between social media accounts and financial transactions on the network. There were no mentions of fees either.
Instead, Facebook’s plan at the time was to double down on two forms of revenue. The interest generated from capital deposited by a global user-base could bring more considerable assets under management than most traditional banks could. Similar to Robinhood. Add to that, the size and distribution of the consortia at the time, and you will see why Facebook’s “currency” could have become larger than individual central banks. For a sense of scale, the cash reserves of the NASDAQ100 ($1 trillion+) is roughly higher than the Swiss National Bank ($885 billion). The other aspect is that Facebook could use the consortia to increase the number of transactions on the platform.
Growing up in India, I used to see how consumer drop-off rates for e-commerce platforms were high because individuals either did not have debit cards, or they didn’t trust the platform sufficiently. Today I see most consumer choices being driven by Instagram/youtube recommendations. Facebook could double down on making it easier for individuals to make payments in a trustless fashion online. Facebook boasted ~800 million users on its marketplaces product as early as 2018. Marketplace communities in Bangladesh could all of a sudden be selling to someone in Manhattan, or a tutor in Singapore could be teaching someone in Ethiopia. What was needed to make this happen was a payments network that worked uniformly across jurisdictions. Paypal had the opportunity to do that in 2010 when the internet was slowly penetrating the developing world, but it missed out on that opportunity. That gap, in turn, was filled by regional payments networks, each of which became unicorns in their own right. Although money went digital in these economies, it failed to go global. That is precisely the gap Facebook is now trying to solve.
What has changed
Major trouble started brewing for Libra around October 2019. In a matter of three months, eight prominent members of the consortium shared plans of leaving it. Multiple fintech behemoths like Paypal, Mastercard, eBay, Stripe and Visa left the association due to concerns of not being able to deal with the regulatory hassles of handling an international financial network. Within a year, multiple Libra’s initial partners rolled out their blockchain initiatives. Paypal rolled out the ability to buy stablecoins through them, Visa partnered with stablecoin provider Circle to enable transactions and Mastercard filed a series of patents related to the technology. Adding to the insult was the response regulators had to the move from Facebook. In addition to existing anti-trust concerns, the social media behemoth received cold shrugs from regulators in France, Germany, the United Kingdom and the United States. Yves Mersch, a member of the Executive Board at the European Central bank came out with a harsh critique on the move by Facebook during a speech on September 2019. His primary argument was that while both state and enterprise issued forms of money can find legitimacy, given the public goods nature of money, it is best that banking at scale remained under the purview of governments. The extent of centralisation in Libra clubbed with the scale Facebook had could be a significant threat to the role Central Banks already played. The Executive Director of Strategy and Competition at the Financial Conduct Authority (FCA) in the UK stated that Facebook’s move fast and break things approach may not work with the capacity regulators had in place. Facebook’s consortium approach meant no single entity could be liable for addressing money laundering and AML concerns and their distribution network meant they had grown too big for a central bank to be comfortable with.
To address these concerns, Facebook gradually released two iterations to their plans over the year. The changes to the network were explained in a 29-page whitepaper released recently. I took the time to read the whole document. Here are the primary aspects that have changed in the whitepaper
The Currency Model
The association’s plan of using a single asset that was backed by bonds and regional currencies faced significant pushback from multiple regulators. The key concern was that LBR, the token being used in the network could expose citizens to foreign currencies without regional regulators having track of how much foreign money has entered their economy. To address this concern, Diem uses a single-currency stablecoin system in developed countries. Each major economy Diem will be implemented in will have its stablecoin that is based on the regional currency. For developing economies, a multi-currency system that weighs currencies from multiple countries will still be in use. These tokens will use a mix of numerous foreign currencies. It is important to note that the whitepaper makes it clear that multi-currency LBR will only be used as a settlement layer and not as a store of value. This is likely to ensure that regional laws around exposure to foreign currencies are not violated. Individuals will have to go through a designated dealer (explained below) to source multi-currency LBR tokens. The whitepaper also makes it clear that it is the association’s intent to transition towards CBDCs as regional central banks begin rolling out support for it.
To meaningfully roll out the proposed payments network, the association has proposed four critical roles in the network.
- The association is at the top of the hierarchy. It will be responsible for conducting due diligence on association members, handling compliance standards, minting and burning libra coins and over-all governance of the network. Members of the association come right underneath the association itself. These are partner organisations that have paid to be a part of the association. Their role is to help expand the reach of the consortium and help bear the cost of operating it.
- The monetary system on Diem’s network is distributed to the end-user via what is referred to as designated dealers and virtual asset service providers. Designated dealers hold the right to buy and sell Libra tokens to the libra network. These will be typically well-financed organisations that can do large transactions.
- To reach the end-user, designated dealers will work with a network of virtual asset service providers (as defined by the Financial Action Task Force). The unhosted user wallet itself will source tokens and settle payments with the virtual asset service providers. This hierarchical model allows the network to have checks and balances in different parts of the world through partner organisations.
Lastly, there are “unhosted wallet users”. These are typically addresses that interact with the network through virtual asset service providers. They will have balances to limit how much money is passed through the network at any given point in time.
The hierarchical nature for the flow of money makes it possible to pinpoint the source and direction of each transaction in the network. It makes it possible to conduct a much higher degree of checks to meet the needs of regulators. Which leads to the most critical bit of these sweeping changes. Diem is heavily optimised to be meeting the demands of regulators.
Diem has a variety of on-chain monitoring tools to ensure bad actors do not use the network for conducting transactions. The whitepaper suggests that an automated protocol-level check system will be implemented at the time of the launch. Much like how stablecoin networks like USDC can blacklist addresses, Diem will be able to block sanctioned wallets and restrict the amounts stored in them. Also, there will be mechanisms in place to ensure individuals from sanctioned regions (like North Korea) do not use the system to conduct transactions through IP-checks. Each of the virtual asset service provider and designated dealers will also have to go through routine AML/KYC checks and due diligence processes to ensure the association is not engaging bad actors on the network. Diem also plans to require each entity in the network to follow the requirements of the travel rule. The association has the resources needed to implement a global-scale regulatory tool in place. Much of the model is designed around existing policy frameworks and will likely be able to roll out as early as January 2021. Given the amount of resources needed to engage with policymakers at a global scale, it is likely that only a large association like that of Diem’s could pull this off.
What Could Be Expected
Diem is a shadow of what Libra set out to be. In the absence of large payment processors on-board the association, Libra’s ability to penetrate markets in a meaningful way is reduced. Besides, Central Bank regulators have rightfully suggested that enabling the association could lead to an oligopolistic entity that could rival the State’s control on the issuance of money. The state theory of money suggests that money finds its relevance when issued by an institutional form of government rather than spontaneous forms of exchanges. Given the public goods nature of money, it is often best not handled by a commercial entity. We have learned from Venezuela and Zimbabwe that governments cannot be trusted with monetary policy. This is why Bitcoin matters.
Diem claims to be focused on financial inclusion but has strict limits on how much money can be stored or transferred via the network if you do not have your identity-related documents. Much of the world’s poor are “unbanked” precisely because of this. The lack of identity. Excluding the fact that the unbanked are not looking to store money digitally due to expenses in their locality being cash-settled, the philosophy ignores that multiple nation-states have mandates for their regional banks to accelerate the opening of bank accounts. Regulators in India, for instance, forced regional banks to spend ~$400 million on opening bank accounts for the nation’s most impoverished. That investment, in turn, has paid off in multiples as most state issued subsidies now go directly to the recipient via bank transfers. If an enterprise based intermediary like Libra was to be involved in the middle, it could accelerate both financial surveillance and dependencies on corporations to deliver public goods. The unbanked likely don’t need Diem’s blockchain association much like it did not need their “free internet” in 2017. Between free-markets and national investments into infrastructure, much of the developing world will have financial infrastructure that is in parity with the rest of the world. Most of the “banking the unbanked’ conversations ignore the fact that if you live on under $2 a day, you will not have much left to “bank” after daily expenses. In that context, what will be lagging in the developing world is wages and the ability to upskill. Both of which aren’t being solved by the association. The network’s positioning as an altruistic instrument for social change has to be met with much scepticism.
Lastly, as Ben Thompson mentioned recently, social networks are increasingly about being contextual and interest defined. Diem is Facebook’s attempt at being in the heart of commerce and context. The initial products (Facebook, Instagram, Whatsapp) were about social networks of scale. The next product (Diem) is about accelerating commerce on those networks. Through working in an association model, Diem reduces the amount of liability on Facebook while simultaneously accelerating the value of transactions within their platforms. This has played out once in the past. Amazon Pay on Amazon has seen substantial amounts of capital parked on it due to the ease of checkout that comes with it. Google Pay’s positioning has enabled it to be a fintech behemoth within the Android ecosystem. Facebook’s ultimate goal with Diem is not to be yet another fintech player. It could do that already with its distribution. The association’s goal is to be a central bank for the internet. Whether that vision could play out or not is something only time could reveal. For now, all I can say is, this goes way beyond just blockchains and come January 2021, assuming Diem does roll out, we may have an inflexion point in terms how we think about networked money.
If you’d like to read academic papers on Libra, consider this document addressing the US Government’s concerns, this report by the Bank For International Settlements and this research paper exploring the risks posed by Libra to regional economies. You can also read my initial take on Facebook’s move to launching the consortium from June 2019.
Let me know what you think Diem could pan out to be in 2021.
Would it barely launch and go bust due to regulatory scrutiny? Or would it do to digital money what AWS did to the web? I would love to hear your thoughts.
Disclaimer: Thoughts expressed above are those of my own and does not reflect that of any of the organisations I am associated with. I don’t have any investment exposure to Facebook or any of its peers.