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June 24, 2019

Libra Basics – What you Need to Know

Posted by Andries Verschelden

A Network Effect

Throughout history, money (whether in rare seashells, gold, notes or bits of data), is only “money” when a network effect[1] enables people to trust it as a store of value, a medium of exchange and a unit of account. Rare seashells can operate as money when we are all willing to accept seashells as payment. Projects attempting to disrupt payments and monetary value transfer using blockchain have greatly struggled against user adoption (i.e. creating a network effect). The announcement of Facebook’s decision to launch Libra is intriguing, in light of this, as we all know that Facebook has a network like no other. If a fraction of the Facebook user network were to adopt Libra, the coin would have a higher adoption than any other cryptocurrency currently in the world.

Libra Zuckbucks

After a hailstorm of “GlobalCoin” and “ZuckBuck” memes, endless speculation, and finally the release of the Libra’s whitepaper, the industry finally has some clarity regarding Facebook’s project Libra. While tribalism has guided many conversations in the space, the utility of Libra (or any cryptocurrency for that matter) lies on a spectrum based on a series of tradeoffs. These tradeoffs – decentralization vs. centralization, security vs. scalability and user experience, on-chain vs. off-chain collateral – are not categorically good or bad; however, tradeoffs do present positive and negatives for different individuals and use cases.

We now have Facebook’s Libra whitepaper with aspirational language about banking the un-banked through a “…simple global currency and financial infrastructure…” If this was an ICO in late 2017, we would have chuckled and thought “another vague solution coin.” So the idea of banking the unbanked using a secure, trustless, decentralized network which allows for peer-to-peer payment is not at all new. Why then is Libra different? Or is it? Why will it work? Or won’t it?

What we  know for certain may actually be very little. However,  we can use what information has been made public, as well as the lessons learned from a decade of the social and crypto-economic experiment that started with Bitcoin, to examine the introduction of Project Libra. We assess the impact Libra may have for the use of open blockchains and the native or tokenized assets represented on them.

What We Think We Know

Libra proposes its own blockchain, with a native Libra Coin that is used for gas fees to use computational resources on the network. Gas fees are expected to be kept at a minimal, and their purpose is to disincentive malicious actors from requesting unlimited network resources.

Libra uses a continuously updated Merkle Tree (called “Merkle Tree Accumulator”) to append transactions to the data structure. Each new version of this Merkle tree is signed by the validators, effectively confirming every transaction (in Libra’s history) with every release of the new Merkle Tree. Therefore, previous versions of the data structure can be “pruned,” or not stored. This is very different than Satoshi’s “proof-of-work” chain noted in the Bitcoin whitepaper.

Other key points include:

Taxation – Since Libra is backed by a basket of coins instead of one currency (USD), fluctuations will arise between Libra and the USD. The IRS currently looks at digital assets as property, not currency. Disposing of Libra (by selling it or purchasing something with it) will therefore result in either a taxable income/gains or losses. Users will need to track their tax basis (cost) and determine the appropriate valuation method based on guidelines (Treas. Reg. Section 1.102-1) for the coins they disposed of (FIFO, LIFO, Specific ID). 

Incentive and dividend tokens for validatorsThe proposed system also includes Libra Investment Tokens which are to be distributed to founding partners/validators of the network in proportion to the amount invested. These grant access to dividends/rewards/gas fees from the network activity, as well as governance powers.

Libra is meant to be mostly-stable in purchasing powerLibra Coin is planned to be a stablecoin, pegged (and asset backed) by a basket of international currencies and other low-risk/yield instruments such as short-term government securities (exact specs TBD).

On-ramping and ecosystem“Gateways” for individual users to purchase/sell Libra Coin will be the new Calibra wallet application, both integrated with your Facebook, Instagram and WhatsApp accounts and standalone; as well as a number ofthird-party partners that the whitepaper calls, “resellers” (most likely Digital Asset Exchanges, and future retail vending/or Libra ATMs)

The way validators reach agreement on transactions is a known techThe consensus mechanism at play is a derivative of a BFT algorithm. Libra uses LibraBFT, or Libra Byzantine Fault Tolerant, or secure as long as two-thirds of validator nodes are altruistic.

Libra uses an “Account-based” system – This design is similar to Ethereum, in contrast to a UTXO-model as seen in Bitcoin or Litecoin.

Libra will likely allow users to transact with some level of anonymity – Libra can be used in a pseudonymous manner and not connected to a Facebook, Instagram, FB Messenger or WhatsApp account and that users can have more than one wallet.

Libra envisions a technology that can scale for serious throughput – The Libra Association envisions 1,000 TPS at launch, and 10 second finality of transactions on its Libra blockchain. This is a hurdle that other public blockchains have struggled with as scale and throughput can mean tradeoffs in security.

Libra envisions an open source renaissance where developers build the programmable money of our future – Libra is made open source for any developer to build apps to work with Libra. A new language (Move) will be introduced for development in the Libra ecosystem.  Move promises to be intuitive and secure, ideally suited for smart contract development.

The process for becoming a validator on the network is restricted. Initial validators will consist of “Founding Members” upon launch, and slowly set to expand to perhaps 1,000 validators over the next five years. Thus, currently Libra is a “permissioned blockchain” as consensus on the state of the ledger is determined by a predetermined individual, with the idea of further decentralization as time passes. The governing group the Libra Association will be registered in Geneva Switzerland, and will be composed of the Libra Founding Members, the Libra Council and Social Impact Partners. Together, these parties govern the technical roadmap, reserve basket, distribution of dividends and funds, and other governance matters.

Libra’s Raison D’être

Libra may offer many millions of the unbanked access to a frictionless payment mechanism

Libra will not offer the unbanked the benefit of earning interest on holding/depositing libra coin in a Libra wallet, which is a benefit that the banked individual enjoys. Instead, the interest on fiat deposits and other financial instruments in the basket will be used to pay for operating expenses, investment in the ecosystem, engineering research and grant to nonprofits. What is left will be paid in the form of dividend on the Libra Investment Tokens (held by the association members).  

This is partially out of necessity. If Libra were to pay interest on your fiat deposit, it would qualify as a regulated security in many jurisdictions around the world, burying the project in red tape at its inception. It also works as an incentive mechanism for association members to drive adoption.

If you assumed that a billion Libra users held an average of $10 USD in Libra, and the Association earned a simple 2% on those fiat deposits, the Libra Association would have an annual operating budget of $200 million. If adoption grows tenfold, which could easily be envisioned, a budget of 2Bn would likely generate some exciting returns to the association members. But keep in mind the membership will grow to 100 and perhaps even 1000 businesses and organizations. This income model ensures the association has more than enough resources, and the members have some skin in the game to turn Libra into a success.

This is a fundamentally different incentive model from Bitcoin or Ethereum, where the entire userbase in incentivized to drive adoption and on-platform innovation as they stand to directly benefit from it. This sometimes turns the cryptocurrency market into a casino, but also creates an internet of money Olympics (or cage fight, depending on how you look at it). Everyone is in a race for their technology, their coin, their tribe, to become one of the ultimate winners. For all the distraction and adoption challenges this creates, some would argue this has led to the incredible pace of innovation in cryptocurrencies. Limiting returns to influential companies and organizations is a return to more conventional investing models.

If Facebook and partners are successful in getting Libra into the hands of a critical mass of consumers, then the Libra Association may quickly become a very powerful player in capital markets.  With the simple assumption of a billion Libra users, with an average daily volume of $100 USD value in Libra per user, the Libra Association will be required to manage a complex basket of cash and cash-equivalents totaling $100 Billion USD-equivalent. In banking the unbanked, they may bank themselves.

One feature of existing public blockchain networks that support value transfer in a native token, or token built thereon (e.g. ERC-20) is that the trustless value transfer is one-way and not reversable. Unless of course there is some trust between transacting parties and your counterparty is willing to send you back some of that overpayment you made in bitcoin. It is still unclear whether the Libra system will support chargebacks or other similar mechanisms between wallets. Will the Association need to develop mechanisms for playing the role of central authority when users wallets are hacked? What role will they play in freezing funds thought to be involved or linked to restricted activities? Who will play arbiter? What jurisdiction’s laws apply?  Only time will tell the answers to these important questions.

Libra Basics

Learn More

To understand the implication for the crypto industry click here. To understand what this means for your business click here.

[1]“Money is like manure; it’s not worth a thing unless it’s spread around encouraging young things to grow,” wrote playwright Thornton Wilder

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