How to regulate Libra 2.0 and the token economy
Authorities around the world are grappling with the rise of digital currencies and decentralised finance based on distributed ledger technology (DLT). The announcement of Libra and similar ‘stablecoin’ projects, such as Tether, USD Coin, and TrueUSD, puts a broader set of regulatory issues on the agenda, including regulations on the quality of asset backing (Fatás and Weder Di Mauro 2019, Cecchetti and Schoenholtz 2019, G7 Working Group on Stablecoins 2019, FSB 2020). The overarching consideration is that, when faced with innovations, how best to apply technology-neutral regulation so that similar economic and financial risks are treated on par.
Yet, the fact that regulation must be technology-neutral does not preclude public authorities from embracing innovation in supervision. Where ‘regulation’ is the process of setting the rules that apply to the regulated entities, ‘supervision’ is the compliance monitoring and enforcement of these rules, which has to be dynamic and adaptable.
Supervision might well evolve with technology. In recent work (Auer 2019b), I put forward the concept of ‘embedded supervision’. Embedded supervision is a framework that provides automatic monitoing by reading the ledger of a DLT-based market (see Figure 1). The ledger of a DLT-based market contains much information which is relevant for supervisory purposes. As such, it can be used to improve the quality of data available to the supervisor, while reducing the need for firms to actively collect, verify and report data to authorities.
Figure 1 Compliance monitoring process using embedded supervision
Notes: Embedded supervision can verify compliance with regulations by reading the distributed ledgers in both wholesale (the green blockchain) and retail banking markets (the yellow blockchain). Supervisors could access all transaction-level data. Alternatively, the use of smart contracts, Merkle trees, homomorphic encryption and other cryptographic tools might give supervisors verifiable access to selected parts of such micro data, or relevant consolidated positions such as to institution-to-institution or sectoral exposures. Firms would only need to define the relevant access rights, obviating the need for them to collect, compile and report data.
Source: Auer (2019b).
Libra 2.0 as a use case of embedded supervision
Allowing for embedded supervision could be important in the development of so-called asset ‘tokenisation’ – the process by which claims on or ownership in real and financial assets are digitally represented by tokens, allowing for new forms of trading and improved settlements (Bech et al. 2020).1
In particular, one key early use case of embedded supervision may be the monitoring of full asset-backing of a blockchain-based stablecoin.2 To exemplify both the merits and limits of embedded supervision applied to stablecoins, consider the revised Libra proposal (Libra 2.0, see Libra Association 2020).3
Figure 2 lays out the basic architecture of Libra 2.0, which has three layers. The first layer is the value-backing of two distinct types of stablecoins, single-currency stablecoins, such as Libra$ or Libra€, and a global stablecoin (LBR), that is a basket of the single-currency stablecoins. On the second layer these stablecoins are made available to payment service providers (PSP) and eWallet providers, such as Facebook’s digital wallet Calibra. On the third layer, the single-currency stablecoins and LBR are made available to retail clients.
The value backing of this ecosystem is two-tiered. The first tier is a traditional bank-based value guarantee for single-currency stablecoins. The second tier is a DLT-based smart contract underpinning the value of the global stablecoin, LBR.
These two tiers are interconnected. Custodian banks guarantee the value of the single-currency stablecoins. For example, bank A guarantees that for an outstanding supply of Libra$ 1 billion it indeed holds highly liquid US sovereign assets worth $1 billion on behalf of the Libra Association. DLT defines how the custodian banks make this guarantee public: rather than posting a signed letter on their webpage, they use their digital signature to cryptographically sign their guarantee into the public Libra Blockchain. Hence, the single-currency stablecoins become so-called ‘asset-backed tokens’ which have a digitally signed guarantee that an institution guarantees the value corresponding to a ledger entry.
The novel aspect is that once these value guarantees are signed into the Libra Blockchain, one can add decentral financial engineering on top of it. This is where LBR, the global stablecoin itself, comes into play. LBR is a smart contract combining several of the single-currency stablecoins into a basket of currencies. Here, the backing is guaranteed by DLT – and nothing else! For every LBR that is created, the smart contract ‘locks in’ the respective amount of single-currency stablecoins on the Libra Blockchain. For example, if a LBR were to be composed of two Libra$ and one Libra€, the creation of LBR 1 billion will lead to an entry into the Libra Blockchain that the supply of Libra$ has been reduced by 2 billion and that of Libra€ by 1 billion.4
This two-tier design allows for embedded supervision of LBR. On the one hand, since the value-backing of the single-currency stablecoin is based on the custodian banks’ guarantees, the supervisory process will have to be traditional. Embedded supervision could however be used to monitor the asset-backing of the global stablecoin LBR, as it involves reading the smart contract and the relevant ledger entries in real time and in an automated manner.
Figure 2 The architecture of Libra 2.0: a global LBR and single-currency stablecoins
Notes: Libra 2.0 is to feature both single-currency stablecoins such as Libra$ or Libra€, as well as a global stablecoin (LBR) that is a basket of the single-currency stablecoins. The architecture has three layers. The first layer is the value-backing. For the single-currency stablecoins, the value backing is guaranteed via reserves held at commercial banks. For LBR, the value backing is a smart contract that locks in a sufficient amount of single-currency stablecoins according to the basket composition. In the second wholesale layer, the various stablecoins are made available to retail payment providers, including designated dealers, virtual asset service providers (VASPs), and potentially also anonymous ‘unhosted’ wallets. An example for a retail payment service provider is Facebook Calibra. The third layer is that these payment service providers, in turn, make LBR and the single-currency stablecoins available to retail clients for use in payments.
Source: Auer (2019b)
DLT is trustworthy due to the principles of embedded supervision
The example of Libra 2.0 highlights that when it comes to applying embedded supervision, one needs to carefully delineate the use of DLT from other traditional elements that involve technology, but still rely on the value underpinning provided by supervised institutions and the legal system. In Auer (2019b), I discuss principles that should govern a framework designed to use a market’s distributed ledger for financial supervision (see Table 1).
Table 1 Principles of embedded supervision
The first of these principles goes back to how the value underpinning of the single-currency stablecoins is guaranteed in Libra 2.0: it is the banks’ digital signatures in the ledger that underpins the value of these coins. Obviously, there is nothing other than the judicial system that obliges banks to honour these guarantees.
The first principle of embedded supervision is that the process of ‘tokenisation’ must be supported by the legal system. The connection between the claim on or ownership in the underlying asset and the record of the digital token must ultimately be established by the legal system and relevant contractual arrangements. This is true for stablecoins, but also for assets such as real estate or shares in a bricks-and-mortar business. Importantly, this means that just as in today’s system, a decentralised financial system needs to be backed up by an effective legal and judicial system as well as institutions that enforce contractual arrangements.
The second principle relates to the trading on DLT-based markets: transactions and transfer of ownership must be irrevocable and final – otherwise its balance sheet items are not definitive for compliance assessment (see CPMI-IOSCO 2012). Economically viable applications of DLT, including Libra 2.0, run on so-called ‘permissioned’ DLT. In such markets, there is no central entity capable of vouching with a legally binding signature, hence another criterion for transaction finality must be established. Embedded supervision focuses on the concept of economic finality proposed in Auer (2019a), where economic finality is the notion that a transaction is final once it is no longer profitable to reverse it.5
However, so far the whitepaper on Libra 2.0 does not spell out how transaction finality will be achieved. It describes a standard process to achieve consensus on transactions via a 2/3 supermajority among the association members. What is however missing is a set of rules that would lay out what were to happen if indeed 2/3 of the members of the association were to coordinate to fraudulently undo transactions via so-called history reversion attack. Further information is thus needed to establish economic finality.6
The last principle concerns the broader societal goals when designing embedded supervision. Despite substantial technological advances of recent decades, the price of financial services has remained stable and high (Philippon 2015). This might partly reflect the high barriers to entry due to the administrative burden of complying with financial regulation. Detailed regulation and supervision in place to tackle the risks of large and complex financial intermediaries, may have inadvertently favoured concentration – by creating compliance costs that weigh disproportionately on smaller intermediaries (see Figure 3).7
Figure 3 Smaller financial institutions are disproportionately affected by compliance costs (%)
Sources: Auer (2019b) and Dahl et al (2016).
From Libra 2.0 to a decentralised token economy
One goal of embedded supervision should hence be to reduce the fixed cost of compliance with the regulations, thus levelling the playing field for large and small institutions. One operational aspect is for supervisors to take an active role in the design of the market, in particular regarding standardisation of the database structure – for example, to ensure interoperability of the Libra Blockchain with other blockchains standards.8
In the context of current developments, where many authorities concern themselves with the regulation and supervision of Libra 2.0 and other large-scale projects, the long-run benefits of embedded supervision might be disproportionally higher for smaller entrants – a welcome side effect.
Author’s note: The views expressed in this column are those of the author and not necessarily those of the Bank for International Settlements.
Auer, R (2019a), “Beyond the doomsday economics of ‘proof-of-work’ in cryptocurrencies”, BIS Working Papers, no 765.
Auer, R (2019b), “Embedded supervision: how to build regulation into blockchain finance”, BIS Working Papers, no 811.
Auer, R and S Claessens (2018), “Regulating cryptocurrencies: Assessing market reactions”, BIS Quarterly Review, September.
Basel Committee on Banking Supervision (2017), “Basel III: Finalising post-crisis reforms”, December.
Bech, M, J Hancock, T Rice and A Wadsworth (2020), “On the future of securities settlement”, BIS Quarterly Review, March.
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Budish, E (2018), “The economic limits of bitcoin and the blockchain”, NBER Working Papers, no 24717, June.
Bullmann, D, J Klemm and A Pinna (2019), “In search of stability in crypto-assets: are stablecoins the solution?”, ECB Occasional Paper Series, no 230, August.
Carstens, A (2018), “Ten years after the Great Financial Crisis – where do we stand?”, lecture at the People’s Bank of China, Beijing, 19 November.
Cecchetti, S and K Schoenholtz (2019), “Libra: A dramatic call to regulatory action”, VoxEU.org, 28 August.
Chiu, J and T Koeppl (2017), “The economics of cryptocurrencies – bitcoin and beyond”, Economics Department Queen’s University, working paper, no 1389.
Committee on Payments and Market Infrastructures and International Organization of Securities Commissions (2012), “CPMI-IOSCO Principles for financial market infrastructures”, April.
Coelho, R, M De Simoni and J Prenio (2019), “Suptech applications for anti-money laundering”, FSI Insights, no 18.
Dahl, D, A Meyer and M Neely (2016), “Scale matters: community banks and compliance costs”, Federal Reserve Bank of St Louis, The Regional Economist, July.
Fatás, A and B Weder di Mauro (2019), “The benefits of a global digital currency”, VoxEU.org, 30 August.
Financial Stability Board (2020), “Addressing the regulatory, supervisory and oversight challenges raised by ‘global stablecoin’ arrangements”, Consultative document, 14 April 2020.
Libra Association (2020), “White Paper V 2.0”, the Libra Association Members, 16 April.
G7 Working Group on Stablecoins (2019): “Investigating the impact of global stablecoins”, October 2019.
Möser, M, R Böhme and D Breuker (2013), “An inquiry into money laundering tools in the Bitcoin ecosystem”, in Proceedings of the APWG eCrime Researchers Summit (ECRIME), San Francisco: 1–14.
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1 Embedded supervision in these markets for tokens could for example entail monitoring compliance with capital standards, such as Basel III (BCBS 2017). It would involve automatic verification by computing the borrowing and lending balances and the associated risk weights within the relevant market ledgers.
2 There are many concerns with Libra that go beyond the discussion of the value backing discussed here (see G7 Working Group on Stablecoins 2019 and FSB 2020). They include risks around financial stability and monetary policy and competition, data privacy, consumer protection, and tax compliance issues. One particular concern is money laundering via digital currencies (Möser et al. 2015). An additional key requirement must hence be a watertight and globally coordinated AML/KYC identity framework that keeps illicit activity out of this novel ecosystem. Coelho et al. (2019) show how technology might help here.
3 Other examples include MakerDao’s DAI, as well as other ‘on-chain’ stablecoins in the terminology of Bullmann et al. (2019).
4 These numbers are chose only for the sake of easy exposition. The revised Libra proposal mentions a 50% weight for Libra$, 18% for Libra€, and 11% for Libra£ (the remaining 21% are not spelled out).
5 Auer (2019a) examines economic finality for the case of proof-of-work-based consensus schemes used in Bitcoin. Bonneau (2016), Chiu and Koeppl (2017) and Budish (2018) offer closely related, but probabilistic concepts and analyse the conditions under which blockchain transactions become prohibitively expensive to reverse via a so-called 51% brute force attack.
6 In Auer (2019b), I also extend the theoretical considerations regarding transaction finality to the impact of the supervisors’ actions on the regulated market. Regulated firms incur a cost in complying with regulation that they would not incur voluntarily. By the same token, in the DLT world, this creates incentives for a regulated firm to cheat the supervisor by altering the transaction history in the blockchain. I thus also model the supervisor’s impact on the market.
7 In particular, following the Great Financial Crisis, politicians, legislators and supervisors have focused on increasing the resilience of the financial system and, in particular, of the large banks that account for the bulk of total positions and thus aggregate risk, an effort that is still ongoing (e.g. Carstens 2018).
8 Another priority might be to develop a freely available open-source suite of monitoring tools with the aim of clarifying how specific regulatory frameworks are applied in practice. Regulators and supervisors can also steer some design elements of new decentralised markets, as they will set the market standards under which regulatory compliance can be automated (see also Auer and Claessens 2018).