Chinese and U.S. Models

Many aspects of our respective societies and governments follow different rules and approaches to organizing our communities. We presumably prefer (most of) our choices over theirs and vice versa. In explaining why we prefer ours, we might freely criticize theirs. But we generally have no right to demand that they abandon their approach and adopt ours.

Consider China’s Social Credit System.  In the U.S. we are “well accustomed to credit checks: data brokers such as Experian trace the timely manner in which we pay our debts, giving us a score that’s used by lenders and mortgage providers. We also have social-style scores, and anyone who has shopped online with eBay has a rating on shipping times and communication, while Uber drivers and passengers both rate each other; if your score falls too far, you’re out of luck.

“China’s social credit system expands that idea to all aspects of life, judging citizens’ behaviour and trustworthiness. Caught jaywalking, don’t pay a court bill, play your music too loud on the train — you could lose certain rights, such as booking a flight or train ticket.”  “China social credit system explained”

A good Social Credit score will ease access to loans and other good things. Compared to our approach to collecting information on our likely credit worthiness, the more comprehensive and centrally organized rating is more efficient and comprehensive. But we are very aware of the Chinese Communist Party’s sensitivity to criticism and its potential (if not certainty) for abusing such extensive access to information on our personal behavior. So, we would never allow such a system.

But what about the U.S.’s strong support (and push) for AML/CFT (Anti-Money Laundering and Combating the Financing of Terrorism) laws and procedures?  How do we (how can we) justify that? The U.S. requires that all financial firms collect information about their customers (KYC–Know Your Customer) that facilitates the government’s tracing payments of potentially illegally gained money and it has forced this requirement on all countries using U.S. dollars. The cost of these requirements is enormous. But why follow allegedly illegally gained money when the government can’t prove that it was illegally gained in the first place? If it could, the government should attack the illegal activity at its source. Thus, it claims, but cannot prove, that the money was illegally earned. Not only are AML requirements very expensive but the benefits (identifying criminals) are negligible and morally indefensible. “Operation Choke Point”

The issue of whether to require a so-called vaccination passport to document that the bearer has been vaccinated in order to enter facilities that require such proof, provides another example of a clash between efficiency and convenience and privacy. The pros and cons of such documentation are currently being debated in the U.S.  “vaccine passports”

My point is that each country has its own models for organizing and sharing information and for enforcing its laws.  We have every right, and should, carefully evaluate our own practices. What China chooses to do, is China’s business. Fortunately, we live here.

Whither Libra?

Every other day, it seems, we witness the launch of a new crypto (digital) currency.  Each combines a medium of exchange (a currency) and a means of payment (a technical process of delivering the currency—of making a payment with it). While many of us have watched the ups and downs of bitcoin and its imitators with amusement, none of us (hopefully) take it seriously as a currency. Bitcoin is a speculative vehicle for gambling.  Processing bitcoin payments is too slow, and its value is too volatile to succeed as a medium of exchange or as a means of payment. Only about 1% of bitcoin transactions are actual payments.  Many new means of payment do not involve a new currency.  Thus, debit and credit cards, checks, wire transfers, PayPal, Popmoney, Zelle, etc., are means of payment of US dollars, or Euros or other sovereign currencies.

Unlike the bitcoins of the world, Libra is a currency and means of payment that is designed to ensure that its tokens will have a stable value.  The legacy members of Facebook, Visa, Uber, and other partners in the Libra Association promise the possibility of rapid adoption. Libra’s value will be fixed to that of a basket of major currencies, its supply will be regulated by market demand at that fixed price (issued via currency board rules), and it will be fully backed by assets of the same value ensuring that holders of Libra can redeem them for the same value at any time.

Suddenly potential regulators are on high alert such as witnessed in the recent Congressional testimony of David Marcus, head of Facebook’s Calibra, to Congress.  By whom and how should Libra be regulated?  Obviously, it will need to comply with Anti Money Laundering (AML/CFT) requirements and whatever else each jurisdiction in which its participants reside (holders of “accounts” with Libra or of its tokens) require of money service providers. Banks take deposits and lend, so Libra would not be a bank. While its tokens might be treated as deposits, it will not lend (its purchases of government debt and other securities with the money paid to buy Libra are investments not loans).  In this short note I will explain why Libra—the coin/token/currency—is not a claim on a mutual fund and thus should not be regulated in the US by the Securities and Exchange Commission.  I will not, however, examine its claim to be a more efficient means of payment.

The nature of Libra’s claim of stability rests on how its value is determined.  Its value is to be fixed to the market value of a basket of currencies yet to be determined. But how does that work exactly?  The world already has an internationally determined and managed unit of account, the Special Drawing Right (SDR) of the International Monetary Fund.  Rather than introduce yet another, competitive unit the case for Libra to fix to the SDR is so overwhelming that I will illustrate the difference between a currency basket as a unit of account and as an investment portfolio with the SDR. The composition of the SDR’s valuation basket is established by international agreement following a well-specified and transparent process.  Fixing the value of a Libra to that of the SDR would remove any risk of its value being manipulated by Facebook or other Libra shareholders. That would strengthen the status of the Libra but also contribute to enhancing the IMF’s SDR as a supplement or substitute for the dollar in international reserves, as called for in the IMF’s Articles of Agreement.

The SDR’s value is determined by a basket of five currencies (the dollar, euro, pound sterling, yen and renminbi).  The IMF computes the dollar value of one SDR (and thus the value in every other currency) daily on the basis of the market exchange rate of each of the five currencies in the valuation basket into dollars.  The dollar values of each currency are added up to determine the dollar value of the basket.  By fixing the value of one Libra to one SDR it sets the price at which Libra can be purchased and the currency value that would be returned if Libra were redeemed.

This might seem similar to, but is in fact very different than, the value of one Libra being determined by the value of the portfolio of investments that back it.  The “Reserve” backing Libra would consist of SDR denominated assets (e.g., SDR bonds) or assets in each of the five basket currencies in the same proportion as in the SDRs valuation basket. Thus, it would bear no exchange rate risk.  However, the investment would have other risks, specifically interest rate and default risks.  To the extent that some of the Reserve’s investments are relatively long term (say ten-year Treasury bonds), changes in market interest rates would change the current market value of these investments. While Reserve investments would presumable be made only in the safest assets and would be limited to relatively short-term instruments, the risk of default or loss in value would not be zero.  So, if one Libra is a claim on its share of the Reserve, its value could differ from the daily dollar value of the SDR valuation basket.

Libra wishes to include the unbanked in its market, thus opening financial and payment services to this broad group now unable to enjoy them. If Libra’s value is fixed to the value of its Reserve, and thus regulated by the SEC (in the US), consumer protection investment regulations would likely exclude the very people Libra is most interested in serving. Thus, Libra should fix its value to that of a unit of account and not to the value of its Reserve.


Operation Choke Point

My letter from the Editorial Board of the Cayman Financial Review addresses the above and other American Government over reaches in the use of U.S. dollars abroad:  Financial Review, April, 2016  

I hope that you enjoy it.