Expect regulators to shape the Libra business model

Out-Law Analysis | 04 Jul 2019 | 12:26 pm | 11 min. read

The way the Libra project is implemented will be dictated by risk-averse policy makers and regulators seeking to protect consumers from harm, guard against financial crime and preserve market stability.

The project's vision of a truly open blockchain-based platform for financial services and the widespread adoption of a global cryptocurrency challenges the current way in which the market is regulated.

It is likely that negotiations will take place over the best way to regulate Libra, and that these talks, together with consideration of issues such as tax implications, fraud and cybersecurity, will ultimately shape the initiative's business model.

... we can expect central banks, international bodies and conduct authorities to negotiate with the Libra Association in an effort to characterise the way the coin operates...

Classification of the Libra coin

The Libra Association has said that, under its plans, anyone in the world will be able to buy Libra coins through a reseller and transact at little or no cost with anyone in the world using blockchain technology. Regulators and academics have grappled with the question of what exactly the 'coin' in a blockchain represents. This has been an important exercise because the classification of a coin as a 'payment token', 'security token' or 'utility token' has influenced the regulatory scrutiny to which it is subjected, and the rules on its use and distribution.

The Libra coin looks like a financial instrument but is designed to behave like a currency. It is backed, at least in part, by a synthetic mix of global currencies and assets held in the Libra Reserve. The value of the Reserve can increase and decrease and is not dependent on the financial soundness of a government, but is designed to fluctuate with inflation. This is unlike many other cryptoassets, which are designed to act like currencies but which in fact are bought and sold as highly speculative investments.

The debate about the classification is important because currency is treated unlike other assets in many situations. The decision to treat Libra coins as a financial instrument that's used like a currency would have significant implications on the solvency of any of the intermediaries or reserves in this new financial system. It might, for example, present new possibilities for secured lending which could both increase the availability of finance but weaken the position of unsecured creditors.

At the heart of the issue Libra presents is the truly international scale of the coin. Domestic policy makers can alter their insolvency regimes or secured lending laws, but it is not obvious why any of these ought to apply to a 'transactional fluid' which would be shuttled around a global system by an open group of unregulated actors. It is why we can expect central banks, international bodies and conduct authorities to negotiate with the Libra Association in an effort to characterise the way the coin operates in a way which enables regulatory controls to be applied.

The plans for the Libra coin and blockchain itself could also spur a change in the way global standard setters and watchdogs intervene in financial services markets...

Global bodies could get more hands-on

The entities involved in the operation of the Libra initiative are also likely to face regulation. These include the validators that would operate the payment system in which the Libra coin would be exchanged, the resellers that would distribute the coin to users in return for fiat currencies deposited in the Libra Reserve, and the Reserve that would hold deposited funds as custodians and invest to generate a low-risk return.

Resellers will constitute securities issuers, e-money issuers or foreign exchange services, depending on how the Libra coin is characterised. That presumes that it is even necessary to characterise the Libra coin: the UK's Financial Conduct Authority (FCA), for instance, could permit only already-regulated entities to act as validators in a bid to limit the potential for consumer harm.

The Reserve promises to be a hybrid between safeguarded funds following the issue of e-money and investment funds. Depending on the characterisation of Libra as a currency or security, the Reserve might also fall within the Bank of England's jurisdiction.

The validators will be a global group of companies, some of whom provide a regulated payment service within their own jurisdiction. Whilst it is feasible that regulatory arbitrage could incentivise validators to incorporate in low-regulation jurisdictions to reduce compliance costs, regulators have an array of tools at their disposal to disincentivise such behaviour.

The plans for the Libra coin and blockchain itself could also spur a change in the way global standard setters and watchdogs intervene in financial services markets. The G7, the Bank of International Settlements, the Financial Stability Board and the International Monetary Fund all play a role in shaping financial markets currently, but the scope of intervention comes from seeking to preserve financial stability.

The Libra project will necessitate a new approach to regulation, and so we may see global bodies take a more hands-on approach in the four common areas that regulation typically focuses on – people, venues, activities and products – to reflect the Libra's would-be global payment system and corresponding global denomination.

Future-proofing the regulatory environment will also be on the minds of regulators and Libra's backers when they negotiate the framework that Libra will operate in...

Negotiation over Libra's business model

There is clearly a will from Facebook and the Libra project's other backers to make the new initiative happen, and it is likely to spur new opportunities for businesses to provide market finance and be part of the future of money.

However, it is likely that regulators will move to alter aspects of the Libra business model.

Stanford professor Joseph Grundfest predicts that regulators will not allow Libra to achieve its aim of operating as a permissionless blockchain. A permissionless system would allow anyone to process transactions, but would make it almost impossible for regulators and courts, even acting together, to exert authority over the operation of the blockchain.

The theory goes that allowing only regulated entities to act as validators would make it easier for regulators to supervise, prevent harm to consumers and subject the blockchain to legal process.

Such a move could see the creation of a new regulated category, agreed at international level and then implemented domestically, to bring Libra validators into the scope of regulation. It is unlikely that Libra validators would fall within the definition of any current UK regulated entity, for example, with the closest equivalents being designated payment systems which fall subject to the Payment Systems Regulator's regime.

Regulators may also see an advantage in limiting the number of Libra validators so that they can be required to enter into a contractual regime to mutualise losses and liabilities. A common structure for central counterparties (CCPs) is that they are jointly owned and capitalised by their largest users. A market shock which results in credit failures will hurt the CCP rather than the full market of creditors, and will be paid for jointly by the large financial institutions which have profited the most from the system. Regulators may seek to create a similar risk-sharing regime which can function across jurisdictions to provide recourse for consumers.

There will also likely be intense negotiation on which institutions can act as 'global custodians' in the Libra Reserve, but the more fundamental question is what exactly the Reserve is. On the one hand, resellers are described as 'depositing' user funds into the Reserve in return for newly minted Libra coins. The intended contents of the Reserve are described as a mixture of low-risk assets – currencies and government securities – which will have minimal volatility. But on the other hand, the Reserve's second purpose is to accrue interest to fund the operating costs of the blockchain and then to give a return to validators and other investors.

Regulators may view a fund which is simultaneously promoted as a ring-fenced deposit box and as an investment vehicle as a contradiction in terms. Strict governance and heavy regulatory oversight of the investment plan can be expected to be required to ensure that the right balance between risk and return is struck.

In addition, the recent suspension of the Woodford fund demonstrates the dangers of operating an open-ended fund whilst investing in assets with differing degrees of liquidity: the fund must sell its more liquid assets in order to let investors redeem their shares, thereby leaving the less liquid assets and triggering a panic.

According to professor Dan Awry of Oxford University, in adverse economic conditions, there is often a flight from substitute financial claims, such as the Libra coin may be classed, towards cold hard cash. To prevent such contagion crippling the Reserve, regulators will likely set rules on when validators can withdraw their investments. However, they probably will not go as far as to put such restrictions on everyday consumers and it is hard to see them providing deposit guarantee insurance for a private investment fund, so one likely alternative could be to prohibit the Reserve from paying dividends.

Libra's aim to assist the world's unbanked population in accessing financial services could also be challenged by governments in the countries in which those people live.

Smaller African nations in particular may be concerned that a move away from the use of the local currency could cause it to plummet in value, triggering a spike in inflation and leading to market panic. In return for permitting Libra to service users in their country, those nations could therefore insist that a portion of the Reserve be constituted in their local currency. This appears on the face of it to contradict the Libra project's plans to include only the lowest-risk currencies within the Reserve's mix.

Future-proofing the regulatory environment will also be on the minds of regulators and Libra's backers when they negotiate the framework that Libra will operate in. Both parties will be keen to ensure it enables the Libra blockchain to be used beyond merely for payments.

For example, the framework will need to provide for the sale of insurance products over the Libra blockchain by regulated insurance distributors, while the blockchain itself may need to be considered as a venue for transferring international securities and not just as a payment system.

Users should seek to understand the tax implications of using any cryptocurency to avoid unexpected consequences. 

Tax implications for users

Even though the documents issued by the Libra Association talk about "coins" and "currency", cryptoassets have yet to be legally defined as "means of payment" in almost any jurisdiction. Instead, Libra coin is likely to be considered means of exchange. This would have tax implications for users. Because Libra coins would be treated as property, not money, transactions in which they are involved would be taxable events.

The tax issues were recently highlighted in an article published by the Financial Times. A spokesperson for Facebook said they expect the market will step in to provide services via the Libra blockchain to help users manage any tax obligations that arise.

Users should seek to understand the tax implications of using any cryptocurency to avoid unexpected consequences.

Users will need to be educated on how the system will be accessed and how payments will be processed so as to minimise users being tricked by sites seeking to mimic the Libra ecosystem.

The cyber risk

Whilst Libra is a technological development with potential to change the institutionalised means of making payments, there are concerns that it may well   provide a platform for fraud and cybersecurity breaches. If Libra, or any digital payment system, seeks to become a leader in electronic payments, then customer protection against fraud and breaches of data privacy must be safeguarded and prioritised.

There is the potential for fraud to materialise on Libra much in the same way we have seen on other technological platforms, online networks and fraud which has occurred on platforms supporting cryptocurrencies.

Recent figures published reveal the scale of the risks posed by scammers and cyber criminals.

Latest FCA estimates suggest that people targeted in cryptoasset scams, such as where they have been conned into buying cryptoassets using fiat currency and have received nothing in return, lost on average £14,600 each in the last financial year.

Total losses attributed to crypto and forex scams in 2018/2019 was over £27 million, the FCA reported in May, although global figures could be significantly higher – BBC Moneybox Live recently cited statistics from a Ciphertrace report published in April 2019 that suggest approximately £950 million worth of cryptocurrency has been stolen or misappropriated from crypto exchanges in the first three months of this year.

There have been arrests over the theft of cryptocurrency in the UK in relation to spoof sites set up to mimic genuine platforms where users can log on and access their cryptocurrency. By entering their details into the fake sites, users inadvertently provide their credentials to fraudsters who subsequently use the details captured to access and deplete genuine crypto reserves. Libra's security measures will need to be sufficiently robust to counter that risk and the companies behind the initiative should seek to educate users on how to access funds held within it.

It is good practice for those thinking of investing in cryptocurrency or utilising a cryptocurrency exchange to consider the length of time it has been established, its reputation, physical location, the identity of the officers of the exchange, the applicable regulatory regime and potential options for enforcement before doing so. Consideration should also be given to storing cryptocurrency offline.

There are several factors behind rising fraud and misappropriation in the context of cryptocurrencies.

The potential to raise capital fast from the growth in interest in cryptocurrencies and from the emergence of 'initial coin offerings' in particular has naturally drawn interest from criminals. These criminals and fraudsters seeking to penetrate the market are increasingly sophisticated, and they are using a variety of means, including malicious code and ransomware, to target users and the platforms on which cryptocurrency is stored.

Exchanges holding cryptoassets are being targeted because of the potential for these new assets to grow in value faster than traditional fiat currencies, and because they are viewed as being softer targets than traditional institutional banks which have developed their security over a longer period.  

Libra, in line with its aim of providing a widely accessible digital payment platform, will need to ensure the security risks that exist with the cryptocurrency market are prioritised and addressed. Users will need to be educated on how the system will be accessed and how payments will be processed so as to minimise users being tricked by sites seeking to mimic the Libra ecosystem.

Because of the complex and global nature of the way the Libra blockchain is designed to operate, a customer affected by a mistake or fraud may not have legal recourse against any of the companies which are involved in the Libra Association. The intended global nature of the project may make it difficult to determine where responsibility may lie and it is unclear where, or to whom, a user or customer should raise any issue.

It has been indicated that in the case of hacking, where a fraudster might attempt to hack into a Calibra wallet – the wallet specifically developed for Libra – lost coins will be refunded. However, it remains unclear how Libra will treat other forms of fraud, or indeed frauds successfully depleting funds from apps which are built to work with Libra. It might be possible, depending on how the ecosystem is developed, that fraudulent transactions could be unravelled, but it is unclear currently whether or how this functionality could be provided for.

Whilst an exciting, innovative proposal, users and those behind Libra need to be aware of the risks, which, in the context of fraud and cybercrime, will no doubt develop as the Libra ecosystem itself evolves.

Andrew Barber, Jennifer Craven and Cristina Carrascosa Cobos are experts in financial services regulation, civil fraud and asset recovery and blockchain technology respectively at Pinsent Masons, the law firm behind Out-Law.