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Morningstar | Libra's Implications for Our Financial Services Coverage: We're Not Worried Just Yet

Facebook has announced plans for Libra, its new digital currency set to launch in 2020, making it the first major company to attempt to bring cryptocurrency into the retail mainstream. Overall, we are not yet worried about a negative impact on economic moats in financial services.

Libra is a cryptocurrency that will be built using blockchain technology. It will be run by a consortium, with Facebook as the lead until the end of 2019, at which point all members will have equal power. It will start out as a "permissioned blockchain," with the ambition to move toward "permissionless" over time. Libra will be backed by a reserve, which Facebook says will consist of "a collection of low-volatility assets, such as bank deposits and short-term government securities in currencies from stable and reputable central banks." This is in contrast to a cryptocurrency like Bitcoin, where there is no fiat currency backing, which leads to wild price swings. Facebook believes this will keep Libra relatively stable in value, although not 100% stable. Facebook’s initial goal is to target the unbanked market. The project also has a focus on cross-border payments, an area that has historically been more difficult to handle from a processing standpoint.

Any prognostications concerning Libra are quite speculative at this point. It is very hard to tell exactly how this will evolve over the next 5-10 years; a lot will depend on how popular it becomes, what the initial uptake is, and if it can reach a critical mass of users and transactions. The initial stages of trying to develop a network effect are inherently uncertain, although Facebook’s existing network effect in its social media platform may help.

In trying to disrupt the financial services industry, Libra will face a number of hurdles. We will focus first on the banks. Facebook's initial strategy is to go after users without a bank account or access to the existing banking system, so this is not a direct attack on financial services at this point. However, once the platform gets a critical mass of users and volume, it is not hard to imagine that it will begin to affect users with bank accounts. The first hurdle we see is that governments will probably not want large amounts of transactions going through unregulated, unmonitored platforms. Facebook said, "The Libra blockchain is pseudonymous and allows users to hold one or more addresses that are not linked to their real-world identity." If the platform becomes big enough, we’re not sure governments would like this. We also have a hard time seeing how this would not create problems for the banks, as they could run into issues around anti-money-laundering and know-your-customer rules. The white paper does say, "While the network is open and accessible to everyone with Internet access, the network's main endpoints, in the form of exchanges and wallets, will need to follow applicable laws and regulations and collaborate with law enforcement," but it is not clear to us what following applicable laws and regulations actually entails, and if it would solve these potential issues. It was mentioned that Facebook had conversations with the Federal Reserve before announcing Libra’s launch, but again, details are sparse around the actual content of these conversations.

The second major hurdle is the potential political and regulatory pushback against the power of the largest tech companies, which we are already seeing. We don't necessarily see politicians and regulators going along with Facebook being involved in and monetizing more aspects of the economy. Libra will be governed by a group of companies, but our understanding is that Facebook will still control Calibra, which will "build and operate services on its behalf on top of the Libra network." We are already seeing pushback here, with comments from Rep. Maxine Waters, chair of the U.S. House Committee on Financial Services, surfacing almost immediately after Facebook’s announcement.

We also wonder if users are going to trust Facebook with their financial transactions, given the trust and data issues that have cropped up recently. Further, we don't envision that clients who are already heavy users of the current regulated banking system will want to use Facebook for a significant amount of their transaction activity. Unless Facebook becomes something closer to a full-fledged bank, with a more complete product offering, it seems more likely that a bank will still be the center of most people’s financial life. Finally, the banks are already working on developing improved cross-border and real-time payment capabilities, and this has even crossed over into the cryptocurrency landscape with offerings such as JPM Coin (although this is not available to the retail market). We expect banks will provide offerings that the market demands.

For payment processors specifically, we don’t see Libra having a discernible impact on most of the payment processors we cover anytime soon. Notably, Visa and Mastercard are partners in the effort, which suggests the management teams at these companies don’t see Libra as a major threat. The networks benefit from their immense volume ($17 trillion annually combined), and Libra is extremely unlikely to approach anywhere near their scale over a foreseeable time frame. In the longer run, we think displacing the card networks and the other players in their ecosystem would depend on developing a payment system that is equally ubiquitous and either materially cheaper or more secure. For all their potential, cryptocurrency and blockchain have not yet established that they can present superior options on either front.

When we look at other niches of the payment space, we do see some spots where Libra could have a more material impact. Recent years have seen somewhat of a proliferation of person-to-person payment platforms with Zelle (backed by the banks) and Square’s Cash App now competing against Venmo. Libra could add another option to that mix, and the support of Facebook could provide the critical mass necessary in what we think is a space with a winner-take-all dynamic over time. Still, we don’t think Venmo is large enough to move the needle for PayPal (which is also a member of the Libra Association), and our view of the prospects of Square’s Cash App is already tempered. The most at-risk company in our payments coverage might be Western Union, as Libra could prove to be an effective vehicle for international money transfers, and the money transfer market is small enough that Libra could build an effective level of scale in a reasonable time frame with Facebook’s backing. We recognize the potential for Western Union to face new types of competition over time. That consideration is the primary driver behind our negative moat trend rating for the company, and we believe this type of risk is already baked into our long-term assumptions.

We see a lot of uncertainty surrounding the ultimate trajectory of Libra and also a lot of hurdles that will need to be overcome for Libra to have any major impact on the incumbents in the financial sector.