Diem explained—a new payment infrastructure and private-sector stablecoin?

Formerly known as Libra, Diem is positioning itself as a neutral piece of infrastructure facilitating innovative approaches to payments.

Bitcoin is the largest cryptocurrency by market capitalization and second to none in terms of popularity. In recent weeks however, the focus has shifted to relatively more performant Ethereum, where the underlying blockchain technology is similar to that of Diem’s which we study below.

Diem differs from the others in that its role will be to bridge the gap between the unregulated world of crypto and the status quo system as we know it now. It is the most ‘diplomatic’ of the crypto projects out there, whose distributed ledger-based system will seek to combine the resilience and openness of cryptos with the mainstream financial system payment space.

Below is a walk through of how Diem might wedge itself into the mainstream, while maintaining some of the properties best observed with Ethereum’s protocol.

 

Formerly known as Facebook’s Libra…

Libra began with 28 organizations on board as a Facebook offshoot project. Groups like PayPal however quickly left the project as soon as they realized that Libra presented a sort of headwind to their business models, especially those reliant on rent seeking payment system behaviors explained below.

However, the bulk of the criticism came from public entities such as the ECB and the Federal Reserve who at the time saw Libra as a rival monetary system to the ones they control. Jerome Powell, the Federal Reserve Chairman alongside other prominent central banking officials said that Libra raised concerns around privacy, money laundering, consumer protection and financial stability and that such concerns were further fueled by Libra’s potential status as a sovereign currency, which they could not allow by virtue of their jobs.

Since then, Libra has been somewhat forgotten by popular media, and ultimately left in the dust. Born out of the ashes, Diem has presented an entirely new design and business model, one different to Bitcoin’s unregulated existence outside of the financial system but nevertheless, one sharing the core properties of cryptography and programmability.

Today, Diem decided to withdraw its application for authorization as a payment system in Switzerland and plans to focus on the US. Diem also became more transparent due to its open source ledger and its relationship with Facebook has faded whereby Facebook only has one vote out of 25 organizations that sit on the panel. Facebook still provided the open source code, but ultimately was Diem’s incubator and that’s all. Silvergate Bank, a well known bank for the fintechs based in California, will be issuing the Diem USD stablecoin and manage the reserve.

Diem’s purpose

Diem’s purpose is to tackle two broad issues in the payments space. The first goal is to improve the remittance market (when you send money abroad). The second goal is to enable more innovation within the current payment system (enable cheaper processing for merchants and retailers). To achieve the first goal, it will have to tackle the retail foreign exchange business, thus pressuring such incumbents as Western Union, Amex and others. For the second goal, it will challenge such players as PayPal and Square, shedding off some of the fees those incumbents charge merchants, by offering more optionality.

In a sense, and in order to provide these sort of services, Diem will weave itself between banks and service providers like PayPal in such a way that would render business to business transactions more efficient. Diem will not provide a business directly facing customers, but rather will permit businesses to use its infrastructure to build smart contracts to charge customers as they would.

In a sense, you can think of Diem like an Ethereum for the general status quo payment space—like Ethereum, Diem lets users program smart contracts to make products that best satisfy their payment needs.

So far so good for merchants, but what of the customers? It is not clear that customers would see a benefit in using yet another currency to accomplish the same transactional goal. Dollars work just fine, and their credit cards don’t charge them fees.

This is probably Diem’s biggest challenge going forward i.e., creating value for customers that are habituated to simple and unintrusive forms of payment. If you did not know, there is a large amount of rent seeking behavior that occurs every time you buy something at a store, but merchants incur the cost almost in full.

 

Rent seeking behavior in the payment space?

When you spend $100 on a pair of running shoes, the merchant usually ends up receiving $99.40 on average, and often times even less. The difference you see here of $0.60 is a spread equivalent to 60 basis points, and in contrast, PayPal noted in a Q1 2021 report that its average take rate was closer to 197 basis points, or about $2 every single transaction (on average).

This means a tax every time a payment occurs. This cash cow is great for firms like American Express, Visa, and other card providers, it’s good for platform servicers and providers and pretty much an entire ecosystem of shards that interrupt the flow of capital in what makes a market less free.

But ultimately, Diem does not threaten incumbents like PayPal and Visa, like Libra might have a couple of years ago. Diem is positioning itself as an added piece of the payment infrastructure, and is not customer facing like PayPal is with payers and Visa is with card buyers. Diem represents a sort of neutral medium that customer facing businesses can use in such a way that empowers them—and in fact, as previously stated, they will be able to code their own smart contracts and grow.

 

How Diem technology works

Diem is intended to be a series of Stablecoins. Stablecoins are cryptos that are backed up by fiat currencies which means you can sell your Diem for dollars and get the perks of added stability if you hold your Diem. Recall from above that Diem is not positioning itself as a competing asset class to fiats like Bitcoin is, which helps align Diem with authorities like Central banks who also want to make their own digital currencies.

Ideally, Diem would not have to originate its own token, and could simply make use of a digital USD managed and run by the central bank. It would simply provide a new infrastructure through which the CBDC could operate, and it would make money by charging fees much like others do now, but at a fraction of the current fees.

 

The thesis for Diem is to provide a superior approach to the status quo, without flipping the bird to it.

Diem’s technology plays a large role in accomplishing some of this thesis. Because the blockchain will act as a distributed ledger with inbuilt smart contracts as opposed to a closed-end ledger that not everyone can program on to their liking, many doors will open for further innovation. Users (service providers) will operate on the Diem blockchain with accounts that are disassociated from their real-life identity which means authenticity of identity and transactions occur through public keys and imply Diem never sees the data or the people behind the flow of funds. More power to the users!

Ultimately, the technology Diem wants to deploy is of a hybrid nature. It is a mix between decentralization and a closed loop system. The cryptography makes it so that Diem deploys a system which can operate with the low trust seen in other cryptos, and the distributed ledger means more scalability in programmability. Diem wants to be a hybrid player because it needs to gain acceptance on two fronts; regulatory approval, and improvement for service providers.

 

Some food for thought

Diem is to become a settlement rail for payments and a facilitator of a diverse range of new payment options. If Diem were to succeed, retail FX incumbents would see added pressure on their business models. Diem would steal not only retail FX market share, but that of other rent seekers like those who process and services payments and charge basis points in the middle.

What a Diem acceptance would also bring is further help on the CBDC adoption side, meaning that a digital dollar could become part of the new financial system much more quickly. Furthermore, this project would facilitate the growth of those same consumer facing businesses that exist today.

Finally, on the crypto side, Bitcoin would see an added pressure in its attempt to become a payment medium and Ethereum would find a rival in a state approved digital financial infrastructure.

Coming out soon in 2021.

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