Don’t trust me: Why Ripple is not the future of money.
First things first: this is my very first medium story, be indulgent. It also represents my personal, biased (!) opinion and doesn’t necessarily reflect views of companies I am associated with.
What drove me to write this piece: After studying the underlying principles of Ripple’s payment network, I realized that so far, most articles are only focused on the technicalities or the controversy around the XRP token allocation. In fact people seem to lose sight of Ripple’s main characteristic which differentiates itself from bitcoin or ethereum: (in many cases) it requires trust.
- Ripple doesn’t transfer actual value between two parties. It transfers debt, so called IOUs. The abbreviation itself nails it: I-Owe-yoU. Picture it like a post-it you get from someone with the words “I owe you $5”.
- This obviously requires a healthy amount of trust, since accepting such IOU post-it from someone means, I trust this someone will be able to pay me these $5 at some point in the future. That’s the very reason why Ripple asks you to setup a trust network when spinning up a node. It’s not an easy thing to do: choosing whom to trust.
- If you spin-up a Ripple node as an individual, chances are high that nobody will trust you. Now you are back to square one: you have to become a customer of a bank, a trusted validator in Ripple. One could argue that this is the very intention of a trust-based system - the need for custodians which trust each other: banks.
This is the crucial difference to open, decentralized systems, like bitcoin: I don’t have to trust anyone. Exchanging value with someone without trust, remains the key innovation of systems like bitcoin. You’ll find a quick summary on how this is achieved below. Trust is required ‘in many cases’, because Ripple actually does offer a way to transfer real value between parties with its product xRapid, which is great. The problem is, it uses its own XRP token as intermediary for traditional currencies like USD and EUR. A simple introduction on this can be found here. However, this is not enforced and the vast majority of institutions don’t use XRP as intermediary at all. Recently, Moneygram was announced to be using XRP, which reveals that noone else is using it IMO. I recommend this read for more details on Ripple’s main product xCurrent which is used by banks and why it doesn’t involve XRP. I can understand banks not keen on using XRP, because it represents a fairly bad intermediary for the following reasons:
- Transacted assets are mostly FIAT currencies, like USD, which value is represented in XRP during the time of the transaction. This takes about 4 seconds and the associated fx risk is acceptable. But in order to avoid further risk exposure, a bank should exchange the relatively volatile XRP token to the underlying transacted USD immediately upon receipt. This would require access to a deeply liquid XRP/USD market. Ripple failed to establish these liquid markets so far.
- In my opinion, it is not realistic for Ripple to be able to do so any time soon, since it simply would require deep and liquid, localized markets for XRP against each and every single other asset on this planet.
- XRP, an asset with 60% of the total circulation in control of one single company and a track record of market manipulation by rogue founders shouldn’t attract traders and liquidity in the long-term.
In practice all this leads to the following: Ripple is naturally dominated by banks and other large financial institutions. Banks, which are sort of familiar with each other and sort of trust each other. In most of the cases our IOUs even have to find ‘trust path’ and pass multiple intermediary banks to reach its destination, because simply not all banks trust all banks.
In short, Ripple replicates bank networks and here is how it works (feel free to exchange ‘bank’ with ‘ripple node’):
- Bank A trusts bank B and bank B trusts bank C. Bank A and C do not trust each other.
- Now, if bank A wants to receive money from bank C, the IOUs from bank C would have to take the route C -> B -> A , since B has trust relationships with both.
- The consequence: banks maintain huge ‘debt balance sheets’ which record how much money they lent or owe to other banks.
Funny things like: banking hours (it’s a machine!), greed (let’s hold off the user’s transaction for a while, so we can go and trade with the money) and numerous trust-intermediaries on the way lead to the banking experience we have today: days of transaction time with substantial fees for the intermediaries.
Voila, this is how our world-wide banking networks function at the inside and consequently the underlying principle of all transfers via bank wire, ACH, SWIFT or SEPA. And Ripple.
The side effects:
In practice, the resulting debts (in the example above C is owing money to B and B is owing money to A) are rarely settled. Simple reason: it’s fairly hard to do. A bank representative would have to hop on a plane with a case of gold. Because … unfortunately most other payment rails use IOUs too. The idea is, that in the long term, debt/lending relationships between banks are more or less balanced out. Meaning, taking the example above, if just enough customers from bank A transfer money back to customers at bank C, we’ll reach a net zero.
Now imagine this: Bank B disappears or files bankruptcy. Or bank C. Actually no need to imagine much, just recall September 15th, 2008 for a famous example. It unavoidably leads to someone losing money because the party who wrote the IOU post-it doesn’t live up to the promise.
This can be summarized in the term counterparty risk. Whenever you are accepting an IOU, this makes you essentially a creditor and you face counterparty risk: the party owing you can default at any time.
On a smaller scale, this happens everyday. Not speaking of the next financial crisis, but definitely to people losing money. In Ripple, participants even started trying to maintain blacklists of bankrupt gateways and avoid accepting their IOUs.
I am convinced the IOU-web is flawed.
Interestingly, we already have asset classes which can be exchanged free of counterparty risk: precious metals such as gold. Gold’s value lies in the physical bullion itself, because of its scarcity. If the bullion is in my possession, the only way it leaves my ownership is if I sell it, lose it, or somebody steals it from me. But there is just no way somebody screws up and my bullion becomes worthless. That’s why gold has worked for thousands of years. The absence of counterparty risk is one of the unique characteristics which bitcoin shares with gold.
Satoshi was very aware of this. Here is how bitcoin does away with counterparty risk: Cryptography
- You own your bitcoin through your private key. Your private key controls your bitcoin, like e.g. sending them to someone else.
- Using cryptography, the whole bitcoin network approves your transaction if it’s signed by the correct private key (everyone knows about your transaction!). Once a transaction is included into a block on the bitcoin blockchain, the receiver can be sure to own these coins now, because bitcoin’s blockchain is immutable (‘irreversible’).*
Consequently, the receiver of your bitcoin doesn’t have to put any trust or faith in you to fulfill your IOU post-it promise later on. The receiver owns your bitcoin after seeing the transfer in a block on the bitcoin blockchain*; the whole network attested this by including it into a block. Another way to put it: the bitcoin blockchain transfers real bitcoin, not IOUs. It was the first of its kind enabling this fundamental financial system to be achieved digitally.
‘Trustless’ is the key innovation of bitcoin and the future of money. Let’s continue improving it.
Feel free to leave your ripple addresses as comment and I’ll send you some ‘money’. The question is… do you trust me?
*Simplified example, waiting for 2–6 block confirmations is recommended and practiced by most services