What is Ripple?
There are 3 main distinctive definitions to make when discussing Ripple to make the solution easier to understand. Keep in mind that in practice Ripple has more tailored solutions for distinctive market players:
- Ripple Inc: the California, venture backed corporation
- Ripple Protocol: design specifications for inter-bank communication
- XRP: currency of the Ripple protocol
The Ripple Protocol is intended to work with existing institutions to facilitate the transaction of any asset globally at lower costs and higher speeds than we do today. The protocol is maintained and developed by Ripple Inc., which currently has unilateral control over the network.
XRP is used to pay network fees in the Ripple Protocol, and can also be used as a bridge currency between institutions. In theory, the Ripple Protocol has the ability to displace legacy inter-bank networks, which would impact trillions of dollars of economic activity, but it is unlikely that this displacement will happen with XRP.
How Banks Resolve Their Debts
Understanding the Ripple Protocol requires understanding of how modern banking systems work. When I deposit $10 into my Bank of Montreal (BMO) chequing account I am loaning that money to BMO and trusting that they will repay me. BMO records a liability of $10 on their balance sheet. If I send $10 to a friend who also banks with BMO, the bank has the same balance of liabilities, but the liability is now owed to my friend rather than me. The bank’s internal ledger keeps track of these liabilities to customers.
If I want to pay someone $10 who banks with Toronto Dominion (TD) this becomes more complicated because each of their internal ledgers need to be updates, and money needs to actually change hands. Larger institutions within the same country typically have trusted relationships with one another where they are comfortable issuing IOUs and agree to settle their balances in the future to facilitate quick transaction times for their customers. This works because of the trusted relationship between banks, and and if there is not a trusted relationship, the customers must wait for money to actually be transferred, or to have the transaction routed between mutually trusted third parties.
If I want to send money to a friend living in Singapore and our banks do not have a trusted relationship, which is common across multiple borders, the payment will go through multiple parties which is costly, slow, error-prone, and requires banking institutions to increase their working capital requirements, which often sits idle until needed to bridge a transaction with an untrusted party.
A Simple Explanation Of The Ripple Protocol
The Ripple Protocol moves institutions to a single database called the Ripple Ledger that significantly decreases transaction times and frees up working capital for institutions. The network maps trust lines and optimizes them so that money follows the shortest and fastest path of trusted parties globally and creates a distributed ledger to record all of these transactions.
Banks can exchange IOUs on decentralized ledgers globally, but these need to be settled eventually. These settlements can be done in fiat, XRP, or any other digital currency. XRP is required to participate in the network to pay transaction fees, and all participants must maintain a balance of 20 XRP in their wallets. XRP is a deflationary currency, where transaction fees are burned upon payment.
What Is The Incentive To Hold The XRP Token?
There is one glaring problem in this model for XRP holders: XRP should not increase in value proportionally to Ripple Protocol adoption.
The XRP token should increase in value with more demand for the token, which would be driven through its use as a bridge currency to settle IOUs between banks. Due to the volatility of the XRP token, rational participants in the protocol want to avoid risk exposure, and therefore they are incentivized to hold tokens for the lowest amount of time required. If a digital currency is used to settle these debts it is likely that it will be a more stable coin.
Therefore, it’s expected that XRP will accumulate value sublinearly relative to transaction throughput and market makers will benefit in this market place by facilitating transactions at a liquidity premium.
The increased adoption of decentralized exchanges will make it easier to exchange tokens in a matter of seconds to decrease exposure to volatility and XRP becomes an unnecessary area of friction in terms of the user experience, that can be mediated by only holding the required funds at the time of the transaction.
Using the Ripple Protocol decreases a bank’s cost base significantly without using the XRP token as a bridge currency between assets, and I believe it’s unlikely they will adopt the XRP token just to decrease settlement times even further.
Since the Ripple Protocol gives the option to settle debts in fiat or any other digital asset, it’s likely that debts will be settled in fiat in the medium term, and participants could adopt a more stable digital currency in the long term.
XRP: Running Before Walking?
Right now I believe the increased speed in facilitating these transactions is a feature creep that institutions are not interested in at this time. It is analogous to upgrading a customer from dial-up Internet to wireless Internet, and then trying to upsell them to purchase a higher speed – they’re probably not interested in the near term. When society upgraded their transportation preferences from horses to steam powered cars, and there were still some horses on the road, a person holding a red flag would walk in front of the cars to make sure they didn’t scare the horses. It’s likely that banks will walk before they run, and walking in this case would be to adopt a shared ledger to settle IOUs using the Ripple Protocol in the first place
David Schwartz, Ripple’s Chief Cryptographer, even indicated that Ripple’s protocol can work without XRP, and without any blockchain technology at all. He said that the protocol improves international payments, and that it is a big enough improvement [without involving XRP] on current legacy systems that banks will use the protocol even if money [fiat] moves in the exact same way that it currently does. Although, he also added that the difficult part getting a bank to adopt a blockchain isn’t the blockchain itself, and that it’s the governance, compliance and integration with current banking systems – their software does all of that, so if routing payments through XRP rather than fiat is even a penny cheaper, then it makes sense for banks to adopt XRP as a bridge currency.
His opinion is that XRP is an easy upsell, and if this strategy succeeds, it could increase the price of XRP significantly.
What XRP Skeptics Believe
Skeptics have argued in the past that there is no rational reason for XRP to exist in the Ripple Protocol other than for a means of funding Ripple by selling XRP tokens on the open market and to incentivize institutional participation, and that Ripple inflates their financial figures by selling their native token.
There are 100 billion XRP tokens in existence that were all premined prior to launching the protocol. In December 2017 Ripple committed to placing 55 billion XRP in a cryptographically-secured escrow account to create certainty around the token’s supply. 1 billion XRP are released from the contract each month for Ripple to use at their discretion, which was planned to be used to incentivize market makers and to sell to institutional investors.
Historically Ripple has been a responsible steward in using these funds (selling approximately 30% of these funds monthly), and unused XRP each month have been placed into a new escrow account.
As of right now, I believe inflated price increases in XRP are due to investor speculation that the token will become a global currency to facilitate transactions between banks, betting on the fact that XRP will be the driving currency behind the disruption of a trillion dollar industry.
It is unlikely for this to occur because the token is not integral for the Ripple protocol, and it does not provide the price stability that will define a global digital asset.
I am bullish on Ripple as a project, and think adoption is a huge step in the right direction for the blockchain industry. It’s a perfect use case that innovates a laggard industry, but I personally don’t see utility or rationalization behind the decision for a retail investor to hold XRP in the long term.