Will the Ripple revolutionize the international payment system?

If Ripple Lab has become famous since a few months, because of its crypto currency incredible rise (it went from $0.20 in October to $2.50 in December, and went up to 22 000 % in 2017), it has been developed since 2004 and officially launched in 2012. One of the most striking features of this cryptocurrency (the XRP) relies on the fact that its growth has not been affected by the recent plunge of the Bitcoin and that it has been recently adopted by major financial institutions[1]. Moreover, the market capitalization of the Ripple overcame the one of the Ethereum, becoming the 2nd market cap among cryptocurrencies[2].

How does Ripple work?

To understand the ins and outs of this success story, it is worth noting that, unlike many crypto-currencies, the XRP is grounded on a real asset. It is at the same a real-time gross settlement system (the Ripple Protocol), currency exchange and remittance network. It is also grounded on a clear and ambitious goal: revolutionizing the system of cross-border payments by providing a cheaper, faster and frictionless alternative to the SWIFT one.

Then, how does the Ripple Protocol work precisely? Ripple functions as a digitalized bill of exchange which is able to accept any input (dollars for example) and to convert it into any outputs (Indian rupees for example). Let’s remind how a bill of exchange works with the following example: John wants to pay 100 $ to Cathy who lives in another country. John will give the money to its local agent, William and ask him to send the funds to Cathy. Then, William will contact Cathy’s agent, David, to release the funds to his client. We see here that money does not move physically from one place to another: John’s agent owes 100$ to Cathy’s agent. David can either record a journal of all William’s debt or IOUs[3] which William would pay on an agreed day, or make counter transactions which would balance the debt.

Now let’s go back to Ripple. It is a network in which agents are replaced by “gateways”, which serve as credit intermediaries between two parties. In addition to the gateways accounting book, there is a global ledger in which all transactions are recorded and updated. To write the transactions on this global ledger, the protocol mandates that a set of validator nodes approve or deny the transactions they observe, and only the transactions that are approved by a supermajority of nodes are allowed to be part of the next ledger. To sum up, the consensus is reached through the following steps[4]:

  1. A transaction is submitted to the next candidate ledger.
  1. Each network node evaluates proposals from “N” peers à Consensus is an iterative process in which nodes relay proposals, or sets of candidate transactions. During consensus, each node evaluates proposals from a specific set of peers, called chosen validators.
  2. Nodes communicate and update proposals until a supermajority of peers[5] agree on the same set of candidate transactions.
  3. The network recognizes the new validated ledger.

Source: https://ripple.com/build/xrp-ledger-consensus-process/

Here comes a major difference between private and public blockchain. Public blockchain is typically the technology used by cryptocurrencies like Bitcoin. It was invented so parties who don’t know each other and don’t trust each other could transact thanks to the proof of work. The proof of works defines the requirement for the generation of a new set of transactions (« block ») to be added to the distributed transaction database (« block chain »). To be confirmed, transactions must be packed in a block that fits very strict cryptographic rules that will be verified by the network. This process appears as mathematical problem to be solved in order for the transaction to be processed. The network consists of miners which compete to solve this mathematical problem by providing their calculation power, to obtain a monetary reward (mining fees paid by the sender of bitcoins to complete his transaction). Once a sufficient numbers of miners agree on the transactions, it is validated and added to the public block chain. The proof of work is very difficult to produce because it requires a great power calculation which comes from the thousand miners but it is easy to verify. This dual property of the proof of work makes it unfalsifiable because 1) it is virtually impossible to produce a fraudulent block since it has to be validated by the entire network 2) producing a fraudulent block would require the entire computation power of the network which is impossible.

Ripple works differently because it is based on private blockchain. Instead of decentralized miners which verify the transactions through the proof of work protocol, the transaction validators, need to be on boarded and accredited to join the ledger. Their identity is known to everyone and they act as validators not because of their calculation power but because they are known as trustful by all the network[6]. This explains why Ripple transactions are so quick (some seconds) compared to bitcoin (10-15 minutes): the validators don’t have to produce this difficult and time consuming “proof of work”[7]. Bitcoin works in a trustless environment (the consensus on transactions is mathematically produced)[8], whereas Ripple works in an environment in which the validators have this function because they are trusted[9]. This is a very important point to underline because it is at the same time a weakness of the Ripple (mathematical proof seems more reliable that human entities) but also a strength because it meets the compliance requirements in banking industry. This is the case because the transactions validators are publicly known, have a sort of “license” to perform their job, so there are accountable to justice (they can be prosecuted whereas bitcoin’s algorithm cannot). That is also why Ripple’s strategy focuses on building confidence in its own system.

Building confidence in a disruptive technology

As technology does not suffice in itself to succeed, Ripple’s focus has already been on conquering the trust of big financial players. It has signed more than 100 partnerships with major actors from the payments industry (American Express), from the banking sector (UBS) and with State Institutions (The Central Bank of England for example). As a consequence, Ripple’s marketing strategy aims to build confidence which is the key in financial innovation (is it necessary to remember that the word “finance” comes from the latin “fiducia” which means confidence ?). The storytelling of the Ripple plays on the contrast with the crypto-world, which appears as bullish, fevered and obscure to governments and financial institutions. As Brad Garlinghouse, Chief executive of Ripple, puts it “There are a lot of blockchain tourists out of there who are kicking the tyres, but we are well beyond that”.

To enhance confidence, the board of directors also enrolled major characters from the finance galaxy: Zoe Cruz, which was the president for institutional securities and wealth management at Morgan Stanley and Benjamin Lawsky, the former superintendent of financial services for the state of New York[10].

A clear goal: revolutionize the payments industry

Today, the international payments industry is built upon two different pillars: the clearing houses on the one hand and Swift on the other hand. It is important to remind that the Swift system does not transfer funds from one account to another. Rather it sends payments orders, which must be settled by correspondent accounts that the institutions have with each other. It is the role of clearing houses to secure at the end of the day that each bank has all transactions properly cleared and any pending credit or debit among different banks is reconciled[11]. The current system has two major flaws. On the one hand, it is quite expensive, as the market is concentrated and ruled by an oligopoly of large firms. On the other hand, it is quite slow. Actually, a cross boarder wire through Swift takes between 3 and 5 days.

Drawing on this market situation, Ripple lab has built its competitive advantages. First, the XRP enables payments of any size for the lowest possible cost on the markets: $0.0007 fees compared to the $1.43 of the bitcoin and the $2 of visa fees[12]. Second, Ripple proposes an integrated solution for payments by enabling the conversion of one currency to another. Ripple’s gateways allow deposits in some of fiat currencies (USD, EUR, NZD, GBP…), a handful of cryptocurrencies (BTC, LTC, NXT…) and a few commodities (gold, silver, platinum). Then, Ripple’s path-finding Algorithm searches for the fastest cheapest path between two currencies. This payment protocol enables to convert, transfer, and reconcile the bank account at the same time: that is why the Ripple Protocol is also extremely quick. Through the XRP, a cross-border money transfer will take place within 4 seconds. While being more comfortable, it is also a way to reduce liquidity and credit risk.

A strategy relying on low entry costs

Upon these competitive advantages, a marketing strategy grounded on cost-cutting has been set up. To enter this concentrated market, the San Francisco based start-up offered the “Ripple Net Accelerator program” which allocate up to $300 million to create incentives to accelerate adoption of XRP. In other words, Ripple is paying the Banks to accelerate the use of its program. Second, the XRP remained at a very low price (less than $0.10 from 2012 to the first half of 2017) which was very attractive for the Banks[13]. Finally, Ripple has set up a two-sided market strategy[14]. The first tool is the software, XCurrent which enables the banks to make instant cross-border payment. But instant payment with longtime settlement makes no sense. This is where the XRP comes in, to enable instant settlement. How does the XRP work precisely? It acts as a universal bridging currency. So if John has USD and wants to pay Cathy’s in EUR, the Ripple algorithm will find the best rate to convert John’s USD to XRP and the best rate to convert your XRP to EUR. That also means that the reserves held up in nostro/vostro accounts are freed up because of the instant conversions. It is cheaper than the current payment system in which a Bank in the US should have currencies reserve with correspondent European banks in nostro account, to make the cross-border payment possible[15].

A difficult and hard road ahead for the young start-up

However, the route to success may be tough for the Californian start-up. The first threat to the Ripple is its high volatility. Although it remained quite stable for a long time, it has been conquered by the speculative fever of other crypto currencies. As a consequence, the XRP seems to be completely overpriced at the moment. Even if promising tests have been conducted by major banks for cross boarder payments, the Ripple protocol is still used by a few and, at the moment, for internal use only. Although the growth of Ripple is not entirely correlated to bitcoin, we can ask ourselves what the impact of the cryptocurrencies bubble broke would be on Ripple. Besides, the long effort of lobbying has to be pursued because the value of the XRP relies on the so-called “network effects”. It will be valuable if it is used widely.

Another attention point will be the reaction of competitors. SWIFT has recently launched its Global Payments Innovation Initiative (GPII) which includes a set of rule to fulfill at best compliance obligations (tracking payments and data monitoring). It will be hard for Ripple to challenge such established and renowned competitors in the context of a market characterized by numerous barriers to entry.  The adoption of Ripple will require the Banks to re-think and reshape entirely their payment system which is not an easy task. The first step was building a reliable technology, the second was building confidence but the third to come is wider: transforming the banking industry and change habits. Moreover, we can imagine that new actors will enter the market. The most serious competitors might not be private company; it could be the Central Banks introducing their own crypto-currencies.

Finally, despite of its competitive advantages, the success of the Ripple hangs by a thread, the one of security. It suffices that some hackers achieve to find a breakdown in the system and the confidence will be ripped apart. In fact, trust is like a house of cards: difficult to build, but easy to destroy.

[1] https://www.ft.com/content/2f595696-ecb4-11e7-bd17-521324c81e23

[2] https://www.cnbc.com/2017/12/29/ripple-soars-becomes-second-biggest-cryptocurrency-by-market-cap.html

[3] https://www.investopedia.com/terms/i/iou.asp

[4] https://ripple.com/build/xrp-ledger-consensus-process/

[5] The supermajority threshold, as of November 2014, requires that at least 80% of peers must agree for a ledger to be validated

[6] https://coins.newbium.com/post/8486-ripple-s-private-blockchain-moves-towards-decentra

[7] https://ripple.com/build/xrp-ledger-consensus-process/

[8] https://keepingstock.net/explaining-blockchain-how-proof-of-work-enables-trustless-consensus-2abed27f0845

[9] http://sammantics.com/blog/2016/3/6/how-transactions-are-validated-on-a-shared-ledger

[10] https://ripple.com/company/board-of-directors/

[11] http://immutable.today/what-is-ripple/

[12] https://steemit.com/cryptocurrency/@lennartbedrage/the-ripple-xrp-effect-fundamental-analysis

[13] https://www.coindesk.com/ripples-xrp-giving-third-largest-cryptocurrency-second-look/

[14] https://www.coindesk.com/ripple-medieval-banking-digital-twist/

[15] https://www.youtube.com/watch?v=wqpOX6vDD3E&feature=youtu.be