What is Ripple and XRP?

One of the major failings of modern commerce is that it takes longer to send money across borders than it does to send a FedEx parcel. If an email takes a second to reach the intended recipient on the other side of the planet, then why does money take days? The reason is that the incumbent payments infrastructure is unnecessarily convoluted and siloed involving way too many fees and time-guzzling intermediaries.

This is the problem that Ripple and XRP seek to solve. Just like the internet uses a standard set of rules called HTTP (HyperText Transfer Protocol) to transfer information, Ripple uses a standard set of rules called RTXP (Ripple Transactions Protocol) to transfer value.

Ripple and XRP are not the same

First, it is important to know that Ripple and XRP are not the same. This distinction is important because I end the article with the conclusion that Ripple is doing admirable work but XRP is a cryptocurrency with limited utility.

* XRP is the native token of the XRP ledger.

* Ripple is a private fintech firm that offers enterprize level distributed ledger technology to financial institutions and payment processors. It was involved in the development of XRP ledger and is the largest holder of XRP tokens.

XRP ledger can process a transaction in 3-4 seconds and has the capacity to process 1500 transactions per second (tps). To compare, Bitcoin and Ethereum can process 7 and 15 tps respectively. XRP claims that it will be able to match Visa’s 65,000 tps standard in the future. The transaction fee is 0.000001XRP. This amount is charged only to stop someone from spamming the network. The transaction fees are burnt making XRP a deflationary cryptocurrency.

How does it work?

Unlike Bitcoin blockchain which can only be used to transfer bitcoin payments, Ripple can be used to transfer payment in multiple assets.

The Ripple network can be used to send 2 types of tokens:

1. IOUs

2. XRP

1. IOU is a type of debt using which one can transfer any asset (crypto or fiat or gold or credit card points). Any participant in the Ripple network can issue IOUs. An IOU itself is not an asset but a promise to give the creditor the asset in the future. It represents something you owe. So if when you receive an IOU, you have to trust the person to pay you back in the future.

This is not very different from how the banking system works. When you deposit money with a bank, it means that the bank now owes you and you trust that the bank will pay you back.

This makes it very different from bitcoin and other cryptocurrencies though. The cryptocurrency philosophy of “Verify. Not trust” means that one shouldn’t need to trust the other person or have to depend on any law enforcement agencies to get someone to behave. The incentive mechanism of the protocol itself gets people to behave.

2. XRP is the native token of Ripple network. Instead of using the convoluted international payment mechanism involving SWIFT, correspondent banks, Fedwire, clearing houses etc, to transfer funds which takes days, one can transfer funds almost instantly using XRP. All one has to do is convert fiat to XRP, send XRP using the Ripple network and then convert XRP to the receivers native fiat currency. It is a lot more capital efficient than the current system. XRP is an asset and not a debt like an IOU. It represents final payment and hence does not carry counter-party risk. However, XRP is quite volatile and banks might therefore prefer to transfer funds using IOUs.

Consensus Mechanism and Security

XRP does not use proof-of-work or proof-of-stake that is used by most cryptocurrencies. Instead, it uses a unique consensus mechanism where participants verify the authenticity of transactions by conducting a poll.

A network of computers called Validators maintains the ledger. Anyone can become a Validator. When an XRP transaction is broadcast to the network, Validators vote on if the transaction is valid or not. If 80% of Validators vote valid then the transaction is added to the XRP Ledger. Validators consult with select trusted Validators called Unique Node List (UNL) to see if the transaction is valid. Each node decides on its own UNL list but a default list of trustworthy Validators is provided by Ripple anyway.

Unlike Bitcoin or most other cryptocurrencies, the Validators do not get paid anything for providing the service of maintaining the network - no block rewards and no transaction fees. While this ensures that the cost of transactions is minimal, it compromises the security of the network.

This is not to say that there’s no reason other than altruism to become a Validator. If you’re a financial institution or payments provider using the Ripple network, then it is in your interest to ensure reliable functioning of the network and hence you’re likely to conscientiously run a node. Having said that, XRP lacks the kind of collaborative yet antagonistic relationship that different participants (nodes, miners, developers, users) of the Bitcoin network have that keeps the network secure.

Also, since Ripple provides a default UNL list, any Validator that joins can simply accept the recommendations of the default UNL. Many of the nodes in this default list are run by Ripple. This makes the network at best highly centralized and at worst susceptible in case the Ripple nodes get compromised. Bitcoin’s economic incentives are what make bitcoin the most secure payment mechanism and XRP lacks that.

Tokenomics

A. Distribution

XRP was launched in 2012 when 100 billion XRP tokens were pre-mined.

• 20 billion XRP were given to the founders- Chris Larsen and Jed McCaleb received 9.5 billion XRP each and Arthur Britto received 1 billion XRP.

• About 45 billion XRP (including those with founders and publicly held by Ripple Labs) are in public hands.

• A single entity, Ripple Labs controls the rest of the roughly 55 billion XRP which is locked in escrow.

B. Demand and Supply

I mention below the aspects that impact the price of XRP

• Utility Demand from financial institutions - that use XRP to facilitate payments is a strong use case. Ripple Labs boasts of over 300 financial institutions and payment providers as customers. These include top-tier names like American Express, Bank of America, Standard Chartered, and Santander among others. This is the only true use case for XRP. The problem though is that these institutions are not buying XRP from the open market but instead from Ripple directly. Also, banks may prefer to use IOUs to transfer funds instead of XRP in which case XRP becomes superfluous to the project.

• Released from Escrow - 1 billion XRP is released from escrow every month and Ripple Labs decides on what to do with it. It regularly sells some of the released tokens in the market. Ripple is criticized for these sales as it amounts to the creators dumping their own tokens.

Brad Garlinghouse, CEO has justified the action saying that Ripple would not be profitable or cash flow positive without selling XRP. This is probably a red flag for anyone planning on subscribing to the Ripple IPO, if it happens.

• Dwindling Institutional Investor support - Exchanges had removed it from their platform after the SEC lawsuit. Grayscale has dissolved its XRP Trust because of the SEC Lawsuit. Even before dissolution, XRP Trust didn’t attract much AUM (Assets Under Management). A favourable ruling will bring XRP back to exchanges but institutions might continue to keep a distance.

• Founder sales - Founder Jed McCaleb left the project in 2013 due to differences in vision and started a rival cryptocurrency called Stellar Lumens. He had originally been allocated 9.5 billion XRP which he has been selling continuously. Limits have been placed on him on how many XRP tokens he can sell. $10k worth per week in year 1, $20k worth per week from year 2 through 4, 750 million XRP per year in year 5 and 6, 1 billion XRP in year 7 and 2 billion XRP after year 7. This represents a big risk. This could easily be higher than utility demand from financial institutions.

SEC Lawsuit

The SEC filed a lawsuit against Ripple in Dec’2020 accusing it of selling unregistered securities worth $1.38 billion. Following this several exchanges suspected trading in Ripple and Grayscale disbanded its XRP trust. Ripple also had to pause its relationship with Moneygram representing billions of dollars in on-demand liquidity.

Centralization

Though supposedly decentralized, XRP has several characteristics that make it centralized.

• It is operated and managed by a private institution, Ripple.

• Ripple Labs determines what will be done with the 1 billion XRP tokens released from escrow every month.

• Many of the Validators in the default Unique Node List (UNL) are under the control of Ripple Labs.

• Ripple CEO has said that he is open to ideas good for the network like burning a sizeable portion of XRP held in escrow. The fact that a unilateral decision like that can be taken by one party is an indication of centralization. How is this different from a Central Bank taking the decision to print more currency because they believe it is for the good of the system? This is a huge contrast to the Bitcoin ethos.

Final words

Net-net, I believe that Ripple the company is doing important work in the payments sphere. The project may not be decentralized or have the same security and immutability as bitcoin but not everything must. Ripple serves a different purpose of executing quick payments using distributed ledger technology, and that makes it a worthwhile project.

But XRP the token is almost superfluous to the project. It is basically used to prevent spamming of the network and can be used as a bridging currency if the users choose to.

Summary of differences between XRP & BTC

• BTC can transfer value only in BTC, while XRP can transfer any type of value in addition to XRP.

• BTC is aimed at retail customers while XRP is for institutions

• BTC miners get paid a block reward and transaction fees for maintaining the network. XRP validators do not get paid anything.

• BTC is censorship resistant but Ripple commits to monitoring and reporting AML red flags

• BTC mining is energy-intensive while XRP has minimal carbon footprint.

• No single party can control BTC or exercise an outsized impact on it. Ripple can influence decisions for XRP.