Source:
https://publication.widmerdun.com/how-ripple-could-succeed-but-xrp-be-worth-nothing-4c2c5152d184
How Ripple could succeed but XRP be worth nothing - Correspondent banking, disruption and confusing offerings.Ripple is probably one of the most misunderstood Blockchain companies out there. This is partly due to the company’s confusing set of offerings and the pivots they have undergone[1]. Add that to the fact that international banking is complex, and you have a situation ripe for confusion. To really understand what Ripple does we need to take a quick look at its history and the problem it is trying to solve.
Ripple (officially Ripple Labs) was founded in 2012 and now has over 150 employees. Since then it has raised over $90 million dollars from investors including Andreeson Horrowitz and Google Ventures.
Ripple’s initial vision was to build a ‘better Bitcoin’ — focussed on banking — with over 1,000 transactions per second and a short block time (time to confirm transactions). This resulted in XRP. Ripple was also developing what can be described as “SWIFT 2.0”. You’ve probably heard of SWIFT in the context of a SWIFT bank transfer. We’re going to dig through how those two things fit together and why it matters. But first, we’re going to have to look at how money moves through the banking system.
Bank Transfers Within a CountryWhen we want to send money across banks, we are saying that we want one bank’s balance to go up and the other’s to go down. We want this to happen in a verifiable way. Luckily, all banks in a country hold an account with the Central Bank. This is a trustable third party. If JPMorgan Chase wants to send money to Wells Fargo they can use the fact that they both hold an account with the Federal Reserve. JPMorgan Chase messages the Federal Reserve to tell them how much they want to transfer and the Federal reserve simply deducts that amount from their account and adds it to Wells Fargo’s. Money has moved. This is called a real-time gross settlement system. In the US this system is called Fedwire. It’s instantaneous but expensive.
If we didn’t need the transfer to happen in real time, another option would have been to collect all the transfers that happened in a day and then settle the net amounts with the Federal Reserve at the end of the day. This is known as a deferred net settlement system. An example is the ACH (American Clearing House). Most countries have variations on both of these systems[2].
International Bank TransfersA challenge arrives when we try to do an international transfer. Let’s say Barclays in England wants to send money to RBC in Canada. Unfortunately, they both don’t share an account at the same Central Bank, so they cannot just transfer funds. What they use is a sort of trick. Barclays holds an account with RBC and vice versa. Each has a certain balance in it, and basically shows how much money each bank owes each other. These can be thought of as IOU’s or promises. When funds need to be transferred the banks can just adjust the numbers in these accounts accordingly. In practice these changes are not made in real time, but are settled at some interval decided by the banks. The banks must also decide on exchange rates and bank fees (sometimes called the bene deduct fees).
Now, RBC and Barclays are both large banks and they hold correspondent accounts (also called nostro and vostro accounts) with each other. But suppose we wanted to send money, from Small Bank A in England, to Small Bank B in Canada. These banks don’t have correspondent relations with oversees banks. What they need to do is execute their transfer through larger banks such as RBC and Barclays. Here’s how the steps might look:
Small Bank A would use CHAPS (a deferred net settlement system of England) to send money to Barclays.
Barclays initiates an ‘international transfer’, through its correspondent bank in Canada, by sending them a SWIFT message. RBC then debits the account Barclays holds with them.
RBC uses ACSS (a deferred net settlement system of Canada) to send money to Small Bank B.
The above process would likely take 4 days to complete. In some cases there can even be more than two correspondent banks. Note that in the ‘cross border’ step, money doesn’t actually move. This step is also structured around whatever agreement the two banks have come to. This includes fees, FX rates and settlement times. Remember this, as it will be important for later.
SWIFTSo how does SWIFT come into all of this? SWIFT stands for the Society for Worldwide Interbank Financial Telecommunication. They are a cooperative that run the SWIFT network. The SWIFT network allows banks to securely send electronic messages to one another. It’s a standardized way for Bank A to tell Bank B that they want to send x amount, from Alice’s account in Bank A, to Bob’s account in Bank B. Think of it as the language that all banks can understand. Once a bank receives a SWIFT message, it can start the process described above. Note that the SWIFT message does not send any funds, it is only an instruction[3].
SWIFT charges banks to use the network and also sells them software. The SWIFT system, however, is fairly antiquated. This year a security vulnerability resulted in over $81 million stolen because of fraudulent SWIFT messages. It’s a system ripe for disruption. So let’s look at how Ripple is competing with SWIFT.
Ripple and xCurrentRipple’s answer to SWIFT is xCurrent[4]. Think of it as a more modern and efficient SWIFT. Banks using xCurrent opt into the Inter Ledger Protocol (ILP), this integrates with banks current ledgers and keeps track of the credits, debits and liquidity across all parties, in real time.
The advantages of xCurrent come from the fast, two way communication protocol. Instead of a one way SWIFT message banks can now share information like fees, FX rates, risk information and KYC (know your customer) information. This two way information sharing means the network can find the best path for a transaction. The increased transparency should result in lower fees and more reliable transfers. Banks can now get a good estimate of the total cost, and path, of a transfer before it occurs. This was not possible in the old system. Transfers can also be tracked at any stage.
Another large cost savings supposedly occurs because the cross-border part of the money transfer is now instantaneous, instead of two days. When banks have correspondent accounts with each other they have to lock up capital to prove that they have the liquid assets to make the ‘transfer’. This idle capital is known as the liquidity cost and is a negative for banks as there is an opportunity cost to having money sitting there doing nothing. The supposed savings using Ripple (xCurrent) are shown below.
One big catch with xCurrent is that all banks need to have opted into it in order to communicate with each other. Network effects are important.
You may have noticed that XRP is not mentioned at all here. That’s because xCurrent doesn’t use XRP. In fact, when you hear about banks adopting Ripple, what they’re really trying out is xCurrent (in fact Ripple and xCurrent are sometimes used interchangeably). So how does XRP fit into this then?
What about XRP?XRP is the idealized solution to money transfer problems. Wouldn’t it be easier if instead of holding correspondent accounts in multiple banks and currencies around the world, banks could just hold XRP themselves and use it to make international transfers[5]? XRP would be a globally accepted currency that could be sent instantly anywhere in the world. Ripple calls this service xRapid, and there’s surprisingly little information about it available from Ripple.
XRP and xRapid would integrate with xCurrent to bring large savings and efficiencies to banks. Banks would no longer need correspondent accounts and could just settle by sending XRP. This would completely turn the current system on its head. The supposed cost savings are shown below.
The path to XRP becoming the universal bridging asset, as described above, is not a simple one. It depends on a couple of key assumptions, liquidity and stability.
Banks don’t want to just hold their XRP, or that would be no better than the old system, where capital was lying idle. The cost savings depend on the ability of banks to find liquidity. That means, if a bank in India receives XRP and they want to be able to trade it for Rupees they should be able to do that on an exchange. Banks also want the price of XRP to be relatively stable, or the risks during transfers would be too high. For XRP to be stable there has to be some price the market settles on for one XRP. This is determined by the demand and supply of the asset.
As we have seen above, banks don’t really want to hold XRP. It is not an investment, but a settlement mechanism. Because of this it doesn’t matter to them if one XRP is worth 5 cents or 5 dollars. Banks want to buy it, send it and then the receiver wants to convert it into a government currency. But who is on the other side of the order book? According to Ripple there will be Market Makers on the other side who are incentivized by profits from trading XRP and currency pairs. The details of how this would work are vague at best.
So, how does the price of one XRP get determined? Right now it is determined by speculators on crypto exchanges. In the long term speculation cannot be the driver of value of XRP. XRP could derive value from people’s beliefs, in the same way as Bitcoin, however, this is unlikely as Ripple’s customers, the banks, are unlikely to be motivated by beliefs and ideals.
The last way XRP could derive value is from the cost savings it provides to banks. Say banks could save $10 trillion a year by using XRP, this would create an underlying demand for XRP that would determine its price. Unfortunately the cost savings provided by XRP are not very high when compared to the risks of adopting it. In the best case scenario XRP would save banks an additional 33% over xCurrent. XRP cannot just be marginally better, but must be an entire league above the existing system in order for banks to adopt it. Would banks really want to take the risk of investing in a new digital currency for what is likely an extra 15% of savings?
If XRP were the status quo, it would certainly have some stable value as all business would be done in XRP. However, it faces a huge energetic barrier in getting to that position, and realizing network effects. It is going to be very difficult for XRP to overcome the current system and become a universal bridging asset. Creating a global currency that is not backed by a state is not easy.
Next StepsRipple has had some success with banks adopting xCurrent, with over 75 banks deploying Ripple. Ripple may very well succeed as a company and disrupt SWIFT, but that does not necessarily mean that the XRP currency will succeed as well. In fact, the company may have to pivot away from that old business model. In this scenario XRP is like an unwanted creation, which Ripple and crypto investors will have to deal with.Source:
https://publication.widmerdun.com/how-ripple-could-succeed-but-xrp-be-worth-nothing-4c2c5152d184
